The Economic Problem of Scarcity - Essay Example

BUSINESS ECONOMICS Contents Contents 2 Introduction 3 Problem of scar in respect to the oil 3 Externalities from oil consumption 10 Control by the Government 11 Conclusion 12 References 14 Introduction Just like any other valuable commodity, oil is subject to the economic laws of demand and supply. According to the demand law, if the price of a product increases, it has an inverse relationship with that commoditys demand, in that, it reduces, and vice versa. The global demand and supply of oil have made it a unique product. Oil experiences derived demand1. In this respect, its demand refers to the quantity that buyers will desire to buy at various prices. On the other hand, the supply of oil denotes the quantity that producers are willing to take to the market for sale at a given price. In order for the law of demand and supply to hold, there is an assumption that everything else remains constant. This paper aims at studying the economic problem of scarcity, in reference to oil prices. It will further address the externalities arising from oil usage and the government intervention. Problem of scarcity in respect to the oil In economics, scarcity is a fundamental issue and requires that economic units make a decision of how much and what to produce using the limited resources. According to Watkins’s (2006, pp. 508-514) study, the scarcity of oil and the eventual decision made by economists give rise to a constant opportunity cost. To address this problem of scarcity, economists have been increasing prices on the scarce resources with a view to discouraging demand and encouraging firms to develop alternatives. According to Asdorian’s (2011, p. 97) analysis, the scarcity of oil rises where its supply falls short of the demand level. Whenever the supply fails to meet some demand at a prevailing price, the economics make prices to skyrocket in order to encourage supply and ration the demand. To get the aspect of oil scarcity, market prices are considered. The market price of oil reflects the opportunity cost incurred in bringing an additional barrel to the market. The opportunity cost compensates the reserve owners for the extraction costs and the loss of a barrel of reserves that could otherwise be sold in the future. Asdorian’s (2011) research findings revealed that whenever the price of a commodity is higher relative to that of other commodities, there is an indication of scarcity, whereas a lower price indicates abundance. The presence of scarcity is also seen when prices change over long periods. From the commodity extraction models, it is deduced that the market prices are relied upon as a reliable guide to opportunity cost that includes the costs that are relative to the expected future scarcity. Asdorian’s (2011) study, however, explains how worth, it is to understand that prices of oil can rise because of other reasons other than its scarcity. The author, thus, states that the strict implication of oil scarcity is the declining oil availability in the long term. However, the scarcity of oil can be experienced in the short horizons where its prices would be high and increasing. Such causes of short-lived price spikes are the temporary supply shock as was experienced during the 1990/91 Gulf War (Oxford Business Group 2012). Large cyclical fluctuations in prices of the oil are also experienced because of the interaction between cyclical factors and low short-term elasticity of the price of demand and supply. The signal from the prices of oil should reflect the expectations of its scarcity, and thus need to be considered, especially its underlying fundamentals. As earlier stated above, the current market prices should be understood since they are signals that aid in the consideration of the prospects for demand and supply (Asdorian 2011, p. 92). The prospects for oil and other energy resources lie on the primary energy demand. Oil is a leading and the chief source of the global energy as it has its use in various sectors such as manufacturing and industries. It is, in fact, a monopoly product in some areas such as the transport sector in the form of gasoline, petrol and diesel. From its diverse use, oil has an inelastic demand over the short-term, implying that the changes in its prices have no much effect on its quantity demanded. The increase in the pace of growth of the global primary energy consumption has led to the scarcity of oil. Some economies such as China and India are in constant development and industrialisation, which has made their oil consumption grow in order to suit their growing economies. There are also other developing economies that are moving towards industrialisation, and this is adding to the increase in demand for oil. Stonebraker’s (2005) evaluation found that the new use of oil in India and China is attributed to the taste and preferences where a significant number of buyers have determined the high demand for this commodity. Asdorian’s (2011, p. 93) findings further argued that the growth in the GDP has been the primary oil demand driver