Economic impact of persistent high oil prices

¶ … economic impact of persistent high oil prices. With extraction flatlined, some see this as evidence of peak oil. With demand growing, especially from emerging economies, the period of peak oil is characterized by increasing demand and decreasing supply. This will drive prices higher. There are a number of impacts on the market for oil that will occur as the result of this and impacts on the market for other fuels as well. This paper will assume a situation in which the long-run supply of oil is diminishing and the long-run demand is initially increasing, leading to higher prices.

The essay will begin with a set of key definitions. This will be followed by a description of some of the theories that are relevant to this problem. Examples of the impact will follow, illustrating how the increasing price of oil will impact on the market for both oil and its closest substitutes. Finally, conclusions will be drawn explaining the implication of these findings.

Definitions

The most important concept to understand is the idea of peak oil. We know that there is a finite amount of oil on this planet, and as a result we know that at some point the production of oil will peak. The peak year for the discovery of new oil was in the 1960s, and world consumption that exceeded new discoveries was in 1981 (Campbell, 2011). Many believe that peak oil has already occurred. The implications of this are that we are still increasing demand at a point in time when we have peaked our extraction -- supplies will begin to diminish from the point of peak oil forward.

Another concept that is important is that of alterative fuels. In economics, alternatives are known as substitutes. Most of the time, a substitute is not a perfect substitute. This is true for energy as well. Alternative energy sources have different output levels than oil, different uses and they have different costs. While powering a light bulb can be done with a number of different sources, large internal combustion engines like jet engines or tractor-trailer engines typically require fossil fuels in order to function. The imperfect nature of alternatives is important in this discussion.

Another key concept is that of price elasticity of demand. This concept reflects the idea that demand for a good varies depending on its price. However, the degree to which price and demand are related is different for different goods. It is also different for the same good over different points in time. Goods with high price elasticity of demand will see demand change sharply in relation to the price; goods with low elasticity will not see much change in demand relative to the change in price. Related to this idea is the concept of cross-price elasticity of demand. This is the change in demand for one good (we'll call it solar power) when the price of another good changes (we'll call that one oil).

Description of the Issue

The first question is what will happen to demand for oil if prices begin to rise strongly and permanently. To understand what will happen, we must know the price elasticity of demand for oil. According to Anderson et al. (1997) the short-term price elasticity of demand for oil is 0.2. This estimate is from 1997 and the trend was downward, meaning that elasticity is probably even lower today. What this means is that in the short run, demand will not change much given a change in the price of oil. So when oil prices rise, demand only changes a little bit. In this case, it appears that only a small portion of the demand for oil is discretionary, and a price increase would therefore only remove that discretionary demand from the market. Basically what this means is that people will drive less, maybe take fewer road trips, combine errands into a single trip and that sort of thing.

The long-run price elasticity of demand for gasoline is stronger at 0.7 (Ibid). This implies that in the long-run, given higher gas prices, consumers will adjust their consumption habits. One example is that consumers will purchase more fuel efficient vehicles, thereby lowering their consumption level. Some consumers may switch to public transit. Young adults entering the workforce may eschew car ownership altogether in favor of other modes of transport. In the long run, businesses will also seek out alternatives for plastics, because those will rise in price as well.

The price elasticity of demand for oil may also exist on a curve. This means that the higher the price rises, the greater the price elasticity of demand will be. It may also change over time, as more consumers and businesses come to the realization that oil prices will not drop at any point in the future. At this point, there will be a profound shift in consumption patterns away from oil. It may get to the point where oil demand falls so far that its price begins to stabilize (albeit at a very high level).

Conclusion

As the price of oil rises, demand for oil is expected to fall. Users will at first seek substitutes, and then over time will simply replace the consumption of oil altogether as the price becomes too high. Eventually, the only demand for oil will come from those users for whom there are no substitutes. Alternative energy sources are the first substitutes and in general the demand for alternative energy will rise as the price of oil rises. Over time, however, consumption patterns may adjust to overall lower demand for energy, which would bring the demand for alternatives down. The impact of higher oil prices will also change as the price rises, and the impact on alternatives will depend on the demand and supply conditions for each alternative in a given market.

Works Cited:

Anderson, P., McLellan, R., Overton, J. & Wolfram, G. (1997). Price elasticity of demand. Mackinac Center. Retrieved November 30, 2011 from www.mackinac.org/1247

Campbell, C. (2011). Understanding peak oil. Peak Oil.net. Retrieved November 30, 2011 from http://www.peakoil.net/about-peak-oil