Monday, September 27, 2004


Here's a brief economics lesson.

Two goods are substitutes if one can be used more or less in place of the other, at least for some uses. Some common textbook examples of this are margarine and butter, chicken and steak, movies and video rentals, and CDs and cassettes. In some cases, consumers might strictly prefer one or the other, but more commonly, people prefer to consume some combination of substitute goods. Stated differently, it would take a lot of just one good in order to make you as happy as when you're consuming some combination of the goods. This makes sense; most people split their entertainment budget between videos and movies, and if they couldn't watch movies, you'd have to give them a lot more video rentals to make them as happy as they would have been before.

If you want to define a consumer's utility function on the two goods, you could write it as a function of the amount of two goods consumed, say U(x,y). In this case, there are two goods, X and Y, and U is some function of those two. Now, U can take many functional forms, and the forms it takes says a lot about the two goods X and Y. For example, it might be that the two goods are not substitutes, but are in fact compliments. Complimentary goods are goods that we only care to consume together; the textbook example of this is left shoes and right shoes. Consuming a thousand left shoes and four right shoes makes you exactly as happy as four left shoes and four right shoes (assuming you have two feet).

The greater U(x,y) is, the greater utility the consumer is experiencing from X and Y. For most goods, the greater x and y are, the greater U will be (but again, this is not necessarily the case; it's not hard to think of "bads," which make you less happy the more you consume). The problem for a consumer is that they have a constraint: a limited amount of money. So the problem is to maximize utility within the budget constraint. Consumers are probably pretty good at this, since they know what their preferences are, even if they don't think about the problem in this way.

So what happens if one of the two goods becomes more expensive? If the goods are close substitutes, then the consumer can substitute the other good for the one that is increasing in price. If the price of steak goes up, you might eat chicken more often; if movies get more expensive, you might rent more often and wait for marginal movies to come out on DVD.

So here's what I really wanted to talk about: oil. The financial markets are once again very concerned about rising oil prices, and with good reason. I have yet to be convinced that we're at "peak oil" or anything like that, but there are other factors. The rest of the world is rapidly industrializing. China's economy has been growing at a breakneck pace, and so has their demand for oil. This year, China replaced Japan as the world's #2 oil consumer, and there doesn't seem to be much that's going to stop this over the long term, as their year-on-year increase in oil usage drawfs that of the United States. And it's a good thing, really, that the standard of living of people in China is increasing.

However, there's almost no scenario in which this doesn't result in higher oil prices for the rest of the world. We're not talking about an oil shock like in the 70s, when OPEC decided to produce drastically less oil. We're talking about a longer-term change in the market for oil, where more countries are trying to buy more oil. OPEC might increase output, but probably not by enough to offset this effect (of course).

So Americans' gas prices are going to increase over the long term. In the past, this meant we were basically screwed, as there's no close substitute for gasoline for our cars. However, now there is an increasingly viable substitute for oil: the accumulated technological knowledge that goes into the production of gasoline-electric hybrid engines. Right now we consume very, very little of that, but as oil becomes more expensive, consumers will increasingly lean on the capital that goes into high-efficiency engines in order to stay as close to neutral in utility as they can.

So if you're looking for a potential future growth industry, look at companies and technologies that will benefit from this, and invest in them. Or if you think you can do better, invest yourself in research that might improve the state of the art so you can make millions of dollars.

Peak oil will probably happen in the next decade. So, in ten years, look back at it. The thing is, we won't know we've reached peak until it's already happened.

I find it shocking the number of liberals and environmentalists who complain about higher gas prices: If you want people to drive less, and stop purchasing Hummers and (the normal kind of) SUVs, higher gas prices is perfect.

As for energy, I invested in the Vanguard Energy Fund. It's been doing so well this year that Vanguard wanted to keep out speculators (or something like that) and raised the minimum purchase amount to $25,000 (it used to be $3,000). Both the energy and REIT funds have been doing very well, while other stocks have been flat these past six months.

Now, just imagine nanotech cars, with bodies and "cages" so strong that safety is superb and the material so light that efficiency is excellent.
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