Oil Prices: Analysis from the Microeconomic Point of View

Oil Prices: Analysis from the Microeconomic Point of View This paper discusses the microeconomic issues as outlined by the article “Global Oil Markets: A Strategic Interpretation” by Alhajji (2005). Classical economics, as derived from the earliest economists like Adam Smith and others, was and is concerned with the efficiency of individual markets - i.e. how to make the most efficient, economic use of given resources. This is microeconomics: the study of consumer and producer behavior in the trade in specific goods or services. In a free market for oil, if demand exceeds supply then prices will rise. Profit-seeking entrepreneurs thus have an incentive to produce more of this higher-priced commodity; they will draw workers, materials and land away from less profitable employments and thus expand production of the homes that more and more people in the market want. Oil prices are therefore vital signaling devices in market systems. They ration out scarce existing supplies between competing consumers and simultaneously induce businesses to mobilize resources, adjust production and so eradicate any shortages and surpluses.

Let us look more closely at this interaction between prices, demand and supply. There are many factors that influence consumer and producer decisions, and some markets react differently from others. Take the example of a local newspaper, on sale every day in a particular city. On the occasion of a major news story - perhaps the success of the local football team - there may be a rush in demand and the newspaper sells out, leaving many dissatisfied customers. How is the market likely to respond to this disequilibrium situation where demand exceeds supply at the ruling market price? In this example we can predict that on the following day, assuming continuing interest in the story, local shops and stallholders will order more newspapers to meet anticipated demand, and the printers will run off more copies. It is also possible that to avoid disappointment some consumers will leave the market - perhaps following the story on local television and radio - rather than risk unfulfilled demand a second time.

In these circumstances, if suppliers have guessed correctly, the quantity of newspapers will adjust to secure the necessary equilibrium between demand and supply. Sales increase; all consumers are satisfied; the newspaper price remains unchanged. A different scenario may operate in the second-hand market for football tickets. On the day of a keenly contested match those supporters who have been sharp enough to buy tickets early may find that there are many frustrated consumers desperate to pay inflated prices in order to secure entry to the vital match. The ability of the local club to increase the supply of tickets is limited by the capacity of the ground, so in this case the shortfall between supply and demand is closed by a movement in prices, quantity staying the same. Tickets are likely to change hands outside the ground, scarce supplies going to the highest bidders.

For many goods and services a combination of both these movements will ensure demand equals supply: there will be some adjustment in prices and some change in quantities traded to bring about market equilibrium. The key point to emphasise here is that there are a number of different influences affecting demand and supply. Consumers’ incomes change, their tastes and preferences vary, advertising has its impact - all these factors, as well as a change in prices, may influence demand for one product rather than another. In production, costs will alter, technological breakthroughs occur, random shocks (from earthquakes to exchange rates) have their effect. These issues, as well as the prospective price the entrepreneur is seeking, will influence the quantity of the product eventually supplied. Some of these factors are more variable than others, and the ‘art’ in the science of economics is to identify - in the case being studied - which is the key variable, and which factors in comparison are relatively unchanging.

A theory of demand, supply and price can thus be constructed and, given factor x changes and y remains constant, we can predict the market outcome. Whether, of course, economists’ predictions are fulfilled depends on whether or not they guessed right on the variables that changed. If x was constant and y changed - or, worse, x and y stayed the same and z varied - their theories need revising. Here you can begin to see the source of controversy in the subject. Some examples will make these issues clearer. Agricultural markets are typically unstable. Supplies of coffee have been decimated by frost; fine weather can produce unexpectedly good wheat harvests; hailstorms can ruin a wine vintage. Even normally stable demand for basic commodities like beef or corn can be drastically affected by health scares such as ‘mad cow’ or foot-and-mouth disease and worries over genetically modified crops.