In the extreme Long Run Oil will run out being a finite resource (diagram E) and at LRAS any increases in demand would merely lead to higher prices as output would be unable to expand. This would be when we are forced to use alternatives to Petrol.
Externalities (Taxation Policy)
Externalities are a cost or benefit received by third parties not directly involved in the production or consumption of a product. Negative Externalities produced from producing and consuming petrol include air pollution, global warming and ill effects to people’s health. The Government often cites the main reason for taxing petrol is to ensure the true cost to the environment in reflected in the price paid and to reduce consumption of the good. The tax imposed upon petrol (fuel duty) would try to raise the Marginal Private Cost curve towards the Marginal Social Cost curve (diagram F) as this would truly reflect the cost to society of consuming petrol and remove the negative externalities. By doing this as can be seen in the diagram Price rises and Quantity Demanded/Supplied falls. This means less of the harmful good is consumed. An alternative to this would be to subsidise a more environmentally friendly good persuading more people to buy it.
Monopolists/Cartels (OPEC)
Middle East Producers who form the bulk of OPEC held 75% of the proven reserves of Oil and supplied 41% of the oil in 2000. By any measure they hold a monopoly position upon the world’s supply of petrol. As OPEC countries have agreed to operate together and not to compete with one another in effect they become a monopolist supplier of Oil. This allows OPEC to be a “Price Setter” rather than a “Price Taker”. OPEC can and does restrict supply to the point where MC=MR and profit is maximised for the supplier (diagram G). The allocatively efficient equilibrium would exist where MC=AR or in other words where Supply equalled Demand. OPEC however purposely restricts output and by doing raises the price thereby earning supernormal profits upon Oil (shaded Area in diagram G).
Cross Elasticity of Demand (Rival Petrol Stations)
Cross elasticity of Demand is the proportion by which demand for one product changes compared to a change in price of a substitute product. Seeing as all petrol stations must pay the same price for their crude oil, all unleaded petrol is the same product and petrol is taxed with fuel duty and VAT the only discrepancy between rival filling stations will be how low they can cut their costs in the distribution and retail of their petrol.
Determinants of Demand for Petrol (Short Run)
A change in Demand means that one or more of the factors which determine demand have changed. An increase in Demand means that more is now demanded at each and every price. The Demand curve shifts outwards to the right (diagram H). Price and Output both increase to a new equilibrium. A decrease in Demand means that less is demanded at each and every price. The Demand curve shifts inwards to the left (diagram I). Price and Output both decrease to a new equilibrium. Short run demand of petrol is influenced by speculative demand for Oil in World Markets, increased automobile use which tends to be seasonal (more journeys in Summer) and panic buying at pumps when shocks occur (e.g. Petrol crisis of 2000). Petrol Prices can also be effected short term by global economic growth levels (Cyclical Demand).
Determinants of Supply of Petrol (Short Run)
A change in Supply means that one or more of the factors which determine demand have changed. An increase in Supply means that more is now demanded at each and every price. The Supply curve shifts outwards to the right (diagram J).Price decreases and Output increases to a new equilibrium. A decrease in Supply means that less is supplied at each and every price. The Supply curve shifts inwards to the left (Diagram K). Price increases and Output decreases to a new equilibrium. Short run supply of petrol is influenced by Production shocks, decisions by OPEC and non-OPEC countries and the amount of spare capacity in the oil and refining sector of the economy i.e. new Oil Fields being exploited.
PRESENTATION OF FINDINGSPrice Elasticity of Demand for Oil (Product)
Figures sourced from EIA
Oil consumption for OECD countries (developed) has risen steadily from 1997 to 2005 rising from 46,863 million barrels/month in 1997 to 49,461 million barrels/month in 2005. Oil Consumption therefore rose by 5.62% over this period. Oil Prices however rose over this period from $18.97/Barrel to $48.97/Barrel a 61.93% rise over this period. These graphs therefore show that Oil is not Price Inelastic it actually represents an exceptional demand curve i.e. there is not an inverse relationship between demand and price. In such a case Oil can almost be likened to a “Giffen Good” a staple good which must be bought until income increases enough to buy alternatives, however as of yet there are few widely used economic alternatives to using petrol in transportation.
