Friday, March 30, 2007

Should we be concerned about running out of oil?

As oil starts to run out the price inevitably increases. Demand for oil is inelastic (higher prices only have a small impact on reducing demand) therefore as supply falls there is a correspondingly bigger increase in price. Basically this is good news for oil producers and bad news for oil importers.

Problems of rising Oil Prices in the west.

1. Increased economic dependence on Oil producing countries. With each increase in the price of oil it gives increased economic and political power of Oil producing countries, which happen to be mostly in the middle east.

2. Inflation. Increased price of oil leads to higher costs for transport. This has the effect of increasing the price of most goods produced in the economy. Therefore it can contribute to rising inflation. This rising cost-push inflation makes it more difficult for the MPC to keep inflation within the government’s inflation target of 2% without lowering growth rates. In the 1970s a tripling of the price of oil contributed to stagflation, a corresponding mid of rising prices, falling growth and rising unemployment.

3. Balance of Payments deficit. A rise in the price of oil automatically makes the value of imports more expensive. Therefore oil-importing countries will experience deterioration in the current account. In the long term this may reduce the quantity of other imports they can afford. It can also lead to devaluation in the exchange rate reducing the value of the Domestic currency.

4. Market failure in developing alternatives. In theory economic principles suggest that as oil becomes scarce it becomes increasingly attractive to develop alternatives. Already cars can run on alternative energies such as Gas and hydrogen. As oil runs out firms should invest more in these alternatives creating an economic alternative to oil. However there is no guarantee that the free market will develop alternatives to offer the same benefits as oil.

Benefits of Rising Oil Prices.

1. Will have the effect of limiting growth in demand for oil and petrol. This will help to limit CO2 emissions, a major contributor to global warming.

2. Encourage greater efficiency of engines. The US in particular has a wide range of inefficient cars SUVs that contribute the most to global warming. Higher oil prices will reduce demand for these.

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