Thursday, November 1, 2007

Oil Prices, Economic Growth and the Global Economy

I've frequently posted on how oil prices can be used in the economics classroom - frequently suggesting that they are good for demonstrating the effect of prices on supply and demand - usually as primary effects.

On the front page of today's (11/1/07) Wall Street Journal (subscription required), is a different opportunity. It still uses oil, but now it provides links to issues related to economic growth and development, foreign exchange and secondary effects. It's worth your time.

The article addresses the connection between the rising oil prices of the past year and growing demand in Asia. It does a very good job of explaining how industrializing countries in Asia have been able to push prices higher. But what it does that usually is lost in the classroom discussion is address the price subsidies many Asian nations have provided on consumer purchases of oil - a classic example of a binding price ceiling as illustrated here.

Now, if graphs freak you out, you should try to ignore all the shaded areas and just focus on a couple things. First, look at the intersection of the supply curve (upward sloping) and demand curve (downward sloping) that is labeled "free market equilibrium". That shows you the price at which the quantity of a good supplied and the quantity of a good demanded are equal. In this case, we are talking about the market price of gasoline.

Second, look at the horizontal line below the equilibrium price. That represents a binding price ceiling, or in the examples used in the article, the subsidized price to consumers that has been set by various governments. Please notice difference between the point this line crosses the supply curve, and the point where it crosses the demand curve. The difference is labeled as "excess demand." This tells us that at the lower, artificially set price, people (or businesses) will use (demand) more fuel, than producers are willint to provide (supply). At this price, some firms would go out of business or customers would find themselves unable to get fuel. But government can choose to make up the shortfall (subsidy). But this means government must find the revenues to cover the expense of doing so.

As we learn in the article, various Asian governments have been providing this. But the cost of subsidizing retail fuel is getting higher, largely because demand in many of those countries has not been provided the proper signals that come with market prices. Consequently, people who use gasoline have continued to demand more, because they are not directly paying the price. Remember, prices serve as signals: what to produce, how much to produce, and for whom. In this last respect, it is also a rationing mechanism. If the price is incorrect, the product (gasoline) is not allocated properly or efficiently. Likewise, the producers are not receiving the market price, and they are receiving signals to produce an insufficient amount to meet demand. They have no incentive to produce more or to bring more productive resources on-line.

The article also points out how many Asian nations have used this subsidy to energy to help drive rapid growth. This is logical. As industries and countries move up the industrialization ladder, they use more energy to produce goods, generally higher value goods. But if the price does not reflect true resource cost, the energy may be used inefficiently, or even in a way that is harmful to the environment.

But, what was most interesting to me about the article was the authors' example on how the decision to reduce (or maybe even end in some cases?) subsidies will impact on other aspects of the economy. The use of fuel to transport food, could potentially impact a nation with a significant income distribution problem that is also facing rising food costs. Furthermore, since oil prices are quoted in dollars, the recent decision by the Fed could further complicate things. Generally, as our interest rates are lowered, the value of the dollar in foreign exchange markets also slips. This means that it takes more dollars to buy the currency of other nations, and foreign currencies will purchase more dollars. As the value of the dollar falls, the price of oil is also likely to rise.

Nations that need dollars to purchase oil have a couple of alternatives. First, they could increase exports of products to the U.S. to sell for dollars, increasing the amount of foreign goods we import. Or they could offer to buy dollars, using their currency or other reserve currencies (euros, yen) in payment. Some questions for your students on these last points are these:

1) What would an increase in imports do to economic growth? (You may have to revisit the GDP equation to help them see the effect.)
2) What would increasing demand on the dollar do to the value of the dollar in foreign exchange markets? (And consequently would that help/hinder inflation pressures and, again, the balance of trade?)
3) As fuel prices rise within the Asian economies, what does that do to the "real income" of citizens? Does that have an impact on their ability to buy domestic goods in their own economy? Goods imported from the U.S.?
4) If fuel prices rise, is there an potential impact on the environment as nations have incentives to use fuel more efficiently?
5) Is it possible that the subsidized price of fuel had an impact on the price of goods/services produced by these nations for export? What trade advantage would that give, if any and what would that mean for their trading position?

I'm sure there are a lot of other aspects that I am overlooking, but these are the questions that popped into my head as I read the article. I welcome your discussion, and any other teaching ideas you might have using this article.

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