Determinants of Demand for Petrol (Short Run)
Global Economic Demand for Oil Increasing in China
The major factor affecting demand led rises in Petrol Prices in the Short Run (2001 onwards) and likely to be increasingly in the long run is the rapid Economic Growth of the sleeping giant economy which is China. In 2003 China passed Japan to become the World’s 2nd largest consumer of petroleum products after the United States. In 2004 Demand for Oil rose by 15% but Oil output only 2% and in 2005 Demand for Oil rose by 9 %. 43% of this Oil is used by heavy industry but a third is consumed in petroleum to fuel China’s rapidly expanding love affair with the automobile. China has accounted for 40% of the growth in oil demand over the last four years. Consumption within China of Oil has doubled since 1995 whereas production has increased by 18%
As see in the diagram an increase in Demand leads to a rise in output and prices. With Supply being so price inelastic even a small increase in Demand can lead to large increases in price. China along with India are demanding ever increasing quantities of Oil because per Capita their demand for Oil is much smaller than that of the OECD countries. With few production increasing capabilities at present in India or China all this extra Demand for Oil is coming without any local increase in Supply of Oil. This is worrying because Aggregate Demand may outstrip Aggregate Supply unless demand growth slows in these two countries or new Oil fields are located.
Price Elasticity of Supply of Oil (Product)
Figures sourced from EIA
Oil Production has risen steadily from 74190 million barrels/month in 1997 to 84181 million barrels/month in 2005 an 11.86% increase over this period. Oil Prices however rose over this period from $18.97/Barrel to $48.97/Barrel a 61.93% rise over this period. Clearly it can be seen that supply from OPEC has risen much slower than the increase in the oil price over this period making Oil Supply Price Inelastic. Also these graphs show OPEC production being cut when prices were low to stabilise the oil price and stop it from declining.
Determinants for Supply of Oil (Short Run)
Supply disrupted by Hurricane Katrina
Hurricane Katrina was the major short term cause of supply led increases in petrol prices having interrupted oil production, importing, and refining in the Gulf area, thus having a major effect on petrol prices. A tenth of all the crude oil consumed in the United States and almost half of the gasoline produced in the country comes from refineries in the states along the Gulf's shores.
At least twenty offshore oil platforms went missing, sank, or went adrift, according to the Coast Guard. One oil rig, in dock for repairs before the storm, broke loose and hit the Cochrane/Africatown USA road bridge over the Mobile River in Mobile, Alabama. Two others went adrift in the Gulf of Mexico, but they were recovered. One platform, originally located 12 miles (20 km) off the Louisiana coast, has washed up onshore at Dauphin Island, Alabama. The Shell Oil Company MARS platform, producing around 147,000 barrels (23,000 m³) a day, was severely damaged.
The Louisiana Offshore Oil Port, which imported 11% of US oil consumption, closed on August 27, and Shell reported a reduction in production of 420,000 barrels per day.
Due to fears that the production of oil in the United States would be cut by up to one-third of normal capacity, the price of oil fluctuated greatly throughout August 28th reaching highs of $70/Barrel. Long lines developed at some petrol stations throughout the U.S. as customers rushed to buy Petroleum, anticipating price increases in the wake of the storm. In North Carolina this led to petrol shortages and queuing.
The Strategic Petroleum Reserve of USA released some crude oil as well as Europeans lending petroleum reserves of its own to combat prices. On Wednesday, September 7, Gulf oil production had returned to 42% of normal capacity. Of 10 refineries that were shut down by Katrina, four came back at full capacity within a week, however another four are still out of commission.
This sudden reduction in Supply in Petrol caused by an outside shock in an already tight oil market produced record high crude Oil Prices. The reduction in supply led to reduced output and greatly increased prices as the model suggested. This eventually filtered through to the UK forecourts as by September 6th, prices had risen above £1/litre for the first time.
Externalities (Taxation Policy)Level of Taxation
As can be seen from this chart government taxation has been increasing steadily over the past 10 years. It can be argued therefore that the Government is to blame for rising petrol prices. The amount pain in tax on petrol has increased year on year, apart from 1990 and of course the major decline in taxation from 2000-2003 as the government backed down to fuel protestors and removed the fuel price accelerator tax and the small decline in crude Oil prices which occurred during this period. Over the period from 1988 to 2005 Petrol Prices increased 59.34% (37p to 91p) and the amount of Tax paid per litre increased by 65.57% (21p to 61p).
