The burning issue of the US economy today is the continuing surge in the fuel prices in US. The prices have fluctuated throughout this fiscal year making oil constitute the major portion of the import bill. The demand of fuel has increased drastically whereas its supply has been limited which has led to shooting up in the prices of crude oil in the market. The prices of fuel namely oil, gas, petroleum have reached their highest records shocking the American consumers. But since fuel is a necessity for the American population, they cannot stop consuming it as it is required in the daily activities of the people.
These rising prices are crippling the American economy because of the rising import bill since fuel is a necessity. This rise in fuel has affected the demand of transport sector considerably. Summer is a season of vacations in US where families leave their homes for travelling purposes. But due to rise in jet fuel prices, the air travels have increased their fares and the number of families going for vacations this summer has considerably decreased. But one of the reasons of the rise in fuel prices has been the increasing demand of transport vehicles.
Since US is a country where it is difficult to manage without a personal car and as the population and incomes of American are increasing, so is the demand for cars increasing. The rise in demand of the transport sector has led to rise in demand of petroleum, diesel and gas but limited their supply due to which their prices have increased. (Mussa, 2000) Reasons for rise in fuel demand The price of the fuel oil at the beginning of the year was around 92 US dollars per barrel and now it has gone to $135 per barrel.
This represents a huge increase and a growing number of people are unable to afford this increase in price and are therefore, switching to other cheaper alternatives comparatively. Following reasons have contributed to rise in demand of the fuel oil (Samuelson and Nordhaus, 2004) • The average incomes of Americans have risen due to which they can buy more of fuel oil thus causing its overall demand to increase. • The population of people residing in US has increased which has caused the market size to increase. When there are more people, there is more demand for fuel oil.
• Since fuel is a basic necessity used in homes, industry and transport sector and virtually no substitute exists for it, people have no other alternatives to chose from so they continue to demand fuel. • The demand for fuel rises considerably in summer seasons when Americans prefer doing travelling with families or spending their holidays somewhere else other than their home city. Greater travelling increased the demand for fuel in the transport sector. Factors mentioned above have caused the demand of fuel to shift rather than increase which means that people are ready to purchase more on the same price.
The effect of price only causes the demand of fuel oil to increase or decrease in the US where both have an inverse relation. Price Inelasticity of Demand As already mentioned fuel constitutes the basic necessity of American population which means that its quantity demanded would not change much with an increase in price. This means that fuel is price inelastic. Fuel prices have risen considerably over the years but still people tend to consume it without much change in the quantity demanded because there exists no substitutes for it and people cannot survive without it.
Fuel has therefore, inelastic demand. On the other hand, when we analyze the price elasticity of supply, fuel’s supply is relatively elastic with price. According to the economic concepts that we have studied in the class, when a good’s demand is inelastic relative to its supply, then the cost incidence is more on the consumers. As the demand of fuel is relatively inelastic as compared to its supply so most of the cost of fuel is shifted to the consumers and this has kept the prices of oil to increase considerably over the years. (Samuelson and Nordhaus, 2004)
Reasons for rise in fuel prices There are several reasons which have forced the fuel prices to reach their highest records. Some of them are as follows: • One of the reasons already mentioned above that the rising demand and decreasing supply has contributed to the rising prices of fuel. Any imbalance in supply and demand causes the fuel prices to increase in the short-term. Supply shortages mainly occur due to refinery problems where crude oil is refined to produce fuel, electricity breakdowns due to which machines cannot be run, pipeline problems and sudden increases in demand of fuel.
Since the demand is more than the supply so this has exerted an upward pressure on the fuel prices. Moreover, since the demand is relatively inelastic as compared to its price elasticity so the incidence of soaring prices is shifted more on consumers. • Secondly, the devaluation of US dollar in the world market has also contributed to the rising prices. Since oil constitutes a major item on the US import bill, the country has to pay more now to obtain the same quantity of fuel due to falling dollar in the market.
