Econ 101:  The Price of Oil

Supply and demand.  Supply and demand.

Every economist of all political persuasions knows that the price of oil in a free market is determined by its supply and demand. The price of oil has risen a lot because its supply has been reduced by the Russian sanctions and the war in Ukraine and because with the easing of the covid pandemic restrictions demand has returned for people to travel on the road and by air. Before you decide what you think should be done about this, let’s be sure you understand how supply and demand works in this (and most every other) case.

The price of oil (let’s talk about gasoline) equates its supply with demand. Gas (short for gasoline in this note) refiners (and those who search for it and drill, pump it out of the ground and transport it to the refineries) and their retail gas stations that sell it to us, sell it for the highest price they can get away with.  But if they set their price too high their customers will buy from a cheaper gas station around the corner and or reduce their driving or will double up for the commute to the office, etc.  People cannot buy more than is available. Allowing the market to freely set the price means that those with a stronger demand get it and those with a more moderate need pass it up. The available supply goes to demanders whose demand is prioritized by those most willing to pay for it. Gas’s high price rations out those with weaker demand.

Suppliers will continue to explore and drill etc., as long as it is profitable to do so (i.e., as long as the pump price is higher than the cost of finding and refining it). Gas’s high price will encourage the production of more of it.

This helps us evaluate what to expect or what to propose in response to current high prices.  The supply side is much more complicated by government regulations and OPEC monopoly agreements among producers, so let’s start with the demand side.

Those of you my age will remember the gas price caps imposed by tricky Dick Nixon in 1971 as part of his wage and price controls to fight inflation. It was a wonderful economics lesson for almost everyone. At the lower price of gas at the pump, demand exceed supply and therefore there was not enough for everyone to buy it who wanted it at that price (demand exceeded supply). Thus, long lines formed as people waited hours for their turn at the pump. Some cities alternated days in which people with license plates ending in an odd number or even number could enter the city, and other crazy things.  If demand is not being rationed by price, government bureaucrats will decide who gets it; or the willingness to wait in line for hours will be added to the price as a rationing devise.

On the other side of the supply/demand equation, price caps reduce the incentives to find and produce more gas. Many factors influence the costs and thus profitability of increasing gas supplies. Environmental regulations, pipeline approvals or disapprovals, some well-considered and some less so, raise the cost of supplying gas. OPEC (Saudi Arabia, Russia, Venezuela, Iran) and geopolitical factors complicate the picture. For many years after Nixon’s wage and price controls most everyone understood that they were a very bad idea.

Hopefully we don’t have to learn that lesson again. The environmental and other regulations that increase the cost of supplying gas and thus reduce its supply need to be carefully considered and justified by honest cost benefit analysis.

Author: Warren Coats

I specialize in advising central banks on monetary policy and the development of the capacity to formulate and implement monetary policy.  I joined the International Monetary Fund in 1975 from which I retired in 2003 as Assistant Director of the Monetary and Financial Systems Department. While at the IMF I led or participated in missions to the central banks of over twenty countries (including Afghanistan, Bosnia, Croatia, Egypt, Iraq, Israel, Kazakhstan, Kenya, Kosovo, Kyrgystan, Moldova, Serbia, Turkey, West Bank and Gaza Strip, and Zimbabwe) and was seconded as a visiting economist to the Board of Governors of the Federal Reserve System (1979-80), and to the World Bank's World Development Report team in 1989.  After retirement from the IMF I was a member of the Board of the Cayman Islands Monetary Authority from 2003-10 and of the editorial board of the Cayman Financial Review from 2010-2017.  Prior to joining the IMF I was Assistant Prof of Economics at UVa from 1970-75.  I am currently a fellow of Johns Hopkins Krieger School of Arts and Sciences, Institute for Applied Economics, Global Health, and the Study of Business Enterprise.  In March 2019 Central Banking Journal awarded me for my “Outstanding Contribution for Capacity Building.”  My recent books are One Currency for Bosnia: Creating the Central Bank of Bosnia and Herzegovina; My Travels in the Former Soviet Union; My Travels to Afghanistan; My Travels to Jerusalem; and My Travels to Baghdad. I have a BA in Economics from the UC Berkeley and a PhD in Economics from the University of Chicago. My dissertation committee was chaired by Milton Friedman and included Robert J. Gordon.

2 thoughts on “Econ 101:  The Price of Oil”

  1. I always liked Milton Friedman’s presentation in his “Price Theory” book (mine was a thin paper binding with mimeographed pages, from the Bookstore; I think it is now on Amazon.)

    Friedman points out the “curves” on the supply-demand chart are actually boundary lines between types of people. (1) those in demand for whom a price is too high, the area on the right of the line; (2) those suppliers for whom a price is too low, as they drop out. And (3) the happy “winners of ‘surplus’.”
    Below and above the price line after overlaying the two sets on one graph, we see the zones of “surplus” (e.g. the greed zones). Some demanders get it cheaper than they would have been willing to pay, and some suppliers make a larger gain over costs.
    Price controls, as well as the behavior effects (lines, shortages, frozen or reduced production). They are a form of cross-subsidy. But also, the amount of greed in the “surplus” that some demanders receive is clear.
    An instructor once told me to take my eyes off the lines connecting dots and look at what all the blank space means, in terms of market watchers/actors. Emphasizing the behavioral effects gives potential dynamic results in the sets of people who get the cross-subsidy and those who just get nothing to buy.
    Obviously an overall loss to the society, with favorites rewarded. This reminds me of national socialism.

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