Source: AA
However if you were to look at the percentage of total cost of petrol made up by tax it would show a different story.
The percentage has actually fallen ever since the fuel protests of 2000 from a high of 83.1% in 1998 to 67.3% in 2005. This is because fuel duty a Specific indirect tax has been frozen for much of this period to take into account the rising cost of Petrol. As Petrol Prices rise, fuel duty remains constant. Any increases in Tax would be from VAT a 17.5% indirect tax upon most products sold. As this is an ad valorem tax the amount paid rose with the price so petrol prices rose so did the amount of VAT paid upon the petrol.
Solving Negative Externalities
As mentioned earlier an argument often cited for placing fuel duty upon petrol is to more fairly reflect its cost to Society by raising the Private Cost to reflect the Social Cost. In this it may be successful however it is impossible to calculate the Social Cost using a product I cannot prove that the Petrol Price is where it should be. However it can be said that the difference between MPC and MSC has definitely been reduced with taxation on fuel.
However the other argument associated with Externality Tax is to reduce Consumption of the product and switch it to more environmentally friendly ones. In Transportation’s case this would be switching from the more polluting per capita Car to Trains and Buses whose pollution per capita is smaller. However as the diagram illustrates even with the fuel cost increases it is still much cheaper to run a car than to use public transport and it is projected that his gap will widen. To truly reduce people’s demand for Car transportation the Government would have to either raise petrol taxes even higher (Politically Unpopular) or subsidise Public Transport to make it more economically viable when set against Private Motoring.
OPEC (Cartels)Evidence OPEC exerts Monopoly Power on Oil Markets
Source of Graph: BP
Apart from the Oil Spikes of the 1860s Oil Prices remained relatively constant for 100 years as Supply met Demand in an allocatively efficient equilibrium. However in 1971 OPEC began to expand its membership so it now could effectively set prices whereas before oil prices were set in the United States. When the Yom Kippur War started (1973) OPEC members observed an embargo on the nations supporting Israel essentially cutting all fuel exports to developing countries. As can be see in the graph oil prices rocketed. Although in this circumstance motivated by political means rather than economics OPEC has acted as a monopoly cutting supply and gouging prices.
Though prices did eventually come back down OPEC’s stated aim is to “coordinate their oil production policies in order to help stabilise the oil market and to help oil producers achieve a reasonable rate of return on their investments.” In other words OPEC wishes to benefit it’s members by ensuring the maximum return possible upon their natural resources which occurs when they supply at MC=MR.
Sometimes however when Oil Prices are high non OPEC members such as Norway and Russia will increase production and therefore bring prices down so OPEC does not have carte blanche over oil prices it is the general price setter but not all the Oil suppliers even within it’s own ranks (Venezuela) play by the rules.
Cross Elasticity of Demand (Retailer/Deliverer)
Source: What Petrol Prices?
This graph shows that there are major differences between different retailers selling Unleaded Petrol even though they are selling to the consumer exactly the same product and are having to pay the same crude oil price. Asda came out cheapest selling petrol on average for 85.3p/litre while private garages on average charged customers 92.3p/litre.
It is interesting to note that 4 out of the 5 cheapest suppliers of petrol were major supermarkets (Asda, Sainsbury’s, Morrisons and Tesco). This is likely to be supermarkets selling petrol at cost or using it as a loss leader to get more customers to shop in their supermarkets. At the most expensive end of the scale are the private garages, unsurprisingly as they are small firms and are unlikely to have the benefit of economics of scale behind them i.e. using large carriers to distribute petrol and selling vast quantities of petrol with a very small profit margin.
EVALUATION AND CONCLUSION
Is the Government to blame for Higher Petrol Prices? This was the question I asked myself back in September 2005 when I began my investigation. The simple answer is yes and no. Yes the government taxation takes up the highest proportion of the cost of petrol at the pumps and yes tax on petrol has increased predominantly year on year (mainly due to VAT after 2000). Government Taxation makes up the lion share of the price motorists pay at the filling stations standing at approximately 2/3 of total cost in 2005. We also have to pay the highest percentage tax on our petrol in Europe.
