The Joy of Economics:  Making Sense out of Life
 Robert J. Stonebraker, Winthrop University
 

Demand and Supply Applied:

Oil Prices

 

 

                                    Genius is nothing but a great aptitude for patience.

                                                                                                .....George-Louis De Buffon

 

 

            My elderly friend loves to reminisce about the good old days.  He tells the same stories over and over again.  He tells of watching Sammy Snead1 hitting towering drives while playing exhibitions at his local golf course; he tells of betting $20 on Seabiscuit in his 1938 match race with War Admiral2; and he tells of buying six gallons of gasoline for a dollar.

 

            Six gallons for a dollar?  During the summer of 2008 I paid $4.36 a gallon while vacationing in Montana.  How could this happen?  Some want to blame profiteering oil companies, but economists prefer explanations based on demand and supply. 

 

            Soaring gasoline prices are nothing new.  It's all old hat to those of us with enough gray hair to remember the energy crisis of the 1970's.   Prices climbed rapidly in the 1970's, soaring from about $3 a barrel in early 1973 to over $35 a barrel in 1980. They then took a long slide through the 1980's and 90's, falling to almost $10 a barrel in 1998 before rising again over the last decade, diving back and then spiking again.  If we adjust these prices for inflation3 we get an even more interesting perspective.  Look at the chart below.  It traces the price of a barrel of oil over the last 50 years in terms of 2012 prices.  In this case, the price increases of the 1970's look remarkably similar to those of the 2000's.  Adjusted for inflation, oil prices in recent years are not much different than what we experienced 35 years ago.

 

                    

 

                                 

Elasticity and prices

 

            While these price changes have been controversial, they are the inevitable results of shifts in demand and supply.  First, we need some background information.  Both the demand and supply of oil are relatively inelastic in the short run: changes in price have little impact on either the quantity demanded or the quantity supplied.  When oil prices rise we spend considerable time and energy complaining but, at least in the short run, spend almost no effort in trying to adjust our habits to consume less.  Similarly changes in price do little to spur new supplies in the short run.  Exploring for, drilling, and bringing new sources on-line can take many years. Since the quantities demanded and supplied change very little as prices rise and fall, both curves are relatively vertical as shown below:

 

 

Because quantities are relatively fixed in the short run, any shifts in demand or supply will cause large changes in prices.  For example, suppose that supply falls.  The decreased supply creates a temporary shortage that will begin to drive up price.  If demand is elastic, only a small increase in price will be needed to get consumers to cut purchases enough to meet the new reduced output. However, if demand is inelastic, it will take a much larger price increase to generate the needed cut in quantity demanded.  You want more graphs, don't you? 

 

            The graph on the left below illustrates the elastic demand case.  The demand curve is relatively flat and the drop in supply (from S to S') causes only a small increase in price (from P0 to P1).  However, if the demand curve is less elastic or more vertical (as in the graph on the right), the same cut in supply causes a much larger increase in price.

 

 

            Do you have the concept?  When curves are elastic, shifts in demand and supply cause only small changes in price, but when curves are inelastic, those same shifts cause much larger price changes.

 

            Apply this to oil markets.  For many years members of the Organization of Petroleum Exporting Countries (OPEC) have controlled most of the world's oil market.4  In the early 1970's, partly reacting to political turmoil in the Mideast, OPEC oil ministers voted to deliberately cut production.  As illustrated above, this shifted the supply curve for oil to the left and drove up prices.  Because demand was inelastic, the price increase was significant.  The higher prices OPEC countries received more than offset the lower sales and their oil revenues rose rapidly.  In 1979 a bitter war between long-time enemies Iran and Iraq shut down more oil fields and caused additional price increases. 


Wait?

Much weeping and gnashing of teeth in non-OPEC countries ensued and, in the wake of the media hysteria that followed, economists were thrust into the national limelight.  How could this energy disaster be fixed?  What should be done?  Never very good at giving answers that people or politicians want to hear, most economists replied: "Don't do anything; just wait." 

