Demand analysis: an example

To illustrate the effects of a price change, we investigate some consequences of a crude oil price change. During the mid and late 1970s, the price increased substantially in two large steps. The first episode was triggered by the decision of OPEC (The Organisation of Petroleum Exporting Countries) to use an embargo on oil exports to America and Europe as an economic weapon in the attack on Israel by Egypt and Syria in late 1973. Cutbacks in production led to the price more than quadrupling, from $2.59 to $11.65 per barrel. The importance of this step is evident when one realises that this increased the revenue deriving from one year’s oil output from ½% to 2½ % of the world’s GDP (gross domestic product). In so doing, it had a major impact on the distribution of income and wealth between countries. The price increase diverted about 2% of all the world’s income away from the purchasing power of net oil importing states into the pockets of the oil exporters.

After a period in which the real price of oil slowly declined, the revolution in Iran paralysed oil production, and initiated a second episode of sharp price rises. The official OPEC price rose to $34 a barrel, with the spot market price reaching as high as $40.

These oil price changes had major short term and long term effects on demand (and subsequently supply) for a wide variety of goods throughout the world economy. The income and substitution effects of the oil price changes were particularly large for three reasons:

  1. The price increases were large in proportionate terms.

  2. The price increases were nearly instantaneous and largely unanticipated.

  3. The good whose price had risen -crude oil – accounted, directly or indirectly, for a large proportion of consumer budgets.

Consider some of the substitution effects. Crude oil price increases led to a rise in the cost of production of many goods and services that used energy inputs. These cost increases were particularly important in the case of petroleum refining, electricity production, transport and distribution, and the industrial materials and chemicals sectors. Cost increases in these sectors led to subsequent price increases, as producers attempted to pass on costs to purchasers. Secondly, many consumer goods are complements to goods whose price had risen because of the crude oil price increases. For example, cars are complements to petroleum, a derivative of crude oil. So oil price rises led to an increase in the cost of car transport.

To some extent, the substitution effect operated by reducing the demand for car transport as a whole. Car sales dropped, fewer miles were driven and the average speed of traffic fell, increasing the mileage driven per unit of petrol. Within car transport itself, other substitutions took place. Large engined, fuel-inefficient cars became relatively more expensive to operate in comparison with smaller vehicles. Consumers chose to buy smaller, more fuel-efficient cars. These substitution effects were greater in the long term than in the short term.

Price increases also had major impacts on real incomes. In the oil importing countries, reduced real incomes reduced the demand for oil and for a wide range of other goods. Although real incomes rose in oil exporting states, much of the export revenue was used to acquire financial assets, and so did not generate additional demand for manufactured goods exports that would have compensated oil importing economies. As a large proportion of oil export revenue was saved, the price increases precipitated a depression in the level of world demand at the same time as price-inflation accelerated. The conjunction of price-inflation and demand-stagnation became known as “stagflation”.

Oil price increases had important supply side effects too. The incentive to search for new sources of oil increased rapidly, and higher prices meant that high-cost oil fields (such as those in deep offshore waters) became profitable to exploit. It is one of the ironies of this whole process that the adjustments set into motion by the oil price rises – increased supply from new sources and decreased demand from users – were so great that OPEC lost its dominance of the oil industry. Just prior to the Iraq invasion of Kuwait, the real price of oil (the price in purchasing power terms) had fallen to its 1973 level.