Friday, December 12, 2014

Microeconomic and Macroeconomic Effects of Falling World Oil Prices

Question from my student: Could you write something about oil prices?

Oil prices have plunged over the last couple of months and economists predict that they could even go much lower than this. What are the possible reasons for this? What are the microeconomic and macroeconomic effects, both good and bad? Is there a lesson to be learnt from here?

First, let us look at the most fundamental reasons for dwindling oil prices- market demand and market supply. If the overall demand is greater than the supply, then there will be a shortage which is responsible for driving the price up. By contrast, if the overall supply is greater than demand, then there will be a production glut and prices will be adjusted downward. The latter explains what is actually happening behind the global oil market. Demand side is softening but the world supply remains stubbornly high. There is more than enough for everyone
In better details:

a. Bleak economic outlook in the Europe and China. The euro-zone economies as a whole is not performing. There is no sign that the economic malaise will subdue soon. In fact, the latest statistics by Eurostat are putting more pressures onto policymakers. Germany which is traditionally known as the euro-zone growth driver recorded the biggest ever fall in retail sales of 3.2%, a sign that the worse events are yet to come in 2015. The same can be said about the Chinese economy. Slowdown can be seen in both the manufacturing sector as well as consumption. Faltering growth is the prime reason why demand for oil falls. Fewer people buy car, those who did may opt to travel less, uncertainty means less likely to travel abroad for holidays and most importantly fewer plastic/ rubber goods were made which in fact covers almost everything-your gadget, car tyres, basic furniture, all the toys you see in Toys ‘R’ Us, consumer goods and others

b. Oversupply. Perhaps, countries like South Sudan, Nigeria, Angola, Libya and Iraq are slow to react to market responses. According to the law of supply, the higher is the price, the greater will be the incentive to produce more output. The same goes here. Earlier on, when prices were at record high level, these countries must have made too much investment thus resulting in oversupply concurrently when the demand is not even there

c. Sanction against Russia. There is also a possibility that the largest oil producer, Saudi Arabia is working closely together with the Washington to put more pressure onto the sanctioned Russia. It is an established fact that Russian economy is highly oil-dependent. About 70% of its revenue is fully derived from oil production. With every $1 fall in world oil price, it loses $2.1 billion and with the current trend, it may lose as much as $30 to $40 billion. If this continues, there is a possibility that its economy will go into recession-unless it has a deep pocket. This justifies why in the recent OPEC oil cartel meeting, Saudi Arabia being the most influential producer refused to cut its supply further to push up prices when it can easily do so in its position

d. Pressuring USA. Once the usage of shale gas is to be more commercialised, the demand for oil from the OPEC will continue to dwindle. Saudi Arabia and other influential members are not going to benefit from this, not into the long term. This is why they brilliantly allow the market supply to remain high so that its price continue to stay low. The intention is to rival the production and sale of shale gas. They are well aware that shale gas is very expensive to extract. By putting pressure on both prices, the margin for shale extractors will remain low and hopefully there won’t be much incentive to continue investing

e. Emergence of substitute. In the study of economics, we always say that one of the determinants of PED is time period. In the short run, PED may be inelastic but in the long run, the development of substitutes may cause PED to appear elastic. True enough in this case. Shale gas is a potential substitute. Thanks to innovative drilling, the USA has successfully discover unlocked oil and natural gas trapped in shale rock. Interestingly, for the first time in 30 years, the States has stopped importing oil from Nigeria. If the recent development continues, there is a possibility that the demand for oil from OPEC will also continue to fall

f. Strong dollar. It is also worth noting that oil is traded in dollar around the globe. When the dollar appreciates, it makes oil artificially more expensive to countries outside the US. Basically, this lowers the demand from those nations that are affected. Perhaps, this is also the reason why cheaper oil prices are not reflected at the petrol pump stations in Malaysia (my country). While global prices have dwindled from about $110 to $62 per barrel, our MYR (Malaysian Ringgit) continues to slide further against the greenback. Therefore, we are unable to enjoy the full benefits of falling oil prices

