Microeconomic Effects of Rising Gas Prices on Firms

Introduction: Business Dependence on Fossil Fuels

When considering the ever-changing and highly competitive global landscape of business today, it is striking how many firms continue to rely on fossil fuels — particularly gas — as a primary means of facilitating operations. The functional inputs of countless organizations across countless industries are at the mercy of gas providers (Dahl, 2001). Transportation mechanisms, factory machinery, construction equipment, and climate control systems almost always require a petroleum-based source of fuel. Such operational instruments are absolutely vital to the market success of a vast number of small and large businesses alike.

While some businesses have recently begun to recognize and actively combat the drawbacks of this type of critical dependence, the actual market share of such firms remains truly minuscule. For the majority of companies, an increase in gas or fuel prices has the potential to cause massive damage to profitability and sales. Moreover, because petroleum is a global industry subject to various sources of fluctuation, firms at the microeconomic level have very few options available to protect themselves from the devastating fiscal effects of gas price increases (Dahl, 2001).

In fact, aside from switching to alternative energy mechanisms — which typically requires a very large up-front investment — there are no risk-free ways for firms to hedge or safeguard themselves in such an instance. This presents a unique situation in that it is one of the only times a firm cannot actively create security in the face of a profitability threat. Other threat sources can be managed through strategic productive and operational tactics, meaning that internal management would ultimately be responsible for any resulting downfall. Conversely, the collapse of an organization resulting from rapid spikes in fuel prices would seemingly be outside the company's control. From the microeconomic perspective, increases in gas and fuel prices almost always carry very negative operational consequences for nearly all firms.

Origins of Gas Price Increases and Their Scope

In order to better understand the true scope of potential victims in the case of a gas price increase, it is important to determine why such spikes occur. The simplest answer is that surges in gas prices occur as a result of increases in the price of crude oil. While gas is a very commonly used fuel, it is also a secondary source of energy. As illustrated by industry data on the typical composition of an average gallon of liquid gas — the most commonly utilized of all gas fuels — gas prices are fundamentally a reflection of crude oil prices (Dahl, 2001; Chevron Corporation, 2005–08). Knowing the even greater number of companies that utilize oil in their operations, the potential microeconomic effects are truly massive.

Inelastic Demand and Supply in the Gas Market

These injurious microeconomic effects are caused by the absolute essentiality of petrochemical fuels like gas in many production processes. While other energy alternatives do exist, they often require permanent systematic restructuring and thus cannot be quickly substituted to combat a sudden gas price increase (Leigh & Geraghty, 2008). This reality creates a large degree of inelasticity in the microeconomic demand for gas. When dealing with inelastic demand, price increases do not equate to demand decreases, as would be the case in a normal supply-and-demand scenario. Rather, inelastic demand scenarios reflect an organization's necessity for a given product — in this case, gas. As a result, firms are solely responsible for absorbing the increased cost.

This upsurge in fuel price is typically represented by a significant increase in operating costs, which usually amounts to an equally significant decline in profits (Nicol, 2003). When the price rises from a lower to a higher level, the quantity produced does not decrease very substantially — a direct result of demand inelasticity. Companies must continue to operate and produce in order to meet the unchanged demands of their customers (Krichene, 2002). Therefore, assuming that a firm will not be able to adequately raise the price of its products or services to sufficiently offset the gas price increase — typically a result of pre-existing contracts or fear of losing market position — the firm is left absorbing the difference as a loss.

Supply also appears to be relatively inelastic in the case of gas. Although a downward price shift produces a mirrored effect, working the analysis in reverse reveals that even a substantial price increase results in only a nominal decrease in the quantity of gas supplied. This situation results from the recently soaring levels of fossil fuel consumption, accompanied by rapidly declining rates of new oil discovery (Krichene, 2002). Consequently, the quantity of gas supplied to firms remains very close to the maximum attainable level in response to incessant demand (Wissner, 2007).

Conclusion: Limited Protections and the Case for Energy Transition

Ultimately, there is little any firm can do to truly protect itself from the potentially devastating microeconomic effects associated with increases in gas and fuel prices. While market knowledge and strategic operational and contractual tactics can be useful, they are often highly speculative and risky. Therefore, a macroeconomic shift — one that would presumably encompass all relevant microeconomic inputs — away from the crippling dependence on gas and other fossil fuels certainly seems like the best long-term solution to this fundamental problem. Given the necessity of energy generation throughout many vital industries and the unpredictability of current fuel prices, the present microeconomic structure seems destined for instability.