How Oil Price Affect World Economy

1. Introduction

The price of oil becomes the bone of contention recently. Oil price seems to be hitting new highs with the regularity of a metronome. It is a bad news for customers who have to pay more on it. More frightening still, this situation may get worse before it come back to normal. No one can exactly predict when the pendulum will soon swing back again since all uncertain factors existing. From the supply side of view, the OPEC is the main producer, being prepared to add or subtract production to balance demand. Moreover, Russia is another major producer of oil in the world. They usually produce more when demand more and subtract when demand reduce to control the price of oil. Anyway, speculator is another factor we have to consider in short run. From demand side of view, every country is trying to reduce the consumption on petroleum, the government use tax strategy to control the oil price. Further more, government strategic oil reserves have to be considered as a factor which causes oil supply shortage. Next, letÐŽ¦s discuss in detail how the demand and supply relation affect the price of oil.

2. Microeconomic Analysis

2.1 Analysis of Market Form

There are not so many oil producers in the world; the countries that produce most of the worldÐŽ¦s oil have formed a cartel, which called Organization of Petrolum Exporting Countries (OPEC). Those countries controlled about three-quarters of the worldÐŽ¦s oil reserve. Within the OPEC countries, they tries to raise the price of its product through reducing in quantity produced and OPEC tries to set production levels for each of the member countries. From this point of view, oil market belongs to oligopoly which only a few sellers offer similar or identical products. In this form, the producers produce a quantity of output greater than the level produced by monopoly and less than the level produced by competition. The oligopoly price is less than the monopoly price but greater than the competitive price. Therefore, supply and demand theory can be applied in oligopoly form of market.

2.2. Supply and Demand Analysis

2.2.1 Oil Supply Analysis

Supply refers to both the ability to sell and the willingness to sell by the producer. Actually, many factors can determine the quantity and individual suppliesÐŽXinput prices, technology, expectations.

The quantity supplied rises as the price rises and falls as the price falls, showed as Figure 2.1.

With the unexpected increasing in demand of oil consumption,(1) OPEC had increased its collective production to 27.5 million barrels a day by March 2005 and prepared to increase 500,000 barrels a day of spare capacity, is high in sulphur, and thick. It requires additional refining capacity, of which there is a shortage. It will cost the producers large amount on the facilities to convert crude petroleum to petrol. The input price and extra capacity will lead to a higher cost of production and shift the supply curve left, meaning that supply same level of product, the price of the oil will be higher.

Furthermore, since the OPEC countries expected the oil price keep in high, they will not tries to produce as much oil as they can. Therefore, the quantity of supply will not increase much.

Another thing we have to consider in supply is speculatorsÐŽ¦ investment, they may take the oil off the market temporarily to aggravate the shortage of quantity supply and pushing the oil price higher. Therefore, extra 500,000 barrels a day may not total enter into the market. It still does not solve the supply shortage problem.

2.2.2. Oil Demand Analysis

Demand refers to the ability to pay and a willingness to buy by the consumer. Demand can be shown by a demand curve which shows the maximum quantity demanded at all prices. The demand curve may different in short-run and long run. Quantity demand can be determined by many factors such as price, consumer behavior, prices of related goods and consumerÐŽ¦s expectations.

Figure 2.3 shows that the quantity demanded of a good falls when the price of the good rises.

Economies have become a lot more fuel-efficient over the past 20 years; as a result, spending on petroleum products is a smaller percentage of income. Governments have also begun taxing fuel more heavily to reduce the consumption on petroleum. See Figure 2.4, when the demand for the oil reduce, the consumers will cut back sharply in the quantity demand from Q2 to Q2.

The consumerÐŽ¦s expectation about the oil price is decreased, thus the demand for the oil will be reduced, and it shifts the demand curve to left. The price of the oil will be reduced also.

2.2.3. Elasticity of Demand