Possible positive economic effects
a. Lower cost-push inflation. Oil is used in almost everything. In fact, it is the ‘mother’ of all commodities. You can name it- every single thing that you have ever touched is related to oil like tyres, erasers, toys for kids, plastic kettle, car, basic furniture, clothes hanger and many more consumer items. Besides, it also affects the operating costs of airline and shipping firms. Theoretically, when the costs of production fall, prices fall too. This may be passed on in the form of lower price and hence lesser cost-push inflation

b. Possible improvement in the standard of living. Global economic slowdown is far from over. With stagnating wages growth rate, a fall in inflation is something to cheer about as this translates into higher real wages. It may not be very large, but, every dollar saved is a dollar earned. There is lesser opportunity cost for everyone. More money can be allocated elsewhere say, food, healthcare, child’s education, holiday, Christmas gifts and others

c. Jobs creation. Falling oil prices may boost the competitiveness of manufacturing industry especially for some uncompetitive euro zone economies as well as the UK. Lower costs should be reflected in the final price of output. An improvement in price competitiveness should be able to increase exports. Factory orders will gradually improve and more jobs should be created over the time. The same can be said domestically. As people are more able to spend, jobs should be created everywhere, from factories to banks

d. Higher potential growth. Theoretically, falling oil prices shall reduce the operational costs of a firm and hence more funds are available for investment. They may consider this as the right time to invest e.g. replacing old machines with newer and better ones, build new factories and others. Investment is one of the components of AD and hence AD may shift rightward. In the long run, it also improves the supply-side of an economy by raising its potential capacity. A boost of (X-M) as mentioned earlier can also contribute to the rightward shift of AD and hence an increase in the real GDP

e. Reducing the current account deficit. Inflation back at home may be lower than elsewhere and after making price comparisons, people decide to shop domestically. This may contribute to lower overall imports. At the same time, price competitiveness may help to boost exports and considering both simultaneously, inflows of money may be greater than outflows. This should be able to reduce the size of current account deficit

Possible negative economic effects
a. Prices are sticky upwards. Most of us don’t actually realise one thing. When oil prices increase, the retailers almost instantly increase the prices of all their goods and services. However, the same cannot be said when oil prices fall. In fact, prices remain stubbornly high. Business owners are reluctant to do so on many excuses such as suppliers are not willing to reduce their price, having need to ‘wait-and-see’ and others. Cost-push inflation may not necessarily eased in this case

b. Jobs cut. While jobs are created somewhere, the oil and gas industry is most likely to shed workers. Oil producing and oil dependent nations are the worst affected. A plunge in oil prices makes investment relatively uninteresting and there is no point to keep so many workers as before. Someone just have to leave their job. Unemployment in the economy will probably increase

c. Economic crisis. Venezuela, Iran, Nigeria and Russia will be in huge economic mess in near future if oil price is not restored to at least $100 per barrel. As mentioned earlier, bulk of the state revenue comes from oil extraction and with a continuous free fall, budget/ fiscal deficit will worsen and this may lead to more problems e.g. rising unemployment from the public sector, negative multiplier effect and hence an economic recession, more expensive to borrow/ issue bonds and others

d. Deflationary threat. Countries in the euro zone are already struggling with falling AD and most of them are experiencing price disinflation- a case where prices are increasing but at a much slower rate. If this is not curb, then it may turn into a full blown deflation, which is the worse evil between the two. As people expect prices to fall, they will cut spending/ consumption into the economy with the hope that they can purchase it at a lower price in the future. However, if everyone thinks a like, then AD will fall further (Consumption is one of the components of AD) thus triggering another round of price deflation. Again, consumption will fall and the vicious cycle repeats itself. It is the least that ECB would expect because there is already not much room to cut interest rate to boost spending and investment

e. More emissions. When oil prices are really cheap, people tend to care less about travelling and conserving. In fact, driving will increase, people will buy large gas-guzzler vehicles, incentives to use or conduct research on renewable energy will slow down and many more

Friday, December 5, 2014

List of Definitions for Chapter 6 (CIE-A2): Macroeconomic Problems

1. Actual growth: An increase in the real GDP/ When points inside the PPC move towards its boundary

2. Birth rate: The average number of live births per thousand people in a country over a given time period, usually a year

