Sunday, July 06, 2008

Short- And Long Term Price Elasticity

One issue related to the issue of the high price of oil is how sensitive, or elastic to use economese, the supply and demand is to price changes. One argument against the "inventory argument" against speculation as the source of higher oil prices is that if both supply and demand is completely inelastic, then higher prices due to speculation will not create higher inventories. Well, yeah if it is completely inelastic then that would be true. But notice the very big emphasis on if. And particularly with regard to demand that is highly unrealistic. If gasoline is $4 per gallon (one gallon is slightly less than 4 liter, so this is equivalent to $1 per liter), then a lot of trips that would have been made with gasoline at $1 per gallon will be cancelled. Meanwhile, as car makers are now noticing, the high price of gasoline is causing a sharp decline in car sales in general and the sale of SUVs in particular. Also, this is likely to encourage the ethanol boom further. So there is certainly every reason to believe that although the short term price elasticity may not be high, it is definitely not completely inelastic. This in turn means that if speculation were a factor, then inventories would have been rising, which they haven't.

It should however be noted that there is every reason to believe that long term price elasticity is higher than short term price elasticity. Although people will respond to a dramatic price hike by canceling leisure related trips or other discretionary trips, they may find it difficult to switch their SUV to a more fuel efficient car overnight, particularly as the value of that SUV is falling on the secondary market. Moreover, although some will switch to public transportation to work, others will find that more difficult. But as time goes by, SUVs are going to get increasingly rare as the new car market will increasingly consist of fuel efficient cars. Moreover, the higher fuel price will increase demand for public transportation and so create new routes and enable more commuters to stop driving their car for work. And also, the higher price of fuel is likely to encourage more people to find jobs closer to their homes.

For all of these reasons, the long term effect on demand is likely to be much higher than the short term effect. It is not just monetary policy that works with time lags, commodity markets also have time lags. This difference in elasticity in the short term and long term is likely to be even higher on the supply side of the market. If oil prices suddenly surge, producers can only respond with higher supply if spare capacity exist. To the extent there is no spare capacity, then supply is in fact inelastic in the short term. However, things are different with regard to the long term. The higher price of oil will encourage producers to explore more, and will also encourage them to drill for known resources. It will take years before these factors will bring out oil to the world market, but eventually it will happen. This means that long term price elasticity for supply could be quite high, even if it is very low in the short term.

This is essentially the explanation for why commodity markets tend to move in cycles.
First you have a boom cycle where there is shortage, which due to the low (but not nonexistent) short term price elasticity will create significant price booms, booms that will last for several years. But then once people switched to more fuel efficient alternatives while at the same time all the new fields get operational, then suddenly there will be excess capacity and prices will fall back significantly. That will however once again encourage people to use more fuel and discourage new exploration and drilling, which eventually after a few more years could create yet another cycle characterized by shortages. And so on and so forth.


Blogger flute said...

Good analysis as usual, Stefan. The difference between long and short term elasticity is particularly interesting.
However, I doubt that higher oil prices will actually encourage a meaningful amount of new production coming online. Simply because all potential new projects are small compared to total world output. Besides, many oil producers seem to use the now rapidly increasing income from oil for uses other than improving the oil production infrastructure, e.g. construction madness in Dubai, or Chavez' slightly misguided uses of oil income.
As for encouraging the ethanol boom, I doubt it. The ethanol industry already seems to have its self-made problems, e.g. "16 Ethanol Plants Filing Bankruptcy, Many More to Come", and a bright future seems less and less likely for them.

2:09 PM  

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