Saturday, August 12, 2006

The price of crude oil is hovering around record-breaking peaks after unrest in Iraq halted production.

Companies are feeling the effect of higher fuel and raw material costs, while there are worries that consumers may spend less. Fears about consequences of any further supply disruption have risen and governments are keeping a close watch on future development.

a. Explain why the price of fuel has been rising rapidly. [10]


The oil price has been rising in the recent months, arriving at the highest level in the history. This rapid rise in the price of fuel is unavoidable given the demand and supply conditions of the oil.

The price of fuel is largely determined by the forces of demand and supply of oil.

From the demand side, there are a few reasons for the increase in demand. Firstly, the world population is growing, the world demand for all kinds of products including cars, TVs and so on increases. And oil is the primary product that is necessary for the production of these manufacturing goods. Thus, increase demand of these commodities has resulted in the increase demand of oil.

Secondly, in recent years, many countries are so keen in developing their economy. Rapid economic development and industrialisation, especially in China, has caused a huge increase in demand for oil which is essential for economic development. Its importance to the economic development is similar to the importance of water to the survival of human beings.

Thirdly, the increase in oil consumption is also resulted from the increase usage of private cars. Due to economic development leading to rising affluence, many people who were previous not able to afford cars are buying cars in countries like China. Moreover, increasing usage of airplanes for long distance travel also resulted in an increase in the oil demand.

(Another demand-side factor to consider: Expectations of future price of fuel)

From the supply side, there may be an increase in supply due to better technologies and output increase order by the OPEC. More importantly, since oil is a primary product, its supply is limited and it is relatively price inelastic in supply. Production of oil is not able to respond to price changes or demand changes rapidly. Since the production of fuel is at its maximum, the supply of oil only increases marginally while the demand has increased greatly. As such, the supply relative to demand is actually decreasing and price of oil, thus, increases. This can be seen from Diagram 1.

As mentioned in the preamble, the production of oil has been seriously affected by the Iraq War. When supply of fuel falls and demand for it increases, price of fuel will increase (Diagram 2).

(However, in reality the war in Iraq has not affected the current supply of fuel much. This is because prior to the war, there has already been an embargo imposed on Iraq's exports, including fuel.)

In conclusion, the huge increase in the demand for oil and the relatively small increase in supply or even decrease in supply together with the inelastic nature of oil supply have resulted in the rapid rise in the fuel price.

b. Discuss why it is necessary to keep a close watch on the future development of oil prices. [15]

According to the preamble, "governments are keeping a close watch on future development of oil prices." This may be necessary for governments as well as individuals because oil price affects the economy to the extent that its impact cannot be neglected.

To the individuals, oil price will affect many individuals' decision making. To a company owner, an increase in the oil price will mean the cost of production is increasing because nearly all kinds of production require oil as raw material. Just take an example of airlines. Jet fuel consists of a great proportion of an airline's variable cost. As a raw material, oil is essential. The rise in its price will result in higher costs. Since traditionally firms are assumed to be profit maximising and profit= total revenue- total cost. When the cost increases, profit will be affected. This will then affect the decision making of a firm when deciding what level of output is to be produced. If the price of oil rises to the extent that its revenue will no longer cover its variable cost, including the cost for oil, a producer may want to leave the industry.

Besides, company worries that an increase in its cost will drive up the price of the commodities which results in the consumers to spend less (reduction in TR). However, this is only necessary if the demand for the commodity is price elastic. Price elasticity of demand (PED) is the responsiveness of quantity demanded of a good with respect to the change in price, ceteris paribus. If the PED is elastic, producer will incur a loss when the price of the good increases due to the increase price of oil because consumers will spend less. Total revenue will reduce from P1BQ1O to P2AQ2O as shown in Diagram 3.

However, if the PED is inelastic, producers will be able to pass on the increase of production cost to the consumers and continue to enjoy high revenue. Moreover, the extent of usage of oil as a production material also needs to be considered. If the usage of oil in industry A is less than that in B which is producing substitute of A. Then, the increase in oil price will not be a worry to industry A because consumers will switch to A as a substitute of B. Thus, whether a company needs to keep a close watch on future oil price depends.

(Other parties: Users of cars - transport industry - travel industry, public transport)

However, for the government, it is important to do so for long run sustainable development of a country. Oil is a primary product. The fluctuation of its price will have effect on all kinds of industries (increased uncertainty leads to reduced investment). Thus, its fluctuation may result in economic fluctuation as a whole, resulting in unstable general price level. As such, inflation due to supply side shock may result. Since stable and mild inflation is important to a healthy economy, price of fuel which destabilizes the GPL needs to be watched.

Further more, price of oil also affects the ability of an economy to further develop. For the oil producing country, since oil is non-renewable, its depletion reflected by increasing price levels is an indication of the danger of unsustainable economic development. Thus, governments in oil producing countries may need certain measures to conserve oil and develop alternative energies. For the non-oil producing countries (oil importing countries), they too need to develop alternative energies (substitute to fuel) to ensure their own long term economic development and survival. In addition, they need to formulate policies to keep out imported inflation arising from rapid rise in oil prices.

Nonetheless, allowing the price of oil to increase rapidly to reflect its growing scarcity may not necessarily be a bad thing. Rising prices of oil tend to encourage users to be more conservative in their use of oil. Some countries try to dampen the increase in the price of oil by practicing price controls or by providing subsidies. However, in doing so, they distort the efficient allocation of resources and encourage excessive use of oil which in turn results in wastage. Conserving the environment is part of sustainable growth.

In conclusion, for a company, whether it is necessary to keep a close watch on the oil price depends due to the different elasticity of demand for the commodities. But for governments, it is important and necessary to do so because oil is an important primary product that the development of an economy will have to depend on.

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