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Oil and Broccoli

Oil is an essential input into everything. Therefore, if the “price” of oil increases, it has to be the case that the price of everything else increases. For example, if oil prices rise, then gasoline prices rise, and since we need gas to make fertilizer and to harvest and clean broccoli, then broccoli prices rise, and since broccoli is an ingredient in many dinners, dinner prices rise, and so on and so forth.

What is wrong with this story? Well, it confuses a change in relative prices with a rise in the overall level of prices. Given a fixed amount of goods and ability to produce, the only way the price of everything can rise is if there is an increase in the amount of purchasing media available to purchase the same stock of goods. If there is no more money around, then it is not possible for prices to rise.

However, if the stock of money is unchanged, and somehow it becomes more difficult to produce the goods and services we desire (say, for example, by having some benevolent organization increase regulations required to be met when you decide to produce), then certainly prices will rise across the board.

But my suspicion is that when you hear a comment like, “increases in oil prices will lead to inflation” people do not have either of these stories in mind. They simply believe in a weird “cost-price” spiral that spins out of control and we are all forced into crazy starvation unless the government comes in an puts on some price controls, or starts producing the oil and broccoli itself.

So what is wrong with the simple cost-price spiral story?

Well, it conflates the idea of relative prices with nominal prices. Put simply, if there is a fixed stock of goods around and a fixed stock of money, if the price of oil increases, it has to be the case that the price of something else must fall. Why? Well, if consumers continue to buy the same amount of oil, that leaves them with less purchasing media to buy the remaining stocks of other goods, meaning the purchasing power of the remaining media are higher – leading to lower prices outside of oil. In other words, unless the government runs the printing presses when oil prices increase, it would be odd to expect the prices of other things to increase. I am definitely leaving out important parts to this story however.

To make the point clearer, suppose the world was limited to two goods: oil and broccoli. And that one hour of work effort produced ten units of broccoli and one hour of work produced one unit of oil. In other words, the “price” of one broccoli is 1/10th of a unit of oil while the “price” of oil is 10 broccoli’s in the very real sense that if I dedicate an hour of work to one, I am giving up an hour of work where I could have produced the other. So, what does it mean if oil gets more expensive? It would mean that with an hour of work effort, I could secure less oil than before (there are many reasons this might happen). Imagine this happens. Now, with one hour of effort, I can produce only 1/2 a unit of oil but with that same effort I still could have produced 10 broccolis.

What has happened to prices after this oil shock?

Now, the price of oil has indeed risen. It has risen from 10 broccolis to 20 broccolis, just as “conventional wisdom” would suggest. But now, what has happened to the price of broccoli? It has fallen. With the time required to get one broccoli, you are now only sacrificing 1/2oth of a unit of oil instead of 1/10th of a unit. In other words, relative prices change.

Note however that this does not imply that the oil price increase makes us better off. But what it does mean is that not all prices increase because the oil price increases. If they do, that is a sign that Santa Claus is not playing nice. But we would never expect that to happen, right? So it just has to be the case when we see an adverse shock, that markets must make then worse, allowing the chaotic, no one in control market to fend for itself would result in some crazy, anarchic price spiral of everything, where Uncle Sam the cowboy must come in a lasso it back for the good of the world.

7 Responses to “Oil and Broccoli”

  1. Speedmaster says:

    Great post. I distinctly remember, in 12th grade and as an undergrad, being taught about both cost-push and demand-pull inflation. But in the last 5 years I’ve come to understand inflation the way you have presented it, largely thanks to Mssrs. Hazlitt & Friedman. I would love to see you comment on the cost-push/demand-pull arguments.

  2. Harry says:

    Yeah, great post. A good section in a chapter for your upcoming book.

  3. Harry says:

    It would be great to hear a debate between advocates of a broccoli dollar, an oil dollar, a labor dollar, a gold dollar, a paper dollar, and a commodity dollar. Maybe the proposition should be,”A fiat currencey is the best way to produce price stability.”

    Don’t knock a broccoli dollar. For the nutrition police, it is a store of value.

  4. Harry says:

    Sorry to clutter your blog, wintercow, but regarding your metaphor of Uncle Sam the cowboy with the lasso, that’s a good one. Uncle Sam first opens the barn, cuts the barbed wire, and after a few weeks of partying realizes the cows are gone. He next goes from Abilene to Denver for a conference, and consults with dudes who came in from Jackson Hole. He consults with Parisian cowboys, and his staff issue reports. Some time later he gets on his horse and rides back to Abilene, goes to the saloon, and complains to the bartender that the price of oats is too high because of some bastards in Dodge City. He goes back to the ranch, picks up his lasso, and ropes his neighbor’s steers and rebrands them, ships them to Omaha, and sells them at a price he complains about because of unfair competition from Iowa farmers.

    In this story you could digress by telling the old joke of a jackalope walks into a bar in Cheyenne and asks the bartender for a bowl of broccoli….

  5. BJS says:

    Am I mistaken when I say that historically when oil prices rise inflation often does as well? I believe that is the case. It seems that is a correlation rather than a causation, but then I wonder why that is?

  6. chuck martel says:

    I’m both a consumer and a producer. let’s say a fisherman, and I buy diesel fuel to operate my trawler to catch the fish I sell. For a normal trip I would buy 500 gallons of diesel at $1 per gallon. On this trip I would catch 500 fish that I would then sell for $1.50 each. Ergo my profit on the trip would be $250. However, if the price of diesel goes to $2 per gallon my trip would entail a loss of $250. Or more, if the price of fish goes down because the price of oil has gone up. Obviously, I’ll no longer be able to fish. My catch will no longer be part of the supply of fish to consumers, there will be less fish available in the market place, not only mine but across the industry. So, according to your theory, even though there is less fish available, the price shouldn’t increase because the price of oil has. The cost of production has increased to the point that the business is no longer profitable. This is actually occurring in fishing and similar businesses. How does that fit in with your posting, or does it?

  7. Harry says:

    BJS — while I do not wish to speak for professor wintercow, the point is that the rise in price of anything does not imply inflation, which is by definition a rise in all prices, which is another way of saying your currency’s value has diminished. Throughout history inflation has been a problem, long before we drove cars or heated our homes with #2 heating oil. It is impossible to find any coin with any Caesar’s likeness in any museum that has not been clipped.

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