There are no shortages of economic fallacies among the mainstream media. Political pundits are so eager to opine on every possible issue despite of their own intellectual shortcomings. These pundits often epitomize the intellectuals who only judge on what is seen.

Few have been as appalling on the issue of oil prices as Bill O’Reilly. O’Reilly has engaged in a hyper populist crusade against Big Oil, speculators, and their alleged price gouging. For months he has been decrying the record profits of big oil and their incessant exploitation of the little guy.

After President Bush announced that the ban on offshore drilling would be lifted, oil prices dropped immediately. Bill asked, how can this be? No additional oil has entered the market. This obviously can’t be simple supply and demand. No this must be price gouging.

This is an issue that has become increasingly frustrating for me. In order to end it once and for all, I am going to present the simplest and most easy to understand analogy.

Price are not determined by how much supply is currently in the market, they are determined by how much supply is expected to be in the market.

How can this be?

Suppose Elton John is coming to town. You love Elton. I mean you really love Elton. There is nothing more you could want than to see him rock out. The problem is that all the tickets are already sold out.
You are desperate so you approach a ticket scalper to remedy your situation. He offers you a ticket at $100 a piece. You know that this is a little steep- only a few days ago prices were $85 from the scalper and a week ago $50 from the actual concert venue,. But demand is high and supply is getting lower and lower and you reluctantly agree.

Right before you hand over the money your best friend calls you and says, “Guess what! The Rocket Man is going to release 5,000 more tickets tomorrow at $50!”

So what do you do?

Do you buy the ticket at $100 or $50? The very instant that you received the price information the market price for tickets dropped. Tickets went from $100 to $50 in an instant- even though no additional tickets have entered the market that night. The supply remained unchanged and the market price changed even though no tickets have even been printed yet! How can this be?

It happened because prices are not determined by the physical supply of goods, but by the expected supply. It didn’t matter that the tickets had not yet entered the market; you knew they would and therefore reasoned accordingly.

Oil is much the same way. When a ban of offshore drilling is lifted, it signals to the market that supply will increase. Speculators will want to avoid losing money and bet that the market prices will began to drop and firms that purchase future contracts will do so at a lower price.

It always comes back to the fundamentals: supply and demand. It always comes back to seeing what is the unseen…

Thank you Bastiat.