Supply and Demand in Energy Market - Essay Example

Introduction Oil is the major source of energy in the world and in the absence of any adequate and reliable alternative to oil as fuel; oil has significant political, economic as well social value in the world. The fluctuating prices of oil and their consistent rise during the recent past has created a widespread debate regarding the energy sufficiency of the economy and how oil prices can actually have an impact. Maintaining adequate supply and demand of oil commodity, as well as the prices, therefore, is considered vital for the economy. Various studies pointed out the impact of changes in oil prices and the growth rates of the economies at the global level. With oil prices being doubled, there is strong probability that the overall output level will decline. (Rogoff, 2006) UK economy is facing one of the toughest economic challenges in its recent history. What started as a subprime mortgage crisis in the US has actually affected the UK and rest of the European countries also. There have been consistent decline in GDP, increase in level of unemployment as well as reduction in the manufacturing output. In such a scenario, raising oil prices can increase overall cost of output and resultantly decrease the manufacturing output and pace of economy more. Libyan conflict, as well as other political conflicts in Middle East, can further increase the prices and, hence, UK economy may suffer as a result of this change. This paper will argue and discuss the overall importance of oil for UK economy. Supply and Demand in Energy Market One of the key factors affecting the demand and supply in energy market is the political and armed conflicts in Middle East Region. Since the region is one of the highest oil producing regions in the world, political and military conflict in the region can create external shocks for the supply side of oil in the market. Political and armed conflicts actually can reduce the supply of oil in the market and, resultantly, short term price hikes are experienced due to constrained supply. Another important factor which has been discussed in the case study is the overall situation in the North Africa with possible ripple effects on the Middle East Region also. (Bbc.co.uk, 2011). The conflicts in countries like Libya can seriously reduce the overall supply of oil in the market. Source: http://frozeninthenorth.blogspot.com/2010/07/canadian-labor-productivity-and-oil.html World oil market is considered as relatively inelastic because changes in prices normally do not result into reduction in the demand for the oil. Increases in prices also do not induce increase in production because it takes time actually to develop infrastructure facilities to meet the additional demand. However, it is also important to understand that the overall consequences of this will be that there will be excessive burden on the economy to foot higher oil bill while at the same time higher expenditure on oil as an input may an impact on the total manufacturing output of the country. In the long run, consumers, however, may adapt to substitutes and as such long terms impacts of price change may not be same. Market Structure The overall supply of oil is controlled by few countries which have established OPEC, i.e. Organization of the Petroleum Exporting Countries. OPEC is considered as a cartel of the major oil producing and exporting in the world which control significant output level in the world economy. The overall market structure of the industry is oligopolistic in nature as the industry is dominated by small number of sellers and there are larger number of buyers and sellers. Barriers to entry are very high too and each firm in the industry has developed into one of the largest firms in the world. Under oligopolistic model, a producer will continue to produce till the marginal cost is equal to the marginal revenue and have the ability to set the prices also. In oligopoly, a producer is considered as price setter rather than price taker however, producers are interdependent on each other. It is also because of this nature of the market that producers collude with each other and forms the cartels. (Perloff, 2008) Considering the overall size and the number of total producers in the market, the overall impact on the profits as well as on prices is relatively higher. Though, it has been suggested that the control over prices is decreasing because of the discovery of new oil resources in outer countries, especially in the US, however, countries/firms involved in the exploration, production and marketing of oil are earning abnormal profits. (Businessweek.com, 2003) Inflation Prices of oil have remained volatile and consistently increased over the period of time. Since oil is also used as one of the major inputs in manufacturing and other sectors of the economy, an increase in oil prices can increase the inflation too. There are generally two types of inflation defined by the economic theory, i.e. demand pull and cost push inflation. Demand