In a situation reminiscent of the 70s, the world economy has been battered by myriad oil price shocks in recent years. The upward trend in and the volatility of oil prices have taken their toll. Can anything be done to make things better?
Changes in oil price tell us something about the scarcity of the resources. As scarcity is the issue at hand, economics provides us with the tools to figure out what can be done.
The 1973 and 1979 crises were the result of a restriction in the supply of oil, first as a result of collusion between OPEC powers, and then as a result of a drop in supply following the Iranian revolution. The shocks were temporary. But over the past decade supply has been unable to keep up with rising demand from the developing world. In such a situation, it is possible that oil is genuinely more scarce, and will remain so – a result that has led to a sharp lift in oil prices.
So how should a government respond to the sharp lift? The same way it responds to any other increase in prices: do nothing.
The increase in the price of oil relative to other goods and services is telling people that oil is relatively scarcer, and that they must substitute or accept a lower standard of living. Lowering the price through subsidies takes away the incentive to substitute – and simply lowers living standards even more heavily.
Matters aren’t that simple. We may believe that information on the supply of oil in the world is very poor and as we’re averse to risk, we may want the government to do something to insure us, but it’s not costless. In this case the government insures by stockpiling oil supplies, using money that could have been spent in other ways. And on average, stockpiling schemes would be expected to make a loss.
There’s one big hole in the argument: households and/or community groups could choose to stockpile. If people in society are genuinely concerned about energy security and could insure against it themselves, why do we need the government to do it?
Matt Nolan is an economist at infometrics and blogs at www.tvhe.co.nz.