The Economics of Oil Prices


Prices of oil rarely follow constant patterns as the may hit extreme lows or soaring highs. Economists have used a series of theories and models to explain this behavior and the paper shall look at some of these suggestions.

What economists say about oil prices and what they will become in the future

Oil or gasoline is price inelastic since consumers cannot immediately reduce their consumption of this commodity every time it registers a price increment. Consequently, oil firms in the country are bound to take advantage of such a position by charging some of the highest prices that can be tolerated by the market. Nonetheless, these oil companies still have played a small role in causing oil fluctuations within the market as there are other forces that come into play. One major cause of sharp oil increases is a similar increase in crude oil prices. The latter prices are determined by world markets which combine a series of factors to get to the final price. US stakeholders often have very minimal powers in such scenarios. In fact, a study carried out by the Federal Trade Commission in 2004 found that approximately eighty five percent of oil prices were related to crude oil increments. Aside from that, refinery activities also have a large part to play in causing some of these fluctuations. If refineries minimize the activities to a small extent, then this is likely to cause a decrease in gasoline prices. Sometimes minimal fuel may be produced during maintenance or implementation of research and development initiatives. (Edmund, 2004)

On the other hand, some economists believe that demand for gasoline can be price elastic if the changes are very drastic. Here, some of them cite the oil crisis of the 1970’s when consumers were forced to reexamine the oil consumption patterns and then think of ways in which they can use less oil. At that time, automobiles underwent various technological changes so as to make sure that consumers could consume less. Energy research became an essential tool for survival in the cut throat industry of energy; therefore, various groups reacted to these increases. On the other hand, if price fluctuations are not as drastic, then consumers are likely to maintain the same patterns of consumption. This is brought on by confidence in the fact that those prices never remain at the same level for too long. In fact, now many US citizens are very skeptical about price increases because they are highly aware of the fact that they are temporary. (Schoen, 2004)

How economists reached this conclusion and the theories that they consider as the most relevant to them

As it has been stated earlier, some economists believe that oil demand is not price elastic. This can be explained by a number of reasons. Firstly, it may be possible to find increases in overall incomes of consumers. When this occurs, demand for oil will rise and suppliers will adjust their prices to mitigate this unexpected increase in demand. On the other hand, it may also be possible to find that consumers are overspending especially when this is due to a big celebration. The prices of oil will still go up because of these issues. The market has a lot of dynamics that can cause oil demand to go up and down and these are the ones that cause the price changes.

It should be noted, that price determination within the oil industry can also be explained by the fair competition model. In a market where there are several players who all have equal leverage in determining quantities and prices offered, it is likely that reasonable prices will prevail. This is because such organizations tend to look for sources of competitive advantage and price is one of the ways in which they can achieve this. In other words, consumers tend to be empowered by such an environment because they have the right to choose one company over the other; all they have to do is identify it. Oil companies do not have the luxury of overpricing because if one company does so, then consumers may simply opt for another company that is not too unreasonable. Competition may not necessarily cause the lowest prices in the market but it does in many ways minimize some of the problems that consumers may face in an unregulated environment.

It should also be noted that the price of oil is also subject to certain external forces. For instance taxation accounts for roughly thirty percent of the oil prices. Suppliers must take into account value added tax, excise tax, import tax and others when determining the prices of their commodities. This is the reason why some lobbyists have been requesting for lower taxes in this arena. However, the problem with such an approach is that it is likely to create low prices (artificially) and this will lead to an increased demand in oil. Suppliers may not be able to meet such a demand and some of them will undergo huge losses. This is the reason why the oil market performs well if it left unregulated.

Effects of tax on firms and consumers through the concept of elasticity

Theoretically speaking one can assume that carrying out tax reform can cause a decrease in the prices of fuel. However, the principal of price elasticity is only applicable in a market where perfect competition exists. In the oil market and in many markets as well, this is not necessarily true as other factors usually come into play.

In instances where competition is not as strong, increases in taxes may actually lead to increased prices. This pattern is usually replicated in those economies that have very few players. For instance when compared to the US, the EU has fewer competitors and taxation can therefore go a long way in protecting oil companies within such environments. When taxes are increased, then such companies will have justifications for making price increments especially when it has been established that the reasons were out of their control. In the end, the suppliers will enjoy greater profits while consumers will be forced to bear the brunt of paying more for their oil. Usually, countries with oligopolistic characters often witness great support from companies and environmentalists for increases in oil taxes.

On the other hand a country like the US has immense competition amongst its oil companies and an increase in taxes for these companies is likely to cause a decrease in asking price which will eventually lead to diminished profits for the concerned companies. This means that the oil suppliers will become barriers to tax increases and this may actually lead to lower overall taxes in oil. In other words, consumers will benefit more from such arrangements than in the former scenario where taxes go up in an oligopolistic environment. Countries like the US tend to prefer lower taxes for the good of both the consumer and oil supplier. But the opposite is true in less competitive countries.


Economists have several explanations concerning oil prices. In the perfect competition model, it is assumed that consumers will be price sensitive when oil goes up and will adjust their consumption. On the other hand, others assume price inelasticity of demand for oil and claim that consumers will keep buying fuel irrespective of prices as it is an essential commodity. Taxes in competitive markets are usually kept low while the opposite occurs for oligopolistic markets.


Edmund, A. (2004). Oil price gouging – a phantom menace. The New York Times, F6.

Schoen, J. (2004). Why high oil prices haven’t cut demand. Web.

Sun, Z. & Xiangdon, X. (2009). Domestic oil tax price effects. Web.

Zambelli, A. (2007). Introduction to Economics. NY: Lieberman & Hall.

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