Why Is This So Hard To Grasp?
I am continually amazed to hear some economists say that energy costs should not have that big of an effect on the economy. What they do is take a look at a typical cost structure for a typical company that shows that energy costs are a small part of the total cost of operations. In a recent attempt to show how costs at each stage of production build up with energy inputs I wrote “Energy costs and the economy”. Then I get this e-mail from a reader who is trained as an academic economist:
You continue to make the mistake of thinking that energy cost are the only important factor in the supply chain costs. Companies pay out far more for materials, labor, and services than they do for energy. Take a look at any typical company's cost structures and you will see that this is the case. Basically, I think computer scientists should stick to computer programming and leave the economics to experts.
Ironically, this reader apparently thought my systems science work was spot on based on comments s/he sent me, but takes serious exception to my dabbling in economics (and being somewhat derogatory in my comments about neoclassical economists!)
OK, maybe I am meddling in areas in which I have no business. But what is going on in the economy seems so astoundingly obvious I just cannot grasp how somebody with a modicum of education can't see this.
The figure below is yet one more attempt to demonstrate the relationship between energy flow and economic activity, and especially the costs of things. In this figure I focus on a supply chain model but in a graphical form (as opposed to my cost accounting model from the blog “What's wrong with this picture?”). Note that at every stage of production there is one common factor that is consumed in the process and that is energy, either in the form of fossil fuel, electricity, or human labor. And the company has to pay for all of those inputs. What is more subtle is the fact that materials purchased from processes earlier in the chain have what is called embodied energy in them in the sense that energy was expended to shape or construct them into the form that is supplied to the next stage. ALL value added comes from work done to make stuff for the next stage up in the chain on the way to the consumer. And that work is accomplished ONLY with energy being expended. Period.
Figure 1. Energy flows into every single process stage in a supply chain. Energy is consumed in the process and leaves the system as waste heat according to the Second Law of Thermodynamics. Materials are worked on at each stage and the embodied energy is equivalent to reduced entropy (the material becomes more usable and valuable at each stage). Money flows in the exact opposite direction of energy showing that money is essentially a message that is employed to direct what work should be done. The money arrows from consumption and extraction do not have a defined target. These may represent externalized costs that are not being paid in real time, but will need to be paid eventually. Not shown are waste materials emitted by each stage in the chain.
What this graphic is attempting to show is that the only real cost item that means anything is the accumulation of embodied energy going into the final product plus the energy used up in the consumption of the material good. The final product production process also shows that there are multiple supply chains that need to be accounted for. This is actually the case for each of the previous stages as well, meaning that a more complete picture would look like an inverted tree with many lower level nodes feeding into the higher level nodes.
At each stage in the chain energy inputs are used up. Most of these come from fossil energy (with a few coming from hydro and nuclear for electricity). Labor, that ultimately depends on fossil fuel inputs to agriculture, is another energy input not really accounted for in the energy bookkeeping. In truth, labor inputs require much more energy than just from agriculture. Every worker has to obtain enough money (wages) for their labor to also pay for the energy they consume in products and services and not just for food. One of the reasons that American labor has essentially priced itself out of the global market is that the energy requirements for a typical middle-class American (family) are so high that producers perceive that they are not getting their dollar's worth out of the labor (work) that gets done by American workers. Ergo, they seek cheaper labor markets off shore to re-balance the costs inputs..
In every case, however, the costs that are building up through the supply chain all have their basis in the energy consumed at each stage. While prices charged for any given item or service might temporarily exceed the cost plus ordinary profit level, competition among suppliers (of non-proprietary goods/services) will tend to bring that down to some norm. Thus the cost build up in any final product from raw material to the finished good is entirely a matter of energy expended and represented in the value added aspect called embodied energy.
The Price of Oil
So once again we come back to the impacts of oil prices on the general economy. Over eighty percent of our energy comes from fossil fuels. Ninety percent of transportation and extraction energy comes from oil. In addition both oil and natural gas are feedstocks for pharmaceuticals, plastics, and agricultural products such as fertilizers and pesticides. Oil is needed, in the form of diesel, to extract coal, so as much as ninety percent of the energy we get from coal-fired boilers is touched by oil in some fashion or another.
And the price of oil is trending ever upward just due to fundamentals of supply and demand. The world is still growing in absolute numbers of humans. A number of developing economies are growing in their per capita use of fossil fuels. China and India are huge economies with huge appetites that are starting to have a significant impact on demand. Meanwhile the non-OPEC producers of conventional oil are going into decline worldwide. OPEC countries, especially Saudi Arabia, are still claiming they have ‘spare capacity’ that they can bring on line to compensate for increased demand, but so far we haven't seen much evidence to give us confidence in those claims. Indeed the overall production rate of global oil appears to be going down. The upward pressure on prices is evident from the price trend for all of the major benchmark oil markets.
At the same time the cost of extracting oil has been going up as well. More cogently, the amount of energy that must be expended to get the next unit of oil energy has been going up meaning that there is actually less net energy to be used for other economic work. I and a number of other biophysical economists (oh, I forgot, I shouldn't call myself an economist!) are reasonably convinced that the problems with the global economy since the meltdown in 2009 are largely due to the rapid decline in net energy that is actually reflected in the prices for energy and food (which is energy). Those are having a major impact on the whole economy especially since the modern economy is so much based on consumption.
We predict that as long as net energy is in decline, and that will be as long as we are dependent on increasingly expensive fossil fuels, prices of all goods will catch up. Producers will try mightily to keep from raising their prices as all cost components of their production inch upward. But eventually they will have to cover those costs even if their profits are squeezed. They can't afford to lose customers and will, individually, be afraid that some competitor will have a cost advantage and under bid them in the free market. But as the graphic suggests, no one will be immune from general cost increases. They will have to eventually raise their prices and everyone will feel it. And please note that I am talking about absolute purchasing power, not just the nominal prices. Regardless of monetary policies that might affect the prices in the economy, each person's capacity to afford consumption is going to go down.
Paying more at the gas pump is one thing. That one is pretty easy to understand since oil is the major component of gasoline, so you would expect more expensive oil would translate into more expensive gasoline. But as I sincerely hope you (especially you economists out there) now understand, the only real basis for costs and cost increases is the price we pay for fossil fuels. And until, or unless, someone comes up with a magic bullet in alternative energy production that matches fossil fuels in power production, and the cost of which does not depend on oil (fat chance), we had better get used to increasing prices everywhere we look and for a long time to come.