in emerging market economies. In his Working Paper No. 14492, Hamilton’s (2015) argument tries to explain what could be the reasons behind the 2008 crude oil prices. The theories behind the movement in oil prices are the commodity price, time delays, strong world demand, OPEC monopoly pricing and geological limitations on increasing production speculations. The price elasticity of demand for oil was low, and the strong growth in demand as it is being witnessed in China and other emerging economies, as well as the failure of the global oil production to increase contributed to the commodity speculations. Hamilton’s (2015) study notes that the oil market is no exemption from others, and it is, thus subject to the effects of speculation. As a result, as pressure mounts on prices through this speculation, some oil producers discovered that the decline in the oil production could cause an increase in revenue. Consequently, the increased demand led to the scarcity of oil (Hamilton 2015). Hamilton’s (2015) study, further notes that a look at the past oil prices, especially the changes in the real prices are somehow permanent and difficult to predict. Based on the economic theory, the restrictions that keep oil prices at equilibriums are the financial futures contract, storage arbitrage, and the fact that oil is prone to depletion. There is a challenge in measuring the price elasticity of oil demand; however, it is believed to be low. The futures market is named appropriately because several individuals are anticipating what is likely to happen to the demand and supply of oil in the future. There are instances when such speculations can cause havoc and lead to an increase in prices while reducing the production of the commodity. At worst, the market crashes when such a speculative action goes out of control. Rapid increases in the prices of oil have sparked debates about the accessibility of global supplies since oil is a crucial energy source across the globe. There are also concerns about the capacity of oil producers to meet the demand in the future and control its supply. Asdorian’s (2011, p. 97) study established that the prospects for the oil supply are strongly affected by the production constraints subjected to oil producing economies from their oil fields. In regard, it becomes apparent that the continued discovery of oil in some regions is likely to increase its supply on the market. The price elasticity of supply of oil is short lived, to imply that the price changes have a greater effect on the oil supply. Precisely, the supply curve of oil is subject to unexpected and substantial shifts in a given time. As a result, the oil prices become volatile. Another factor that influences the supply of the oil is the geopolitical situation. Empirical cases have been witnessed across the world. These political unrests have drastically led to the decline in oil production. For instance, the 2011 civil war witnessed in Libya led to a noticeable decline in oil supply. Historically, in 1973 and 1974, the Arab Oil Embargo and the Yom Kippur War, led to a significant scarcity in the oil supply. Consequently, the prices of oil quadrupled. Other geopolitical events include the Iraq-Iran war of 1978 and 1981 that brought about a shortage in oil supply, and change in Saudi Arabia’s oil policy that led to over flooding of the market. Currently, the presence of Islamic crisis and the Russia and Ukraine standoffs have significantly contributed to the reduction in oil supply. It should be understood that oil supply is also affected by the production restrictions that have been imposed by some agencies or cartels such as the Organisation of Petroleum Exporting Countries that controls oil production in its member states. The Organisation of Petroleum Exporting Countries thus, affects oil supply as it works to coordinate and stabilise oil markets with a view to secure an efficient, and economic, as well as a regular supply of oil to consumers. As this analysis mentioned earlier, speculations exhibited through fears and expectations of oil producers, primarily to maximise their profits have a significant impact on the oil supply and availability. There are instances when they may hoard the oil and cause a scarcity in its supply. Such actions may crop black markets. Additionally, the substantial and unexpected shift in the oil supply makes its price highly unstable and volatile. As a result, producers find it hard to determine the precise market price of this particular product. On the same note, economic challenges are affecting the supply of oil. It has become difficult to find oil from easy fields, leaving it to the difficult unconventional oil fields. In addition, the production of oil requires substantial capital investment for its development and production. This financial investment is difficult for many economies to afford, hence retarding the oil supply. Figure 1: The Movement of the prices of oil Figure 1 above will be used to demonstrate how the law of demand and supply could have been influencing the elasticity and prices of