pull inflation occurs when the overall spending on goods actually increase the prices. Demand pull inflation normally occurs due to increase in income and to reduce this inflation a reduction in consumer income is considered. Cost push inflation occurs when the prices of input increases and as a result of this increase, inflation occurs. With the rise in the oil prices, economy experiences cost push inflation because oil is used as one of the inputs in the manufacturing and production processes. (Krugman, and Wells, 2009) In order to control the inflation, government can actually increase the taxes in order to reduce the aggregate demand. By increasing the taxes, government can actually influence the aggregate demand which will be met by the suppliers by reducing the prices. (Blanchard, 2007) On the other hand, in order to reduce the inflation, government can also increase interest rates to make borrowing expensive. By increasing interest rates, central bank can actually reduce the purchasing power of the consumers and, hence, reduce the aggregate demand. Government can also reduce its fiscal expenditure to reduce the aggregate demand too and to influence the reduction in the inflation within the economy. Economic Growth and Unemployment Source: http://www.economicshelp.org/dictionary/c/circular-flow-income.html It is critical to note that the UK is a net importer of oil; therefore, it is more reliant on outside sources for oil. Due to this reason, the UK has to import oil from other countries and resultantly have to spend its foreign exchange on the purchase of the oil from international markets. Imports in circular flow of income are considered as leakages of income because economy actually spends its money on the import of oil from outside. As a result of this, income leakages occur as economy has to pay on its higher level of imports. It is also important to understand that higher oil prices actually results into higher cost of operations. Since oil is a major input in the manufacturing, airline, auto industry, an increase in the oil prices actually increases the cost of doing business. Higher cost of production reduces the aggregate demand because consumers no longer can afford to purchase high priced goods. As a result of reduction in the aggregate demand, aggregate supply reduces too and in order to remain profitable, firms have to cut on their labor to meet the costs and remain profitable. The reduction in the output level, therefore, creates more level of unemployment as producers no longer require more labor to meet reduced demand needs. It is also important to note that in order to stabilize the prices of the oil or any other commodity, substitutes can be introduced to not only stabilize demands but prices too. In order to stabilize the prices for the oil, government can focus on the development and production of alternative fuel such as bio-diesel, natural compressed gas as well as LPG and other sources. However, in order to make a transition towards the new substitutes it is important that the government should clearly take into consideration the supply of such alternatives in the economy. One of the key considerations therefore should be whether the economy has adequate substitute resources to replace oil as the main commodity. Conclusion Oil is one of the major commodities at the global market and is also one of the major inputs for the manufacturing. However, during the recent price hikes, there have been distortions in the supply and demand of oil at the global level. One of the key factors determining the supply and demand at the global level is the overall situation in the major oil producing countries in the world. With armed and political conflicts in Middle East and North African regions, the supply of oil can be affected and resultantly there could be price hikes in the short run. It is also because of this reason that oil is considered as price inelastic in the short run, however, in the long run, consumers can rely on substitutes. It is also important to note that an increase in the oil prices often creates unemployment and also increases inflation. In order to control inflation, government can actually increase the taxes. References Bbc.co.uk, 2011. BBC News - Oil prices rise as Libyan conflict intensifies. [Online] Available at: http://www.bbc.co.uk/news/business-12619017 [Accessed: 16 Nov 2012]. Blanchard, O., 2007. Macroeconomics. 4th ed. New York: Pearson. Businessweek.com 2003 Is OPEC About to Lose Control of the Spigot? - Businessweek. [Online] Available at: http://www.businessweek.com/stories/2003-01-19/is-opec-about-to-lose-control-of-the-spigot [Accessed: 16 Nov 2012]. Krugman, P. & Wells, R., 2009. Macroeconomics. New York: Worth Publishers. Perloff, J., 2008. Microeconomics Theory & Applications with Calculus. 3rd ed. New York: Pearson. Rogoff, K., 2006. Oil and the Global Economy. [Online] Available at: http://www.nes.ru/public-presentations/Papers/Oil%20and%20the%20Global%20Economy_Rogoff__v2.pdf [Accessed: 16 Nov 2012] Read More