However due to the freezing of fuel duty since 2000 for most of that period the argument that Government is the main cause behind fuel price increases is simply wrong. There were in fact a number of factors leading to the unprecedentedly high petrol prices in September 2005 both short and long term.
The main factor which led to the price spike in September 2005 I feel was the production which was knocked out by the Hurricane Katrina disaster and the price speculation that followed this period. Supply barely exceeded Demand in September and this caused Oil markets to become jittery. When it was unknown how badly oil production in the area had fared prices spiked.
Source: What Petrol Prices?
As can be seen from the diagram after the initial speculation of damage and gradual replacement of the lost capacity in the Gulf occurred Petrol Prices began to tail off now resting at approximately 87p/litre, higher than before Hurricane Katrina occurred but nevertheless much lower than £1/litre. This gradual decline in price was due to increased petroleum stock (Release of Petroleum Reserve) becoming available meaning there was more spare supply in the market effectively shifting the supply curve outwards to the right increasing output and reducing price.
Until LRAS is reached over the long term petrol prices will continue to rise slowly but inexorably due to continued global economic growth throughout the world providing steady and increasing demand for Oil and Petroleum products. Of late this growth in demand has been from the Tiger Economies of India and China and this has merely accelerated the increases in consumption of Oil year-on-year. The emerging economic power of China importing more and more Oil I feel to be the most important factor in the general upturn in Oil Prices. This is continuing to shift the Demand curve outwards increasing both output and price.
It can be argued by some environmentalists that the Government’s Taxation on Petrol is too lenient and does not reflect the true Social cost of using this product. However since the fuel protests of 2000 fuel duty increases at a time of already high petrol prices make such an endeavour highly politically damaging. However because demand for Petrol is so Price Inelastic the government earns much tax revenue from taxing fuel which some would argue is it’s main purpose rather than to discourage Car use. However the government only uses a low fuel duty upon more environmentally friendly Bio-diesel which is also renewable.
I was surprised at the discrepancies I found in the difference in Petrol Prices between different retailers within the market. I assumed that this would not be a contestable market however there proved to be large differences in the prices charged on forecourts depending upon which company you bought from. If Petrol Prices continue to be high however I can forecast Independent Retailers being forced out of the market as Supermarkets and Major Oil Companies can afford to charge much lower prices than these and still be profitable.
Using statistical data I was able to prove that Oil Supply is very Price Inelastic with a PES of 0.19. The data also showed to me that Oil Demand is not only Price Inelastic it actually is positively inelastic so it slopes the way a supply curve does. This shows just how reliant the world really is upon Oil that demand increases even when price is increasing. Soon however I feel that alternatives to Oil will become economically viable and Oil Demand would become increasingly price elastic as Solar Powered/Hydrogen Powered Cars become the main source of transportation. Hydrogen is already being tested on some London Buses.
To improve my investigation I would have hoped to have researched local filling stations to gain primary research however the filling stations were unable to supply me with the price information I needed because these details were not kept within the shops themselves. I would also have liked to have done a more in depth analysis upon OPEC and its internal workings to discover just how true a monopoly market structure it actually operates. I have tried to show how it does exert monopoly power upon the market i.e. 1973 Oil Crisis however I am not sure whether the price setting is more to do with political motivation rather than profit maximising. I would have also like to have been able to do more research into the new alternatives to Petrol cars being developed.
So is The Government to blame for Rising Petrol Prices? The answer before 2000 with the fuel accelerator in place and 80% of petrol cost being taken up would have been a resounding Yes. However as my investigation has shown more worryingly in fact Petrol Price increases are now out of Government hands as Demand led rises in prices are likely to continue. The era of cheap petrol appears to be coming to and end and with our North Sea Oil stocks dwindling it is likely our petrol prices are about to become much more expensive and much more volatile.
BIBLIOGRAPHY
Stan Lake’s “Introductory Economics”
http://www.petrolprices.com
http://www.AAtrust.com
http://www.whatprice.co.uk/car/petrol-prices.php
http://news.bbc.co.uk
http://www.eia.doe.gov