 

The answer was both unpopular and correct.  Demand and supply are far more elastic in the long run than in the short run.  After oil prices rose, firms began shifting to less energy-intensive ways of manufacturing goods and services.  Similarly, consumers started to conserve as well.  They insulated homes heated by oil furnaces and shifted to alternative energy sources.  More importantly, they began buying different types of cars.  They gradually ditched the gas guzzlers they purchased in 1971 when fuel prices were not an issue and bought smaller, more fuel efficient vehicles.  As we shifted from cars getting 12 miles per gallon to ones getting 28 miles per gallon, the demand for gasoline (and its price) began to fall. 

 

            Supplies adjusted as well.  The increased prices of the 1970's unleashed a frenzy of successful new exploration and drilling.  New oil fields came on line all over the world in places such as Mexico, Russia and the North Sea.  Fields that were not profitable to develop when oil was $4 per barrel proved to be veritable bonanzas at $35 per barrel.  The combination of conservation and new supplies gradually drove prices down until, in inflation-adjusted terms, they returned to 1972 levels.5

 

            Regrettably it did not last.  Prices began to inch up again after the turn of the century and recently have climbed well above historic levels.  Why? What happened?  Is it still demand and supply?

 

            It is.  First, demands rose rapidly over the last decade.  Consumers, lulled by low prices, abandoned their fuel-efficient Hondas and Toyotas for behemoth trucks, vans, and SUVs.  Perhaps more importantly, strong economic growth in countries such as China and India created more factories and more cars that need more oil to run them.  Supplies also have suffered.  During the U.S. invasion many Iraqi oil fields were destroyed and production there remains well below pre-war levels.  Production in other countries also has been disrupted, most recently when militant attacks in early 2008 closed major oil fields in Nigeria.  Rising tensions in the Mideast added to the problems.  Fearing that current pressures might rekindle armed conflict between Iran and Iraq and cause further cuts in supply, many oil brokers increased purchases in an attempt to lock in supplies at current prices.  Not surprisingly, this speculative buying increased demand and drove up prices still more.

 

Do you see it?  Increased demand from U.S. motorists, from other countries, and from speculators worried about even higher prices in the future, coupled with supply cuts in Iraq and Nigeria caused oil prices to increase.  However, by late 2008 problems in U.S. mortgage lending set off a crisis in global financial markets that led to a global economic slowdown.  The slowdown, in turn, caused a drop in demand for oil and began pushing the price of oil back down. [Can you picture how a shift in the demand curve can do this?]  Once prices began to fall, speculators who had purchased large volumes of oil expecting to be able to resell at a higher future prices, began to lose money rapidly.  To cut their losses they dumped their supplies on the market hoping to unload them quickly before prices fell further.  Of course, this increased market supply and drove down prices even more rapidly.  Oil prices that peaked above $140 per barrel in July 2008 had fallen to a mere $40 by December.  Waiting worked.

 

Rats.  It didn't last.  Unrest in the Middle East, accentuated by popular uprisings in Tunisia, Egypt, Libya, Yemen, Bahrain and Syria refueled speculative fears.  Will lengthy civil wars break out across the region? Will oil fields be destroyed?  Will pipelines and transportation corridors be shut off?  As firms rushed to lock in supplies, demand surged and prices soared back above $100 per barrel.  By May 2011 domestic gasoline prices once again approached $4.00 per gallon.  

 

What now? Most expect the Mideast crises to stabilize and for oil prices to bump back down.  But, given the political instability in the many major oil-exporting nations, coupled with inelastic demands and supplies in the short run, the roller coaster price rides of recent decades are likely to continue.


Lower prices?

Some argue that the government should step in and mandate lower prices.  Such schemes pander to populist preconceptions, but make little economic sense.  Are you ready for one last graph?  Suppose the government decides to lower gasoline prices by decree and forbids firms from charging any price higher than P1 in the graph below.  In economic jargon, P1 becomes a ceiling price.  Consumers immediately react to the lower price by increasing their quantity demanded from Q0 to Q2.  However firms react in the opposite way.  Stuck with a lower price they reduce their quantity supplied from Q0 to Q1 and a shortage results.  The quantity demanded (Q2) now exceeds the quantity supplied (Q1).       

