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Does the Oil Equilibrium Price Exist?

 


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Many predictions and explanations are offered to the price spike in oil; speculation, rising demand from newly developing countries (China and India) and others. Many believed that the price will drop or reverse its present trend after it reaches a certain threshold. When this is reached, it is assumed that the demand will drop, as the price will make the usage less affordable to normal folks. Thus, the price will revert to equilibrium and everyone is happy again and the usage will go back to normal, and waiting for another round of spike in the future. This is the standard economic thinking, where the equilibrium plays a role as attraction to the price.

However, this threshold level might not exist at all! There are several reasons to this;

1) If oil producing countries or companies are profit maximizing entities, the price charged will not be gradual or continuous as argued by the threshold theory above. Rather, it is more maximizing to set a price at a higher level and let the price adjust to the demand. In other words, instead of letting the price to adjust upward, the price is set a higher level to let it adjust downward. If the latter strategy is more profitable, why should the companies set the price at low level and let the consumers decide which level to buy and which level is the threshold value?

2) In the standard economic demand theory, that the demand curve is sloping downward to the right; as when the price increases, the demand of the commodity drops. That is to say the consumption be it from end consumers, or producers in the manufacturing sector, have to cut the consumption of oil. Thus, the production has to be reduced and consequently the GDP is to be slowed. However, having seen the ever increasing price for the past two years, the drop in demand is no where to be seen. Rather, the increasing price is accompanied by increasing demand. Thus, the theory that the spike might be caused by heavy industrialization might have some truth in it. And i would say the spike in oil price will be “accompanied" with more usage of oil especially from the industrializing countries such as China and India.

3) Another reason that there might not be a price reversion level is the prosperity effect. Many may think that the price hike causes us to reduce our usual demand, have to adjust our budget and so on. In other words, the price hike makes us feel poorer in terms of disposal income. This is true in some extent if the country is not moving forward or the economies are static; the growth is slow, unemployment is high, and so on. For countries achieving 8-10% growth per annum may not feel the pinch very much, but rather the increase of price and demand are signs of prosperity.

Having said that, it does not mean that the price of oil defies the standard economic demand theory. On the contrary, the price hike follows very much what the standard economy has to say about the price mechanism. The demand curve in this case is not determined by the price alone; the demand curve is also determined by the prosperity, the economic growth and also the profit seeking objective of the oil companies. The demand curve is shifted by these effects rather than sliding along the curve caused by the different price level. Thus, if the shift of demand curve outward due to these effects is larger than the sliding down along the demand curve due to price effect, the world demand will not drop although the price is high. ( we assume away the other distortions in the oil price market such as hedging and speculation) Thus I very doubt there is an equilibrium level where the price can revert to.

John Chng at http://economicsandpolitics.blogspot.com/

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