Price Elasticity of Demand and Supply for Oil

This is my first commentary written for my economics portfolio. It is a commentary on the article Low investment level to keep oil prices rising by Business Day.

The price elasticity of demand (PED) is the relation between the change in the quantity demanded of a good and the change in the price of that good. The PED for oil is very low, since a major increase in price is required for the demand of oil to be significantly, moved. This situation is caused by consumer, such as plastic industries and almost every car-owner, being nigh-dependent on oil. In the same way, the demand will not rise a lot if the price is reduced, because consumers need only meet their own, limited needs. This low PED is partially caused by oil lacking a close substitute. There are of course substitutes to oil – e.g. electricity and synthetic oil – but these substitutes would require a substantial initial investment from the consumers, which is why the oil prices need soar before the demand is affected. Note also that in the long run, the PED for oil is probably higher, since consumers will be able to invest in the one-time cost for adapting to other sources of energy, e.g. electric cars.

The price elasticity of supply (PES) measures the responsiveness in the supplied quantity of a good to the change in its price. Just as the demand for oil, the supply is very inelastic. This is because the main factor of the price elasticity of supply for a good is the close substitutes which the producer can produce instead of the initial good. When it comes to oil, there are no substitutes: the oil platforms cannot be changed to drill for milk instead. The only way for producers to change their production according to price is to expand or diminish production. If more oil platforms and drills are built and maintained, more oil will be extracted, which increases the supply. This way of increasing supply, however, does only have any effect in the long run, since building more platforms takes time.

The article states that the demand for oil is increasing rapidly, and that we will probably not see an investment in oil fields of the size required. First, this is yet another proof that the PES for oil is low: as demand increases, supply does not increase much. Second, this will entail a big increase in the oil prices. Because the demand is greater than the supply is, there is a shortage of oil. Shortage will lead to an increase in price, since the producers do not lose anything in doing so, as they would have done if there was an equilibrium in the market. Thus, the equilibrium is re-instated – however, it is so on a higher price than before.

In the article, it is also stated that countries with oil reserves which are being used by other countries are actively seeking to get more out of the affair. The barrier of entry for the oil market is high due to the required technology, which means that those countries are unlikely to start extracting their oil by themselves. Thus, they will probably demand an even larger amount of money from the countries which are already extracting their oil. If this happens, the companies extracting the oil will find less gain in doing so, which means that supply will sink even more. With the supply sinking, the prices will rise even more.

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