oil. According to Stonebraker’s (2005) findings, the prices illustrated in figure 1 above could be controversial, but they are inevitable as a result of changes in the demand and supply of oil over this period. Figure 2: The demand and supply curves Normally, the demand and supply of oil are inelastic in the short run as illustrated in figure 2 above. This implies that the change in price impacts very little in the quantity supplied, or quantity demanded. When the prices of oil increase, consumers spend considerable energy and time complaining, but over the short run, they will not have made any effort to adjust their habits and consume less. In terms of supply, the short run changes in the prices of supplies do not warrant new supplies during this period. This is based on the fact that, exploring, drilling and making these new oil sources to be economically productive takes many years. Therefore, since the quantity demanded, and the quantity supplied shifts very little from prices’ fall or rise, the supply and demand curves remain relatively vertical. In the short run, the quantities are relatively fixed, and a shift in the supply or demand will substantially affect prices of oil. In case of oil scarcity, the temporary shortage makes prices swell up and if it occurs when the demand is elastic the price will increase by a small margin. This scenario is presented in figure 3 below. Figure 3: The shift in supply when demand is elastic The temporal scarcity in the supply of oil is represented by the drop in its supply from S to S, leading to a small rise in the price, from P0 to P1. If the demand is inelastic, the scarcity in oil supply causes larger price increases as illustrated in figure 4 below. Figure 4: The shift in supply when demand is inelastic As illustrated earlier in figure 1, there was a greater price increase in 1970s since the demand was inelastic due to oil scarcity when the OPEC oil ministers agreed to cut oil production deliberately. In 1979, the oil scarcity aggravated from the fight between Iran and Iraq and made the oil prices to rise further. In the long run, however, consumers and suppliers of oil adjusted, leading to the fall in oil prices. In addition, there was an additional oil production from the newly discovered oil fields in Russia, Mexico and the North Sea. Since the prices remained relatively lower for a longer period, the consumers demand for oil increased, which later led to an increase in oil prices after the 21st century. Externalities from oil consumption Externalities are either positive or negative, and they refer to the benefits or costs of activities that spill over onto third parties (Bohi et al. 1996, p. 9). According to a previous study (Dwivedi 2002, p. 570), the positive externalities are benefits that are infeasible to charge to offer while the negative externalities, on the other hand, are those costs that are infeasible to charge not to offer. According to Birur et al.’s (2013, p. 16) findings, externalities are inefficiencies that are as a result of accrual of some benefits or cost imposed on individuals who have not been directly involved in the market agreements. The consumption of oil products has several externalities. Among them, are the environmental externalities that come from the transportation fuels. The transportation fuels emit GHG emissions and according to the studies conducted using the LCA technique, their full impact; both direct and indirect environmental and economic ones have been identified for all its life cycle stages. According to a recent research (Birur et al. 2013, p. 17), the GMG emissions are responsible for the climate change, after confirming that GMG emissions contributes to approximately 23% of climate change. Other than the GMG emissions, the transportation sector has significantly increased the presence of carbon dioxide in the air with the US CO2 being around 27%, whereby two-thirds of it, come from diesel and gasoline. Another negative externality on the environment from oil activities relates to the oil spillages. There is an assumption that there are around 8,000 tankers that are engaged in the business of transporting oil and its products. In case of tanker accidents, there are oil spillages. Through exploration, and particularly its extraction, oil has led to a permanent change in the use of land as witnessed from the worst environmental disasters. Such cases occurred in 1989 when the Exxon Valdez spill occurred and during the 2010 British Petroleum (BP) oil spill. The Exxon Valdez spill led to the death of around 35,000 seabirds. In addition, native wildlife, as well as the natural environment is yet to recover since there are instances when the oil pool directly below the shoreline’s surface. British Petroleum (BP) oil spill led to a loss of approximately 4.9 million barrels. The British Petroleum further suffered a financial loss of up to $14 billion in its bid to clean up. Additionally, $20 billion was set aside for economic claims, as well as restoration work. Gasoline has also been a chief source of water pollution because