Consequences of a Fall in the Global Price of Oil - Coursework Example

CONSEQUENCES OF A FALL IN THE GLOBAL PRICE OF OIL INTRODUCTION Oil is one of the key raw materials in the world and is used for various purposes. The refining of oil results into a number of different by-products which have multiple uses of their own and serve as raw material for many industries. Oil products such as petroleum, kerosene, paraffin, wax, vegetable oils, diesel etc. are used in many industries for heating, lighting, fuelling, road-making, cooking, manufacturing of plastics etc; because it is associated with so many products and their by-products any change in the price of a key product such as oil does cause a ripple in prices of various commodities. Most economists believe that since oil is associated with so many products any change in its price have a trickle-down effect or a chain reaction affecting the prices of many commodities and/or affecting the rate of inflation in the economy or the general price level. MICRO-ECONOMIC EFFECTS If we suppose that there has been a fall in the global price of oil there will be a fall in the quantity supplied of oil because the producers will now be left with a lower profit margin and some of them may also go out of business if they would find it difficult to cover their average variable costs. There will be an increase in the quantity demanded of oil and buyers who were not able to afford oil at previous prices and opted for substitutes may now turn towards oil, current buyers may also buy more. If we take the example of British Petroleum, BP will reduce it quantity of oil supplied to the market because they will now experience a lower return on oil, its current customers may want to buy more since the product is now available at lower prices and some customers may now be interested in purchasing oil rather than purchasing its substitutes such as coal, gas etc. The fall in oil prices may cause some producers who were already finding it difficult to cover their costs to go out of business or shift to the production of other commodities, this means that BP will now have a lower number of competitors in the market and will face a lower competition than in the past. Since the affect on the quantity supplied is due to price there will not be a shift in the supply curve of BP, it will operate on its previous supply curve but at a lower point because of the contraction in supply. Similar is the case for quantity demanded, BP will not experience a change in its demand curve because of a change in price, it will operate on the same demand curve but at a higher point due to the extension in demand. This fall in price will have different consequences on the quantity demanded, quantity supplied and any shortage or surplus that may occur; it depends on whether BP was operating at the equilibrium point or any other point on its demand and supply curves before this fall in the price of oil. If BP would have been operating at the equilibrium point, this fall in price will result in a shortage of oil. This is because at any point below the equilibrium point quantity demanded of oil is greater than the quantity supplied of oil resulting into a shortage. If this situation persists for a longer period time a black market for oil may develop, more and more oil producers will find it difficult to operate as they would not be able to cope up with their costs or find it less profitable to continue manufacturing oil and may shift to the production of other goods. If oil prices continue to fall and the there is no intervention of the Government (as in a free market economy) then the supply of oil will be exhausted further and the shortage will increase causing the prices to rise (due to the black market and customers who are able and willing to pay a price higher than the current price), there will be increasing profit margin for current producers and again will attract other producers into the market, the prices will continue to rise until the industry is again at the equilibrium point (i.e. where quantity demanded = quantity supplied). If BP would have been operating at a point above the equilibrium point (surplus), i.e. at a point where quantity supplied is greater than the quantity demanded, this fall in oil price will result into a lower quantity supplied (contraction in supply) and a higher quantity demanded (extension in demand); the company will shift towards the equilibrium point and if the prices fall sharply it may even result into a shortage of oil. MACRO-ECONOMIC EFFECTS At the macro-economic level, the fall in the oil prices will affect the prices of many other goods; this is because oil has a large number of complementary goods, a small number of substitutes and is used as a raw material in many industries. The fall in oil prices will result into a fall in prices of goods like petrol, natural gas, kerosene, vegetable oils, asphalt, plastics, paraffin, wax etc. each having various uses of its own, the fall in the prices of these goods will in turn affects prices of cooking products, transportation, toys, road-making, lighting, heating and various other commodities. The effect of a fall in oil prices and a reduction in its quantity supplied may result into lower employment levels in the oil and energy sector, but since other complementary goods which will now be facing a higher demand for their goods because of lower prices may employ more labor and employment in such sectors will increase. The effect of a fall in oil prices affects the Aggregate Supply of the economy, it will cause the aggregate supply curve to shift to the right and an increase in the level of potential output of the economy as energy-intensive technologies will now become less expensive. The GDP will increase and there will be a downward pressure on the general price level. If we view it from the demand side of the economy, the Aggregate Demand will increase in the case of a fall in oil prices, it is so because other commodities that use oil as raw material or for purposes like lighting, heating etc. will now experience lower costs of production and hence may charge their customers a lower price. The customers will now find it more affordable to purchase the goods and hence the overall Consumption Expenditure (a determinant of Aggregate Demand) will increase causing a rise in the Aggregate Demand of the economy and a rise in the living standards (higher GDP). Oil exporting countries may also find this decrease in oil prices as beneficial; it is so because they will experience a rise in demand for oil from oil-importing countries causing their Net Exports (another determinant of Aggregate Demand) will increase resulting into a higher Aggregate Demand. On the other hand, Oil-importing countries may find that the fall in oil prices may negatively affect their Aggregate Demand; this may be due to the increase in the import of oil which results into lower Net Exports (a determinant of Aggregate Demand). This will result when the increase in Consumption Expenditure is less than the increase in its oil import. Oil prices may also affect the general price level or rates of inflation in the economy. If there is a fall in the price of oil, there will also be a decrease in prices of its complementary goods causing their demand to increase, current customers find it more affordable to purchase and may increase the volume of their consumption and new customers may also start purchasing these goods hence increasing the quantity demanded of these complementary goods. DECREASE IN THE US DOLLAR EXCHANGE RATE If the US dollar nominal exchange rates fall, US and other oil exporting countries which carries out their trade in US dollar will experience a fall in the value of their exports and this may affect their Aggregate Demand, they will have a lower cash inflow and any imports made by those countries will now become relatively more expensive. On the other hand, companies which import oil from US will benefit firstly from the fall in the price of oil and secondly from the fall in the US dollar exchange rate which means that they will now have to pay less for the same volume of import. CONCLUSION This report leads to the conclusion that a fall in oil prices will result in a lower quantity supplied of oil (contraction in supply) and an increase in the quantity demanded of oil (extension in demand). The fall in the oil price will cause an outward shift in the Aggregate Supply and an extension in the Aggregate Demand of the country. The increase in Aggregate Demand can be associated with higher Consumption Expenditure and higher Net Exports; this will result into a higher standard of living (GDP) and a lower inflation rate. If the US dollar exchange rates fall, countries which import oil from US will now find it cheaper to import oil from US. The US will also experience a fall in the net value of their exports as they would be receiving less money for the same volume of import. BIBLIOGRAPHY BOOK: Lipsey, Richard G, & Chrystal, K. Alec (1999). Introductory Economics.New York: Oxford University Press. Read More