Have you ever wondered why economists are always talking about the price of oil? What effect does the price of oil have on the economy? Hopefully by the end of this short article both of these questions will be answered.
Oil is known as a commodity (primary sector product) in the world of economics and sold by the barrel in the currency of $. This means that factors such as exchange rates actually play a part in the price we pay for a barrel of oil in the UK.
The price of oil is viewed with such importance economically because of dependency the production of many products have on this commodity. For example we all typically think about oil as impacting on the price of petrol, however oil is used in the production of plastic, something that nearly all of the items we purchase today will be made of. Oil is also used as a form of fuel for heating and power generation, so a change in price here could impact the overheads that a business has to pay.
Typically the cost of oil will impact;
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Transportation Costs
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Direct Costs
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Indirect Costs
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Consumer Disposable Income Levels
So if the price of oil was to increase by just a few $ per barrel then the knock on effect to businesses and the economy could be huge. All of a sudden a business could be faced with;
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Increased Transportation Costs
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Increased Direct Costs
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Increased Indirect Costs
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Reduced Consumer Disposable Income Levels
The business then needs to decide how does it tackle the issue of these increasing costs? Typically it has two options; either increase the selling price to generate increased revenue or absorb this increase in costs themselves and reduce their profitability.
Both options have their advantages and drawbacks. For example increasing the selling price could mean that your customers start to look elsewhere to make a purchase, thus reducing your sales. Also at a time when consumers have less money to spend increasing the price of a product / service is unlikely to be the best way to tempt them to spend. However, if the business was to absorb the increase in costs then in the long term this could cause issues with any shareholders as this would be reducing the profit figure the organisation makes.
So hopefully as you can see that black liquid pumped from the ground actually has a fairly large impact on how an economy will perform. In a future article I will look at the factors that actually cause the price of oil to change.