Effect Of Oil Price Change - Essay Example

Effect Of Oil Price Change The demand and supply framework in oil price change Oil is an example of a normal good in the economy. Its price change forms part of one of the biggest topic when it comes to matters of international economy. It is a challenge to forecast commodity prices such as that of oil but the demand and supply framework comes handy in such situations. Every market has a demand and supply mechanisms that set its prices. The oil market is a dominant market internationally which price falls and rises are usually forecasted. The big question is how these changes in the prices of oil are forecasted in the market. The demand and supply framework in the market show the players to buy or sell at each given price. Equilibrium is achieved in the market if its demand is equal to its supply. The oil price at the market equilibrium is the market price of oil at that given time. The demand and supply framework of oil price changes is very complex and becomes understandable when divided into two. The two segments are; the short run and long run demand and supply (Fried and Schultze, 2013). The short-run responses to oil price changes refer to the immediate changes in the event of an oil price change. Players in the market do not make immediate adjustments to their costs and procedures with effect to the oil price changes in this period. In the real world situation, consumers using cars and home equipment that use oil will respond slowly to a change in the oil prices. For example, an increase in the oil prices will make these consumers reluctant to change their consumption behavior of oil and oil-related products to cut their expenditure on oil even though they are not impressed with the prevalent high prices (Krichene, 2008). In the short run, the sensitivity of demand to the oil price change is quite low. In the long run, the demand for oil changes with relation to a change in oil prices. The consumers respond towards a rise in oil prices in the long run by initiating actions channeled at cutting their consumption of oil. These actions are such as the using of more fuel-efficient cars and equipment to cut their expenditure on oil. The price sensitivity, in the long run, is more than in the short run since oil consumers can make changes in their consumption of oil more in the long run than in the short run. This effect makes the demand curves of oil prices to be steeper in the long run than in the short run (Prasch, 2008). (petronomist.com) The above diagram explains the shift in the demand due to changes in oil prices. Oil prices have an impact on the supply of oil too. The changes in the price of oil have an effect on the supply of oil in both the short run and the long run. For example, a fall in the price of oil will keep the producers of oil producing the commodity in the short run. They will do so until it reaches a situation where the marginal cost of production is higher than the production despite it having adverse effects on the company’s profits and performance. This happens in the short run since the company is better off making losses in the company as long as it meets the variable costs instead of shutting down the main operation. In the long run, the fall in oil price will make companies not able to support their operations resulting in strategic choices such as the shutting down of some oil plants. In the long run, the supply of oil will be low too due to the unavailability of oil plants. This will tend to increase the oil demand in the market until a point where equilibrium is reached in the oil market (Horsnell and Mabro, 2011). (Simon taylorsblog.com) The diagram above shows the supply of oil in different prices in the different regions in the world. Price elasticity and Income elasticity of oil The price elasticity of oil is inelastic since it has very few direct substitutes in the market. According to the recent statistics in oil prices, the demand for oil does not change with the changes in the oil prices. The demand for oil globally was 123 million barrels in 2011 when the price of oil was one pound per liter while the demand in 2014 was 123.76 million barrels at price level of 1.30 pounds per liter. In this scenario, the price elasticity is determined by the division of the proportional change in quantity demanded of oil by the proportional change in oil prices. The price elasticity is, therefore: = % change in quantity demanded / % change in prices = ((123.76 - 123) / 123) * 100% / ((1.3 – 1) / 1) * 100% = 0.0206 The price elasticity of oil is 0.0206, which is negligible showing that its demand has a very low sensitivity towards price changes. The average world income was 1000 pounds per person in 2011 and 1230 pounds per person in 2014. Using these income statistics, the income elasticity of oil is: Income elasticity = % change in quantity demanded / % change in oil prices = ((123.76 -123) / 123) *100% / ((1230 -1000) / 1000)* 100% = 0.027 The income elasticity of oil is 0.027 implying that it has an inelastic demand too in relation to income. The negligible income elasticity of oil shows that the demand for oil is not sensitive to income (economicsonline.co.uk). Oil as an essential commodity in the global market has certain features that make it have inelastic price elasticity. The good does not have substitutes in the market and it is a basic good used to run most of the operations. The price elasticity and income elasticity of oil are very useful tools to an oil production company since they guide its pricing policies. If the price elasticity were elastic, the company would be keen when changing its prices due to its sensitivity on the quantity demanded (Perry, 2010). In this situation, both the income and price elasticity of oil are inelastic implying there is no effect in the quantity demanded of oil with either price changes or income changes. The company can, therefore, utilize this advantage in the short run by raising the prices of oil to increase its accounting profits. References Economicsonline.co.uk, 2015. The market for oil. [Online] Available at: http://www.economicsonline.co.uk/Competitive_markets/The_market_for_oil.html [Accessed 2 Nov. 2015]. Fried, E. and Schultze, C. 2013. Higher oil prices and the world economy. Washington: Brookings Institution. Horsnell, P. and Mabro, R. 2011. Oil markets and prices. Oxford: Published by the Oxford University Press for the Oxford Institute for Energy Studies. Krichene, N. 2008. Crude oil prices. [Washington, D.C.?]: International Monetary Fund. Perry, J. 2010. Energy prices. New York: Nova Science Publishers. Prasch, R. 2008. How markets work. Cheltenham, UK: Edward Elgar. Read More