Fall-Term Economics 101 Final Exam: Oil
December 8, 2014
Here at the Tuck School of Business at Dartmouth, second-year students and undergraduates alike recently finished their fall-term studies with final exams, papers, and other deliverables that support America’s caffeine industry. Keen to give our first-year students their money’s worth, they are still looking ahead to finals as their 13-week fall term continues.
The best final exams and papers are often those connected to the world headlines of the day. So in that spirit let us offer three Economics 101 lessons that have been overlooked by much of the recent commentary on the tumbling world prices of oil.
Lesson #1: Technology innovations that expand supply tend to reduce prices of the products enjoying the innovation. A basic way to think about the economics of innovation is it boosts supply: either of products where none existed before or more of already existing products without expanding the inputs used. For nearly any widget, greater supply tends to drive down the price of that widget. Thus do more innovative industries tend to exhibit either slower-growing prices or outright price declines. From 2000 through 2013, the overall basket of goods and services in the U.S. government’s Consumer Price Index rose by 35.3 percent. Quick: Name a low-innovation and a high-innovation industry. What’s that you say, health care and information technology? Right: Over those same 13 years the U.S. price of health care services rose by 70.7 percent while the U.S. price of personal computers fell by 87.7 percent. (Yes, you read that “fell” correctly—and bonus points for those who noted that health care prices rising at double the rate of overall prices is what will, if left unchecked, drive U.S. federal debt to unprecedented and perhaps unsustainable levels.)
A major force behind the recent tumble in world oil prices is America’s technology revolution. It is difficult to overstate how unexpected America’s energy boom has been to almost all involved. Think back five or 10 years. Wise people foresaw “peak oil,” with fading production and rising imports for America’s energy. Today U.S. oil output has reached a remarkable 9 million barrels per day and is widely forecast to surpass world-leader Saudi Arabia within a year or two. And U.S. oil reserves are at their highest level since 1975. This boom in U.S. energy output has been a byproduct of the technology revolution of horizontal drilling and hydraulic fracturing—known, for better or worse, as fracking—that today extracts gas and oil from rock and other spaces previously thought impervious.
Lesson #2: In markets with inelastic supply and demand, when either supply or demand move price movements tend to be much larger. “Yes,” the astute Tuck student will respond, “I see that greater supply tends to reduce prices. But why have oil prices fallen so much in such a short period of time?” In the approximately six months since mid-June, world oil prices have fallen by about 40 percent. This tumble is far more dramatic than the gradual price changes we experience for almost all other goods and services. For example, the U.S. computer prices cited above have never experienced a six-month decline anywhere near 40 percent. The short answer to this good question is what economists ineloquently term, “inelastic” supply and demand.
The (price) elasticity of demand measures how responsive consumers are to changes in prices: it is defined as the percentage change in quantity demanded from a 1 percent change in prices. Similarly, the (price) elasticity of supply measures how responsive firms are to changes in prices: it is defined as the percentage change in quantity supplied from a 1 percent change in prices. Over shorter time periods, both the supply and demand for oil tend to be pretty inelastic, or price-insensitive. Many oil consumers cannot easily buy less fuel as soon as price rises (or vice versa)—e.g., airlines that need to fly their planes every day. Similarly, given the massive capital (and other) investments in producing oil, firms involved cannot easily scale up or down in response to price changes. If you can visualize the canonical supply-and-demand figure with quantity on the horizontal axis and price on the vertical axis, then a market with inelastic supply and demand have near-vertical supply and demand curves that nearly lie atop each other.
Now, this sort of market—like the oil market—has recently been shocked, with the supply curve shifting right (or shifting right over time more quickly) thanks in part to America’s emerging energy revolution, and the demand curve shifting left (or shifting right over time more slowly) thanks in part to slowing economic growth in places including China and the EU. What results is not just a drop in prices, but a big drop in prices.
Lesson #3: Each country’s terms of trade play a major role in determining overall economic output and income. For a country connected to the global economy, keeping track of all its linkages and the economic impacts thereof can get very confusing very quickly. A handy summary statistic for how all the channels of international trade affect a country is what economists call its “terms of trade”: the price of a country’s net-export products relative to the price of its net-import products. A country almost always gains overall when its terms of trade rise—and, conversely, suffers when its terms of trade fall. Yes, within a country any shift in terms of trade will help some and hurt others. But the net national impact is well summarized by how its terms of trade move.
America’s energy boom notwithstanding, the country still is a large net importer of oil. So America and other net importers overall gain from plunging oil prices raising their terms of trade. Yes, some companies and workers in North Dakota and Texas will suffer if oil prices stay down. But these losses will be more than offset by the scores of millions of workers and families whose real incomes will rise thanks to lower costs for heating oil, for gasoline, and so forth.
Conversely, net oil exporters overall suffer from plunging oil prices. Last week the Russian government, for example, downgraded its 2015 GDP forecast from growth of 1.2 percent to a contraction of 0.8 percent—and also forecast that average household disposable income will fall by 2.8 percent. And for oil net exporters such as Russia, Iran, and Venezuela the damage may well extend beyond economics to political unrest as well—both within and beyond their borders.
Economics is by no means the be all and end all. But classic lessons like the three above can, aged though they are, help clarify the headlines of today.
Articles © 2014 Matthew Slaughter and Matthew Rees. All rights reserved.
Publication © 2014 Trustees of Dartmouth College. All rights reserved.