of the leakages from gas stations, and emissions are from the internal combustion engines (Birur et al. 2013, p. 18). Another serious environmental impact of oil is associated with the drilling and extraction process of petroleum. The production process consumes much water, and around 8 gallons are required per crude oil gallon. Poor disposal practices have added contaminants into the water system. The use of gasoline in vehicles has also led to the emission of other gases such as nitrous oxide, methane, carbon monoxide and volatile organic compounds. The use of diesel also emits GMG and low amounts of CO2, compared to the gasoline. Besides, the environmental impacts that diesel presents like water and soil pollution, it alters the cloud cover and rainfall patterns, which leads to changes in the albedo (Birur et al. 2013, p. 19). Control by the Government According to Sovacool and Brown’s (2007, p. 131) research findings, the price of oil product fails to include fuel costs, leading to too much energy consumption. This necessitates intervention by the government in order to achieve efficiency. The government can use tax to remedy externalities. By imposing the tax, consumers pay the total social costs of the energy. The revenue realised by the government from oil is used to compensate for the people who get harmed as a result of oil activities done by others. The energy tax’s goal is to estimate the market that is likely to arise if polluters are to compensate those harmed from their oil consumption. Then polluters would factor these payments into the prices they charge for services and other goods. In order to charge the right price, the health and environmental externalities as a result of energy consumption are monetized. However, a challenge is encountered in valuing these externalities with experts failing to agree on the relationship between human health and the exposure to the various substances. The government can later modify decisions to energy consumption in order to take health concerns into consideration. Other than taxations, the government can exercise direct regulatory intervention for a number of reasons. First, the voters are opposed to the energy taxes, but may tolerate direct environmental regulation since taxes impose visible costs while such regulations have less visible costs. Second, energy taxes are likely to yield uncertain pollution amounts while regulations can determine the emission rates directly. In fact, environmentalists and lawyers argue that through energy taxes, firms are allowed to pay to pollute. Third, voters are opposed to the energy taxes, making it hard for legislators to intervene on behalf of their constituents, but regulations permit them to. Sovacool and Brown’s (2007) research further established that the energy taxes are unreasonable because they are imposed even on motorists who are not involved in the emission of externalities. For instance, costs in relation to the traffic congestion are best internalized by tolls, which will vary based on the roadway congestion. Also, the costs related to the traffic accidents are best addressed by automobile insurance premiums. Conclusion The oil market is subject to the economic laws of demand and supply. In the short run, the demand for oil is elastic and inelastic in the long run. The scarcity in the supply of oil causes prices to rise because it lacks close substitutes in addition to its wide use across the globe. This paper established that many factors cause oil scarcity. They include geopolitical situations, regulations, financial constraints, and discoveries of new fields among others. Despite its immense benefits, oil usage poses adverse effects to human health and the environment as a whole. To address these problems, this paper established that the government uses tax and/or environmental regulations. References Asdorian, G., 2011. Oil Scarcity, Growth and Global Imbalances - IMF. Washington DC: International Monetary Fund International Monetary Fund. Birur, D.K. et al., 2013. Externalities of Transportation Fuels: Assessing Tradeoffs between Petroleum and Alternatives. Research Report Occasional paper. North Carolina, United States: RTI Press RTI International Press. Bohi, D.R., Toman, M.A. & Walls, M.A., 1996. The Economics of Energy Security. Illustrated ed. Berlin: Springer Science & Business Media. Dwivedi, D.N., 2002. Microeconomics: Theory And Applications. New Delhi: Pearson Education India. Hamilton, J., 2008. Understanding Crude Oil Prices. [Online] Available at: HYPERLINK "http://www.nber.org/papers/w14492" http://www.nber.org/papers/w14492 [Accessed 28 April 2015]. Oxford Business Group, 2012. The Report: Oman. Oxford: Oxford Business Group. Sovacool, B.K. & Brown, M.A., 2007. Energy and American Society – Thirteen Myths. Illustrated ed. New York: Springer Science & Business Media. Stonebraker, R.J., 2005. The Joy of Economics: Making Sense out of Life. Rock Hill: Winthrop University. Watkins, G.C., 2006. Oil scarcity: What have the past three decades revealed? Energy Policy, 34(5), pp.508-14. Read More