Price Elasticity of Oil - Short Term and Long Term
Posted by Max Dunn Thu, 26 Jun 2008 23:17:00 GMT
When the price of something goes up, it makes sense that demand for it should go down and production should go up. But in the case of oil, that doesn’t seem to be true. Oil prices have gone up 400% over the last 5 years while consumption has been flat in the US and global oil production has been relatively flat for the last 3 years.
However, it is not easy or quick to change demand or production of oil. People still need to drive to work and they might be stuck with a gas-sucking SUV. Over time they might start car-pooling, working at home or trading in their SUV for a hybrid. On the production side, you can’t just turn up a valve on an oil field to produce more oil. Oil fields generally produce as much oil as they can all the time, so to get more oil it is necessary to drill more wells or discover new fields. All this takes time.
What this means is that in the short term, oil has a very small price elasticity – meaning that the price of oil can go up and down a lot without changing the demand for oil very much.
Gary Becker, an economist at the University of Chicago, has calculated that in the past, over periods of less than five years, oil consumption in the developed nations dropped by only 2-9% when the price doubled. Likewise, oil production in countries outside OPEC grew by only 4% every time the price doubled. But over longer periods, consumption dropped by 60% and supply rose by 35%. (The Economist: Double, double, oil and trouble.)
So it is not surprising that oil demand and supply hasn’t changed much in the short term even with a tripling of prices, but it is also likely that over time the effects will be much greater.