Monthly Archives: August 2010

Impact of Oil Price Changes on Consumers & Producers

Some students have asked what determines whether the cost of oil price changes will be more likely borne by consumers or producers. (One of the 2009 GCE ‘A’ Level essay questions).

First, we should note that the demand for oil is a derived demand. Oil is demanded not for itself, but is derived from the demand for energy and other final products which use oil as a raw material. Oil is used as a fuel for energy production (eg. in cars, aeroplanes electricity generation, etc.) and manufacture of petroleum related products such as plastics, paints, solvents, lubricants, etc. Changes in price of oil therefore can impact a wide range of goods and services (eg. bus transport). In general, the price of oil has been rising over the years due to demand and supply conditions.

The impact on consumers and producers therefore depends on the type of goods and services which are impacted by the oil price hike. An increase in price of oil represents an increase in the cost of production for the final goods and services — hence a leftward shift of the SS curve.

1. The more inelastic the demand for the good, the more likely consumers will bear the cost of the oil price increase. This can be shown using a DD-SS diagram. (Try drawing). Eg. bus transport. If demand is price inelastic, producers are able to pass on more of the cost increase to consumers. The more inelastic the demand, the greater will be the increase in price of the good, and hence consumers will bear more of the cost of oil price increase.

Conversely, the more elastic demand, the smaller will be the increase in price of the good (with a shift in SS curve), hence producers will bear more of the cost increase.

2. The more elastic the SS of the good, the more likely that consumers will bear the cost of the price increase. An increase in cost (due to oil price increase) is shown by a leftward (vertical) shift of the SS curve. The vertical distance between the new and old supply curves represent in the increase in per unit cost (and hence price at each quantity). A more elastic SS curve will result in a greater increase in price and hence more of the cost increase is borne by the consumers. With a more inelastic SS curve, the same vertical shift in the SS curve will cause a smaller increase in price, so that more of the cost increase will be borne by the producer. (Try drawing the DD-SS diagram).

The conclusion is that whether the cost of an oil price increase is borne more by consumers or producers would depend on the relative elasticities of demand and supply of the good or service. It could also depend to some extent on the type of market structure. If it is a monopoly, it is more likely to pass the cost increase to consumers since it is the sole supplier. If the industry is monopolistically competitive, producers are less able to pass on their cost increase to consumers since there are many substitutes available. Producers may have to bear more of the cost increase. For oligopolies, the high mutual interdependence among firms could limit their ability to pass on cost increases to consumers. However, if there is high degree of collusion among them, consumers may end up bearing more of the cost increase.

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Investment and Shift of LRAS

There seem to be some confusion among some students with regard to shifting the long run aggregate supply (LRAS). Some students mentioned in their essays that a fall in investment would lead to a leftward shift of the LRAS which would mean a fall in productive capacity. Is this correct?

We know that the LRAS is determined by the productive capacity of the economy (ie the total output of goods and services possible when resources are fully employed). Investment refers to the acqiusition of fixed capital and addition to inventories. With more capital stock, the productive capacity of the economy would increase and hence LRAS shifts to the right. Does a fall in investment then mean a fall in productive capacity and a leftward shift of LRAS?

The concepts of gross and net investment would apply here. As capital is utilised, it is subject to wear and tear. This is what we call “depreciation” of capital or “capital consumption”. Hence part of the investment is to replace worn out capital. This is known as “Replacement Investment”. Gross Investment is the total investment ie acquisition of capital. Since part of it is used to replace worn out capital, the remaining part is called Net Investment. Hence Net Investment = Gross Investment – Replacement Investment (capital consumption).

As long as gross investment exceeds replacement investment (ie Net investment is positive), there is a net addition to capital stock and hence an increase in productive capacity. So LRAS will still shift to the right. So even if investment falls, (eg. due to fall in foreign direct investment inflow), LRAS can still shift to the right as long as it is still greater than replacement investment. It is therefore not correct to say that a fall in investment would cause LRAS to shift to the left, unless we qualify that it falls below replacement investment (which is quite unusual in most cases).

What is more likely is that the LRAS shifts rightward by a smaller extent due to the fall in investment ie the increase in productive capacity is smaller – which is what we refer to as a fall in potential growth of the economy. (Note there is still positive growth but at a slower rate).

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Economics Humour

For students who are getting examination stress, here are some economics jokes to lighten up your day!

I’m a walking economy,” a man was overheard to say.
“My hairline’s in recession, my waist is a victim of inflation, and together they’re putting me in a deep depression.”

An economist is someone who gets rich explaining others why they are poor.

A woman hears from her doctor that she has only half a year to live. The doctor advises her to marry an economist and to live in South Dakota. The woman asks: will this cure my illness? Answer of the doctor: No, but the half year will seem pretty long.

Economics is the only field where there can be 2 Nobel Prize winners saying opposite things.

The First Law of Economics – Every economy tends to remain at full employment equilibrium unless acted upon by an economist

The Second Law of Economics – For every economist, there is an equal and opposite economist.

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