There is no doubt that the oil price increase that happened a few months ago has impacted many countries. Of course, United States is one of them. Since almost all basic commodities need oil in their production, prices of these commodities also increase whenever oil price increases. However, the oil price today has continuously decreased. According to Musante (2008), gas prices have decreased by more than 50% since July. Diesel prices, on the other hand, have decreased by more than 40% since July.
What could have possibly triggered these oil-price decreases after having set record high prices last July? Well, first we should know what caused the increase. The oil price increase that happened a few months back may be caused by the increase in production costs. However, price increases can also happen whenever the good becomes scarcer.
In economics, pricing is directly based on the cost of production especially average costs (Piana, 2003). Average cost is the cost producing one unit of a product. In the case of gasoline and diesel, it can be the cost of producing one gallon or barrel. In order for the firm to profit, the selling price of diesel or gasoline should be higher than its average cost. If the average cost continues to increase, the company has no choice but to also increase the selling price of the products. This is probably what spurred the high oil prices in first and second quarter of 2008. Decrease in oil prices could also be caused by this. However, this kind of pricing, average cost pricing, can also lead to inefficiencies and distortions.
The use of average cost in pricing rather than marginal cost may impose inefficiency on firms especially for those unregulated monopolies. In using average cost as a basis for pricing, marginal costs are neglected. In the case gasoline, it is assumed that marginal cost is constant and that it is not very different from average total cost at the output level at which the firm operates. In reality though, oil producers operate at various levels of marginal cost because they have factories/plants of different ages. In setting prices, regulatory agencies tend to look at the historical costs of these facilities. Production facilities that were built many years ago are listed at the cost that was paid for them at the time that they were built eventhough this is below the cost of replacing them or adding to their capacity. Average cost as measured in historical terms falls short of marginal cost because the cost of generating an added, say gallon of gas, means the cost of generating it in new facilities. Setting prices below marginal cost can lead to inefficient use of resources.
When it comes to oil price decrease, it may seem that it is always beneficial to the economy because it makes the consumers better off. However, I think this is not always true. According to the article, “crude investors are concerned that as the global economy slows, demand for fuel will fade worldwide.” If this happens, oil prices will continue to decrease and might trigger a severe deflation. As said earlier, this might sound good because it means lower prices. However, the notion that inflation is bad and deflation is good does not always hold true. According to Samuelson (2008), a slight deflation, just like slight inflation, cannot be detrimental to the economy. However, severe deflation, just like inflation, can cause a lot of trouble.
One harmful effect of deflation is that debts would be harder to pay for companies. This is because prices decrease while debts remain fixed. This will in turn result to bankruptcy and increase in the unemployment rate. In the case of households, debts will also be hard to repay because wages will fall. Another effect is that consumers would tend to consume less today and wait until the prices still lower in the future. People will think that if prices are low to day, it will still decrease further in the future (Samuelson, 2008). This is why lower prices are not something that we should always rejoice at. In the long run, we are still the ones who will suffer.
Musante, K. (2008). Gas prices continue to fall. CNN Money. Retrieved December 1, 2008, from http://money.cnn.com/2008/11/23/news/economy/gas_prices/index.htm?postversion=2008112308
Piana, V. (2003). Costs. Economics Web Institute. Retrieved December 1, 2008, from http://www.economicswebinstitute.org/glossary/costs.htm
Samuelson, R. (2008). Recovery Killer? How lower prices could actually hurt the economy. Newsweek. Retrieved November 29, 2008, from http://www.newsweek.com/id/168326?tid=relatedcl