Economic Issues: Impacts of Increase in Oil Prices

Economic shocks

Several events occur in an economy and they are likely to cause a significant effect on the economy. Most of these events are erratic while others are predictable. In some cases, they take place outside an economy while their consequences are felt in the economy. These events are the economic shocks. Examples of these shocks are changes in oil prices, natural disasters such as flooding and earthquakes, the occurrence of accidents such as gas or oil spill, and devaluation of a currency among others (Reserve Bank of Australia 2014). The paper discusses the impact of an increase in oil prices on prices, quantity demanded and quantity supplied in an economy.

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Cause and consequences of the shock on prices

An increase in the price of oil is caused by a number of factors. The first main factor is the escalating demand for the commodity. Statistics show that the demand for oil in the recent years has increased significantly and it has overtaken the speed of production and excess capacity (Australian Bureau of Statistics 2014). The rapid increase in the demand is mainly experienced in economies that are growing rapidly. The second cause is the panic of supply disturbance. An interruption of supply of the commodity creates anxiety which exerts an upward pressure on the price of the commodity (The Economist 2014). The graph presented below shows the original state of the economy before a rise in oil prices.

Demand and supply of commodities before changes in oil prices.
Figure 1.0 – Demand and supply of commodities before changes in oil prices.

In the graph above, DD1 shows the demand curve while SS1 shows the supply curve. The equilibrium price and quantity are P1 and Q1 respectively. Oil is a key factor of production for various commodities used in the economy. An example is gasoline used by households. An increase in the price of oil will result in an increase in the price of gasoline. Apart from household, businesses also rely on oil in a number of operations. Businesses use the commodity for transportation, heating, and production. Thus, it is treated as a key factor of production. Therefore, an increase in the price of oil will result in an higher prices of commodities in the economy. The graph presented below shows a new equilibrium position in the economy after the rise in oil prices.

Illustration of the increase in prices of commodities.
Figure 1.1 – Illustration of the increase in prices of commodities.

In figure 1.1 above, it can be noted that the price level rises from P1 to P2 as a result of the increase in the oil prices in the economy. Further, it can be noted that the economy is not at equilibrium at this price level.

Cause and consequences of the shock on the quantity demanded

The demand curve shows the inverse relationship between the price of a commodity and the quantity demanded while holding other factors constant (Arnold 2011). Thus, an increase in price will result in a decline of the quantity demanded. This is caused by the fact that a rise in the price of commodities reduces the purchasing power of consumers. This implies that the volume of commodities that they can purchase with the same budget before the rise in prices reduces. The effect of the increase in price on quantity demanded is illustrated in figure 1.1. An increase in price from P1 to P2 causes the quantity demanded to decline from the equilibrium position of Q1 to Qd.

Cause and consequences of the shock on the quantity supplied

The supply curve shows the direct association between the price of a commodity and the quantity supplied while holding other factors that affect supply constant (Arnold 2011). This implies that as the prices of commodities rises, the producers will be motivated to produce and sell more. The increase in the cost of production as a result of the a rise in oil prices will be passed on to consumers. The impact of a rise in oil prices on the quantity supplied is illustrated in figure 1.1 above. An increase in price from P1 to P2 causes the quantity supplied to increase from the equilibrium position of Q1 to Qs.

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Movement along the demand and supply curves

As mentioned above, a rise in oil prices causes the prices of commodities in the economy to rise. A rise in prices causes movement along both demand and supply curve as illustrated in the graph below.

Movement along demand and supply curves.
Figure 1.2 – movement along demand and supply curves.

In figure 1.2, the initial equilibrium position is at the point where price and quantity demanded are P1 and Q1 respectively. The movements along demand and supply curves to the new price level P2 are shown by the arrows in red and blue. At this price level, it can be noted that the economy is in disequilibrium because the quantity supplied Qs exceeds quantity demanded Qd. This shows that there is a surplus in the economy (Mankiw 2011).

Shift of the demand and supply curves

A rise in prices of commodities as a result of an upsurge of oil prices reduces the purchasing power of commodities. A reduction in purchasing power makes the demand curve to shift to the left. Also, oil is an input in the production process (Reserve Bank of Australia 2014). Thus, a rise in the price of oil as an input lowers the supply of commodities. This causes the supply curve to shift to the left. The shifts are illustrated in the graph below.

Shifts of demand and supply curve.
Figure 1.3 – shifts of demand and supply curve.

The initial equilibrium position is at the point where the price is P1 while quantity is Q1. A rise in oil prices will cause the demand curve to shift from DD1 to DD2 while the supply curve will shift from SS1 to SS2. The shifts creates a new equilibrium position at the point where the price is P2 while quantity is Q2. The magnitude of changes in price and quantity depends on the elasticity of demand and supply of the commodities (Mankiw 2011).

Policy implication

The discussion above illustrates that an increase in oil prices causes the general price level of commodities in an economy to rise. This creates inflation. Further, increase in oil prices slows down economic growth as seen in the inward shift of the supply curve. A reduction in quantity supplied results in low output at the end of the year and in turn lowers economic growth. Reduction in supply also may result in reduced wealth creation and growth in the unemployment rate.

References

Arnold, R 2011, Economics, Cengage Learning, USA. Web.

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Australian Bureau of Statistics 2014, Australian social trends, 2014. Web.

Mankiw, G 2011, Principles of economics, Cengage Learning, USA. Web.

Reserve Bank of Australia 2014, Publications. Web.

The Economist 2014, Economics. Web.

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NerdyRoo. (2021, October 27). Economic Issues: Impacts of Increase in Oil Prices. Retrieved from https://nerdyroo.com/economic-issues-impacts-of-increase-in-oil-prices/

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NerdyRoo. (2021) 'Economic Issues: Impacts of Increase in Oil Prices'. 27 October.

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