2009 Essay Question 3

Question

There have been large changes in the price of crude oil over the past few years.

Discuss what determines whether consumers or producers are more likely to bear the cost of these oil price changes. [25]

Answer

Students need to distinguish between the demand factors and the supply factors which may lead to a rise in the price of crude oil.

Increase in the demand
An increase in the price of crude oil may be due to an increase in the demand. This may occur due to an increase in consumers’ income. For example, when consumers’ income rises, the demand for private cars will rise will lead to an increase in the demand for petrol resulting in an increase in the demand for crude oil. If this happens, oil consumers will suffer as they will pay a higher price. Oil producers will benefit due to two reasons. First, they will receive a higher price. Second, they will sell a larger quantity.

Decrease in the supply
An increase in the price of crude oil may be due to a decrease in the supply.

A decrease in the supply of oil may be due to a decrease in the production capacity. For example, when Hurricane Katrina swept across the Gulf of Mexico in 2005, many oil production facilities in the United States were damaged which led to a decrease in the production capacity and therefore the supply of oil. If this happens, oil consumers will suffer as they will pay a higher price. For oil producers, those whose production facilities are not damaged will benefit as they will receive a higher price. However, those whose production facilities are damaged will suffer as they will not be able to produce any output.

A decrease in the supply of oil may be due to a rise in the cost of production. For example, when oil workers bargain for higher wages, the cost of production of crude oil will rise. If this happens, oil consumers will suffer as they will pay a higher price. Oil producers will suffer due to two reasons. First, they will sell a smaller quantity. Second, although they will receive a higher price, the rise in the price will be less than the rise in the unit cost of production. When the cost of production of crude oil rises, firms will pass on the rise in the cost of production to consumers in the form of a higher price in order to maintain profitability. However, as the demand for crude oil is not perfectly price inelastic, the rise in the price will be less than the rise in the of the unit cost of production.

In this case, oil consumers and oil producers will both suffer. The question on whether oil consumers or oil producers will bear the cost of the oil price increase to a larger extent will depend on the PED relative to the PES. The side of the market which is less responsive to a change in the price will bear the cost of the oil price increase to a larger extent.

If the demand for oil is less price elastic than the supply, oil consumers will bear the cost of the oil price increase to a larger extent. When oil consumers are less responsive to a change in the price than oil producers, oil producers will be able to pass on a larger proportion of the oil price increase to oil consumers in the form of a large increase in the price without causing a large decrease in the quantity demanded. This may happen because the demand for crude oil is price inelastic due to the high degree of necessity and lack of close substitutes. Students need to draw a diagram showing oil consumers will bear the cost of the oil price increase to a larger extent.

If the demand for oil is more price elastic than the supply, oil producers will bear the cost of the oil price increase to a larger extent. When oil consumers are more responsive to a change in the price than oil producers, oil producers will not be able to pass on a larger proportion of the oil price increase to oil consumers in the form of a large increase in the price without causing a large decrease in the quantity demanded. This may happen as the supply of crude oil may be price inelastic as the production time may be long. This is because there may be no or little excess capacity in crude  oil production and the construction time of oil rigs is long. Students need to draw a diagram showing oil producers will bear the cost of the oil price increase to a larger extent.

Crude oil is an essential factor put which is used in the production of many goods. Therefore, a rise in the price of crude oil will lead to a rise in the cost of production of many goods. This will lead to a decrease in the supply resulting in a rise in the prices and hence affecting the consumers and the producers. Therefore, apart from the effects of the oil price increase on oil consumers and oil producers, students should also discuss the effects on the consumers and the producers of other goods. In this case, a discussion of the effects on two other goods will suffice. Students should ideally discuss the effects on a good whose PED is less than the PES, and the effects on another good whose PED is greater than the PES.

Tobacco (PED is less than PES)
The demand for tobacco is price inelastic due to the high degree of necessity and lack of close substitutes. The supply of tobacco is likely to be price elastic as the production time is likely to be short given that it is mass produced on assembly line and it can be stocked in large quantities given that it is small in size and non-perishable. Therefore, the PED for tobacco is likely to be less than the PES. If this happens, tobacco consumers will bear the cost of the oil price increase to a larger extent.

Luxury watches (PED is greater than PES)
The demand for luxury watches is likely to be price elastic due to the large proportion of income spent on the goods as they are generally expensive. The supply of luxury watches is likely to be price inelastic as the production time is likely to be long given that they are typically high quality goods that generally undergo stringent quality control. Therefore, the PED for luxury watches is likely to be greater than the PES. If this happens, luxury watch producers will bear the cost of the oil price increase to a larger extent.

Evaluation

Point 1: Students can explain why the large increases in the price of crude oil over the past few years are more likely to be due to increases in the demand rather than decreases in the supply.

Point 2: Students can explain why a rise in the price of crude oil is not all bad and no good.

A more elaborate answer to 2009 Essay Question 3 will be provided in the economics tuition class.

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