Thursday, November 29, 2007

Oil Price: Then and Now

In the 1970s, OPEC cut oil supplies to created a price shock within the global economy which lead to a nasty global recession. Today, oil price hover around $100 dollars a barrel, and price seem to be climbing still. Why is it that the world's economies are able to absorb the new price change now whereas three to four decade ago, economies were at the mercy of the shock?

Lets first consider what an increase in oil price mean for the economy. An oil price increase is fundamentally an increase in production cost, or similarly, it can be view as an added tax on production and the costs of operation. Firms that use oil face a higher cost which force firms to increase price on its goods and services, this in turn force consumers to pay more for certain products which leave them with less income to spend on other goods and services. With increasing price of goods and services - inflation - people would want to find a better paying job, but due to higher operational cost, it become more difficult for firm to hire which fundamentally increase unemployment rate. As one can see, for an energy driven economy like the US, oil price increase mean a lot of things for the economy.

The differences, though, is that in the 1970, there was a shock whereas now, the change came at a pace in which the economy is able to absorbs and adjusts. For instance, what does an individual see what they see a certain price? Subconsciously, an individual would look at that price and compares it to their body of knowledge, determining if that price is a good price or not wherein the price would equal the expected price +/- some variability (market noise.) After such examination of the price, the individual would act accordingly. If the price is much higher than the price the individual expect, they would reason out what the market noise is if any.

In the 70s, when news of supply side shock and high gas prices reach the people, the rational behavior seem to be to run the pump to get as much gas as you can. Now, price climb at a steady pace instead of a rapid one, which allow people to see a general trend which allows people time to adjust their life style, and for company, it give them time to work around the new market price. As any classical economist would suggest, in the long run, everything even out, but life does not work in the long run alone. However, if change come slow enough, then expectation can changes alongside changes and adjustment can be made wherein there would be less market disruption. That is the different between the rational response to oil prices in the 1970s compared to now.

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