 

 

            Some consumers do get gasoline for a lower price, but others get no gasoline at all.  Since output has been cut from Q0 to Q1 there is less gasoline to go around.  It simply is not profitable to produce as much at the lower price.  Who gets the gasoline and who does not?  In a free market consumers would compete for the scarce gasoline by offering higher prices; those willing to pay the most would get the gasoline.  However, with a price ceiling in effect, paying higher prices is illegal.  Firms and consumers must find a different way to decide who gets the gas and who does not.

 

            The traditional alternative is first-come-first-served.  Those who get to the station first get the limited supplies; those at the end of the line do not.  The gas is gone by the time they get to the pump.  But think about this.  If the product goes to those in line first, what will you do?  That's right.  You'll try to be first in line.  Unfortunately, everyone else will be doing the same thing.  The result will be long lines (and short tempers) at the pump.  Those who "win" and get to the pumps first will get their gas at a lower price, but they must pay a higher price in terms of time and energy spent waiting in line.  Those at the end of the line lose twice.  They lose by having to wait in line and lose again by seeing the gas run out before they get to the pump.

 

Could this actually happen? Readers who remember the 1970's know that it could and that it did. To "protect" consumers, we did slap price ceilings on oil and gas products, only to be slapped back with the long lines and shortages described above.  It was ugly.

 

Most economists offer the same advice they gave thirty years ago: wait.  High prices are painful, but they serve a very real economic purpose; they discourage consumers from using a scarce resource and encourage suppliers to produce more. In the long run higher prices will cause consumers to shift back to more fuel-efficient cars and adopt other measures of conservation.  In the long run higher prices will cause firms to increase exploration and drilling to bring more supplies to the market.  And, more importantly, in the long run higher oil prices will create incentives to develop cleaner and more renewable energy sources. OPEC oil ministers understand this quite well.  Saudi officials often have pushed for moderation in oil prices precisely because they fear prices that rise too much too quickly will drive consuming nations to get serious about conservation and alternative energy programs.  They understand that this could destroy the long-run market for oil and, in turn, damage their future economic growth.

 

Despite their bad rap, rocketing gasoline prices actually can have very beneficial side effects.  Evidence suggests that the low gas prices of the past caused an increase in driving which, in turn, led to more pollution, more traffic-related deaths and more obesity.6  As the pinch of higher pump prices causes us to cut back our highway mileage, the likely result could be a cleaner, safer and leaner America.  Calls for patience may not win elections, but may be sensible policy nonetheless.

 

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Notes:

 

1.         Sam Snead was the Tiger Woods of his day and still holds the record for most lifetime wins on the PGA tour. 

2.         Termed the most famous match race in history, Seabiscuit pulled away from heavily favored War Admiral in the stretch.  You can view a video of the race on the web. Seabiscuit's life also inspired an acclaimed 2003 movie starring Jeff Bridges and Toby Maguire.

3.         A later chapter will discuss how such calculations can be made.  As an example, suppose that average prices doubled from 1985 to 2008 (which is approximately true).  If the 1985 price was $14, it would be twice as high (or $28) when restated in terms of 2008 prices.

4.         The members of OPEC in 1973 were Algeria, Ecuador, Indonesia, Iraq, Iran, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, United Arab Emirates and Venezuela.

5.         Readers familiar with cartels and game theory will recognize that this and subsequent explanations, though largely true, are simplified.

6.        Carey, John, "Should Oil be Cheap?", Business Week, August 4, 2008, p. 56.

 

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Testing Yourself

 

To test your understanding of the concepts in this reading, try answering the following:

 

1.         Explain and illustrate why shifts in demand and supply cause larger price changes when the curves are relatively inelastic than when they are relatively elastic.

2.         Explain why oil prices rose in the 1970's but then fell through most of the 1980's and 1990's.

3.         Explain what demand and supply shifts might have caused oil prices to change in recent years.

4.         Explain how speculation might be impacting oil prices.

5.         Use demand and supply curves to illustrate the effect of a price ceiling.  Explain in words what happens and why economists tend to oppose such ceilings.

6.         Explain why "waiting" might be a good way to deal with high oil prices.

7.         Explain the beneficial effects high oil prices might create.

 


Permission to reproduce or copy all or parts of this material for non-profit use is granted on the condition that the author and source are credited.  Suggestions and comments are welcomed.

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Last modified 05/22/13