Oil price is quite unique from other products because it cannot be easily substitute. Therefore, the demand will be less elastic because many consumers will buy oil regardless of how much it costs. For this situation, the oil price is called as a price inelastic of demand.
What is it – price elastic of demand?
Price elasticity of demand (PED or Ed) is a measure used in economics to show the responsiveness, or elasticity, of the quantity demanded of a good or service to a change in its price (ref Wiki https://en.wikipedia.org/wiki/Price_elasticity_of_demand)
Price electricity of demand is determined by the following equation:
Price Elasticity of Demand (PED) >=1, this means the good or service is elastic.
Price Elasticity of Demand (PED) <1, this means the good or service is inelastic.
In this discussion, we will discuss only oil price which always has PED less than 1.
The slope of demand of oil price (shown in Figure 1) is steep and it means that big change in oil price has small effect on consumption.
Figure 1 – Demand and Supply of Oil (Supply Decreases)
Conversely, the slope of supply curve is shallow as shown in Figure 2 and it illustrates that only small increase in oil price will stimulate a big increase in oil production. When oil price raises due to high demand, oil companies will increase their level of investment on exploration and production to produce more oil. Eventually oil companies can increase their profits. The investment has minimal effect on oil price at the beginning because oil companies take long lead time to develop new fields. Once the new fields are developed and additional supply of oil is introduced into markets, oil price will drop.
Figure 2 – Demand and Supply of Oil (Demand Decreases)
Reference Book
Thomas Sowell (2007) Basic economics: A Common Sense Guide to the Economy, New York, New York, USA: Basic Books.
