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The elasticity of oil production and consumption

Classical economists still insist higher prices will bring out increased production sufficient to give us the oil we humans need.

This is a response.

Although written for the American audience, it applies to any nation that must import a substantial portion of its oil or natural gas.

Elasticity

A quick lesson in economics. Elasticity. The production, or consumption, of a specific product is often referred to as being elastic – or – inelastic.

  • If production is elastic, we assume that if the price of a product goes up, or if a shortage of the product develops, then competitors are able to add new capacity to increase the availability of that product. Higher prices and/or shortages encourage suppliers to invest in additional plant, equipment, materials, and labor in order to increase sales and profits. Economists generally believe that when this new capacity comes on-line, a surplus of product will eventually develop, and the resulting competition for business will force suppliers to reduce their prices in order to sell more products.
  • If production is inelastic, then higher prices and/or shortages do NOT bring forth new capacity because suppliers are unwilling, or unable, to increase production.
  • If demand is elastic, it simply means that consumers will buy more of a product when the price comes down. They will buy less when the price goes up. Yes. There are other reasons why consumers increase or decrease consumption, but price is a fundamental driver of demand.
  • If demand is inelastic, changes in price initially do very little to change consumer buying habits. Lower prices do not encourage much more consumption. On the other hand, consumers are willing to pay higher prices (up to a point) to keep on buying what they need. As prices continue to increase, however, consumers will begin to purchase cheaper substitute products, and/or will seek to change their lifestyle, because they can no longer afford the product. Although low income consumers are usually the most vulnerable to these realities, middle income consumers are seldom far behind.

Classical economic theory contemplates that increased demand drives up the price. Higher prices attract new investment in the means of production (materials, labor, machinery and so on). Higher rates of production create a subsequent surplus of product, driving prices down as manufacturers compete for business. Unfortunately, classical economics does not understand how to deal with a depleting resource – such as oil or natural gas. Since both production and consumption are relatively inelastic (ignoring the impact of political, cultural and environmental disruption), changes in investment – even huge changes in investment- are unlikely to bring about a corresponding increase in supply.

The world oil market has become relatively inelastic in the sense that large increases in upstream investment no longer produce contemporaneous increases in supply. Even assuming there are no political obstacles, cultural disruptions, weather problems, or geographical challenges to delay exploration and production, it still typically takes many years to develop a new oil field. In addition, our ability to bring new production on-line is further limited by the political objectives and cultural challenges of the producer nation. Take a look at nations such as Iran, Iraq, Venezuela, or Nigeria. As described by cultural economics, any potential elasticity has been decreased by local restrictions.

Conclusion

As oil and natural gas deplete, suppliers will attempt to charge as much as the market will bear. That – in turn – will force demand destruction as higher prices and availability curb consumption. Unfortunately, since American oil demand per household has been relatively inelastic since 1982, demand destruction can only occur if the economy is forced into a recession, and/or Americans make substantial changes to their lifestyle.

Neither option will be pleasant.

Editorial Notes: Other posts on EB by Ron Cooke ("The Cultural Economist"). More posts on energy on his website. -BA

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