Oil price fall illustrates several micro concepts

The drop in oil prices (to a level below that of 2004) has been reflected in gasoline prices, which you may have observed at your local gas stand. The demand for oil is partly derived from the demand for gasoline. It is also derived from the demand for electricity and many other items.

Notice how the price movement ties in with economic principles:

  1. The fall can be explained with simple demand and supply analysis. While demand has  been shifting left (for various reasons, such as the increased availablity of substitutes) and will continue to do so (if the COP 21 promises are upheld), supply has been shifting right, due to fracking and shale oil etc.

2) But the price drop is particularly large due to the inelastic demand for oil. Draw such a curve and then shift supply right on it. Notice the large drop in price.

3) In addition, supply has continued to shift right even though it is against the collective interest of cartels, such as OPEC.  Game Theory can be used to demonstrate that each “player ” (in this case, each oil-producing country) encounters the dominant strategy which leads it to increase supply and thus reduce  prices. All the players try to maximise their own self-interest but end up in an equilibrium in which they are all worse off.

4) The important issue of market failure due to negative externalities of consumption and production also plays a large part in explaining the movements in demand.


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