The Ins and Outs of Elasticity in the Price of Petroleum

Understanding the future price of oil, gasoline and all products dependent on them (read that the price of just about everything we need or think we need) requires, among other things, an understanding of the economic importance of price elasticity and inelasticity. When we say that the supply of a product or service is highly elastic, we mean that it responds quickly and smoothly to changes in the purchase price. A good example of a highly elastic service is college teachers of English literature. There’s a surplus of qualified providers now doing other things. Increase the pay a little bit, and they’ll sign up. Increase the pay a lot, and they’ll be breaking down the door. You can envision a point at which all those qualified to teach English literature in college would be employed teaching it and therefore the supply would be inelastic. Okay, maybe you can’t envision it; we have a tough time with that, too, but you get the point.

On the other hand, those who want an original Picasso find the supply of these dear treasures to be quite inelastic. That is, offering more money doesn’t dramatically increase the supply of original Picasso work available for purchase.

That’s the supply side of the equation. What about demand? In our household, we’re aware that there are some things we consume for which our demand is quite elastic. We buy and eat lots of squash and zucchini, but we could get by without it if there were a sharp spike in the price. Not so coffee. Double the price, and Amanda still needs her morning coffee. Heck, increase it by six-fold, and she’s still a coffee-drinker. She may stop eating, but she’ll still have a cup in the morning. So at least in the Borden household, our demand for coffee is relatively inelastic.

So, you say, what does all this personal trivia have to do with the price of petroleum products? Our demand for petroleum is relatively inelastic. In fact, it’s far more inelastic than most of us realize. A dramatic increase in the price of petroleum would change how we live our lives, but because we can’t change where we live or work easily and can’t easily trade in one vehicle for another, there’s relatively little we can do quickly to decrease our consumption. We may have to stop buying more clothes and/or having our hair done and/or buying a new hard drive and/or giving to our synagogue, but many if not most of us will buy almost as much gasoline as we did when the price was lower.
elasti1And despite the breathless feel-good stories coming from the oil industry and their media and consultant lap-dogs, when the peak arrives, there’s not much you can do to increase the supply, no matter how much you’re willing to spend. That’s the awesome power of peak oil. The supply of petroleum after peak will be almost totally inelastic.

The collision of an increasing, inelastic demand and a decreasing, inelastic supply is inevitable. The price of petroleum and all things that need petroleum will increase, and at a rate we still don’t fully understand. Perhaps more importantly, there will be times when you just can’t get it at any price.

Now here’s one more piece of data to plug into your future planning. The rate of oil production will fall. The rate of oil export, from those few remaining countries that export it at all, will fall even faster. That’s because as oil production falls in an economy whose citizens are hooked on cheap fossil fuels, governments tend to solve their closest problems first and keep the oil flowing at home; this in turn means a rate of oil export that falls faster than the decline rate for oil production.