3. Business/ trade cycle: Fluctuations in the national output of a country which involves a succession of stages or phases like boom, recession, slump and recovery

4. Death rate: The average number of deaths per thousand people in a country over a given time period, usually a year

5. Demand deficiency/ cyclical unemployment: Joblessness which is due to the fall in aggregate demand (AD)

6. Disguised unemployment: Joblessness that are not captured by the official statistic due to reasons like the stigma of claiming benefits and strict inclusion which resulted in many unemployed people being deliberately excluded

7. Economic development: A broader perspective that goes beyond an increase in the national output/ income to include factors that can affect the quality of life

8. Frictional/ search unemployment: Joblessness that will always exist in an economy because some people may take a longer time to move from one job to another

9. Full employment: The level of employment as a result of everyone who is willing and able to work having a job, with the exception of those who are frictionally unemployed

10. Migration: The movement of people from one area to another, either within or between countries

11. Natural rate of unemployment: The rate of unemployment that will exist even when the labour market is in the state of equilibrium/ even when the economy is running at full capacity

12. Optimum population: The number of people in a country that will produce the highest per capita economic return given that the existing resources are fully and efficiently utilised

13. Potential growth: An increase in the potential GDP/ When PPC shifts outward

14. Real wage/ classical unemployment: Joblessness that occurs because the real wage is above the equilibrium level

15. Regional unemployment: Joblessness that disproportionately concentrates in one particular region

16. Structural unemployment: Joblessness which is due to a change in the structure of an economy, say from manufacturing to service sector

17. Sustainability: It is when resources are being exploited in the most optimal way, benefiting not just the present generation but also the future generations  

18. Technological unemployment: Joblessness which is resulted from an improvement in the level of technology such as manual workers being replaced by machines

19. Voluntary unemployment: Joblessness that exists because some people have chosen not to work because they do not feel that wages at the existing equilibrium are high enough to justify them working

Is Allocative Efficiency and Social Efficiency the Same?

Allocative efficiency
It is when scarce resources are being combined in such a way to produce the highest number of output using the least cost method and these products are actually what the consumers desire the most as reflected by the value they place on it. Therefore, this relationship can also be written as P = MC or MB = MC or AR = MC (P = AR = MB)

Social efficiency
The condition for social efficiency is stricter and harder to be achieved. It is when scarce resources are combined in such a way to produce the maximum number of output using the cheapest possible method of production and these goods are what people value the most, taking into account both negative and positive externalities. The condition for social efficiency is when MSB = MSC

Relating all together
As can be seen, allocative efficiency may or may not be the same as social efficiency, depending on the case studies that we use. In practice, as observed, they are unlikely to be the same. In fact it is quite impossible for the relationship between the two to be identical

To simplify our analysis, consider merit goods like alcohol and cigarettes. A firm is said to be productively efficient if these cigarettes are produced using the most cost efficient method. In other words, the company itself is operating where MC = AC

The same firm can also become allocatively efficient if the cigarettes that they manufacture are actually what the smokers desire the most as reflected by the price that they are willing and able to pay. Therefore the condition of P = MC is met

However, cigarettes are demerit goods and smoking is always associated with negative externalities. In a pure market economy, firms will only take into account their own PB and PC during the production process. Therefore, cigarettes are manufactured up to the point where MPB = MPC. The same can be said with consumers. As they smoke, they only consider their own MPB and MPC and so will smoke up to the point where MPB = MPC. However, from the society’s point of view, smoking is harmful and its production or consumption should be reduced up to the point where MSB = MSC. The overproduction and overconsumption of cigarettes have resulted in the case of market failure

In conclusion, even if a firm is both productively and allocatively efficient, it is not necessarily socially efficient. Yes, they produce goods and services that consumers value the most and therefore in theory, allocation of resources should be efficient. However, the firm does not meet the last condition. Not everyone concurs that cigarettes are ‘beneficial’ and in most cases, societies (majority of the population which is non-smoker) often object their existence. Therefore, allocatively efficient and socially efficient are not the same