Oil Price Elasticity

Economics 100 Semester 2 2007 Assignment

Chapter 4 - Elasticity

A rising oil price not all bad news for citizens of an energy exporter

Vanessa Burrows

The Age

14 September 2007

Vanessa Burrows' article states that oil is becoming more and more scarce in the world due to an increase in the demand for fuel and a shortage of resources. Through economic theory this essay will examine how and why there is a shortage of oil, and what is being done to increase supply, such as finding alternative solutions to the increasing fuel shortage.

(express.howstuffworks.com/gif/oil-on-water.jpg - 2007)

Key points of this article:

* Oil prices have risen to a record $US80.18 a barrel

* Prices are expected to continue to rise

* "Australia seems to have a bunch of fairly small puddles, or pools, of oil...really starting to be extremely valuable" (Arden)

* The price of gas, a substitute good of oil, will rise as consumers switch from oil to gas power supplies

In today's increasingly highly consumer-driven society, the demand for goods has increased dramatically. This is pushing up the prices of all the raw materials needed in order to create these goods. This rise in price is especially evident in the increase in oil prices, fuelled by:

* The scarcity of the raw material

* The war in Iraq, and

* The new focus on sustainability has also had an impact in regards to resources being spent on technology rather than supply.

The lack of oil availability has meant that more money is being spent on technology in the hope of finding an alternative to oil scarcity, rather than on increased oil exploration and extraction.

Price Elasticity of Demand

Crude oil is an inelastic good. It is used for operating motors, and for supplying power. These uses have become a necessary part of life in western countries and economic centers of developing countries. Due to the consumer culture and the western mode of production, fuel has become essential in industry, for transport, and in supplying the needs of everyday life. Oil is therefore essential to the lifestyle that the west has become accustomed. This makes demand for oil inelastic.

The closer a substitute of a product is (to the product) the more elastic the demand is. For example, oil's substitutes (such as gas and coal) aren't closely related to oil so the demand for oil is inelastic. Oil cannot be replaced easily for its purposes, for example, using coal or gas to power motor vehicles is impractical and inefficient.

Consumer's incomes also affect the elasticity of demand. Oil does not take up a large portion of people's incomes. This also adds to the demand of oil being inelastic as it doesn't affect an individual's monetary situation because it does not have as much of a noticeable change to their other expenditures. People are not likely to care too much about the declining supply of oil as increasing in the price of oil have been enough to effect their wallets. As prices continue to increase, however, the more a good will take up a larger portion of consumer's incomes and will gradually become more elastic. It is becoming more evident in every day life, that as the price of oil rises people are taking more notice to how much petrol and energy they consume and are taking steps to reduce their use.

Time elapsed since a price change

The longer the time since a change in the price of a good, the higher the elasticity of demand. Oil prices change daily so an increase or decrease in price is not very noticeable over a short period of time. This means that the demand for oil is inelastic in regards to price changes because demand won't be affected every time that there is a price change. It is better to make assumptions of the elasticity of demand based on monthly or even quarterly oil prices. For example, "When the price of oil increased by 400 per cent during the 1970s, people barely changed the quantity of oil and petrol they bought." (McTaggart, Findlay, Parkin)