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.