It has been speculated that the price of an oil barrel will go up to 200 US dollars if the dollar continues to fall in the world market. (Lynneon , 2004) • Another reason for the rise in prices of fuel is the increase in its demand considerably in the US market as well as in the world market. The reasons for the rise in demand of fuel have already been explained above. • Most of the world’s oil is located in politically unstable areas from where it is difficult to extract oil at times of instability. The supply fluctuates causing the prices to rise.
• Oil prices also depend on a country’s state of economy. Since US has a strong economy as compared to other developing and developed countries, the fuel prices rise relatively more in US. Strong economy means more resources can be used for purchasing the fuel at higher prices. • The main cause in the rise of fuel prices is the rise in the crude oil which is the constituent of all fuel goods. There have been no major oil discoveries in the recent years due to which there has been a shortage of crude oil and therefore, its prices are soaring.
US has to purchase crude oil first which is then refined into other fuel goods. When the raw-materials are expensive so naturally the finished goods will also be expensive. (Lynneon , 2004) • Taxes are also added to final price which is charged from the consumers. Tax rates can go up to around 50%. This represents an additional cost to consumers who have to pay this tax and this why they are kept on shocking with increasing fuel prices. The above reasons explain why fuel prices have risen drastically over the years.
They have almost tripled from what they used to be. This year the increase in prices has caused the demand of petroleum to decrease because people have shifted to CNG which is a cheaper substitute to petrol in the transport sector. But still fuel consumption cannot decline. Natural gas is used at homes for cooking, oil is used by industries to produce electricity and manufacture goods, and different fuel grades are used in the transport sector. The overall global demand continues to rise because of lack of substitutes. Application of the Economic Principle
The shooting up of fuel prices has been attributed to the economic principle of demand and supply. Any gap in demand and supply results in shift in prices until they are once again in equilibrium. This demand/supply imbalance is the main cause behind the fluctuations in the fuel prices throughout the year. The economic principle of demand and supply states that if a commodity’s demand is greater than its supply then an upward pressure is exerted on the price (Samuelson and Nordhaus, 2004). The reasons for the rising demand and supply shortages have already been explained in the above paragraphs.
If the demand rises due to factors other than the price then the price increases and the quantity demanded also increases. And combined with this, when there are shortages in supply, the prices rise even further causing the quantity supplied to decrease. Here the commodity is the fuel whose demand has increased considerably causing the price to increase and at the same time the supply has decreased which has resulted in soaring fuel prices. The supply is short enough to satisfy the increasing demand of the US population.
It has been forecasted that prices will continue to rise further because of the shortage of crude oil in the world. The prices have already hit their highest records especially the crude oil, diesel and petroleum prices. Consumers after purchasing fuel have little cash available with them to buy other basic necessities of life. There is actually a shift of income from consumers to producers of oil. The costs of production of all the goods have risen because every good’s manufacture requires fuel as a crucial input raw material. The inflation in the US economy is also peaking.
This all is having an adverse effect on the US economy. This condition of fuel prices in the US is heading the economy towards recession combined with the slump in housing market, rising debt and interest rates and negative savings. (Mussa, 2000) Explanation through Graph The above graph will further clarify the economic principle explained above. It is a demand supply graph where the interaction of both curves determines the equilibrium price. D1 represents the actual demand curve of fuel and S1 represents the actual supply curve of fuel. Their interaction determines the fuel price which is P1.
As the demand has increased so the demand curve shifts towards the right. The new demand curve is D2. The interaction of new D2 and S1 shows that the prices have increased to P2 as denoted in the graph. This makes us understand how the prices rose when demand for fuel oil increased. Then the US faced problems with the supply of fuel causing a supply shortage. The supply curve shifts to the left when supply declines due to factors other than the price. The new supply curve to the left is denoted by S2. The price is now determined by the interaction between D2 and S2.
The new interaction occurs much above P1 and P2 which means that prices have risen further due to a shortage in supply. The new price is denoted by P3. If the demand continues to rise and supply continues to shift towards the left, the prices will rise higher and higher. Thus, the above graphical representation has further clarified the concept and explained how the prices rose of fuel in the US market. (Samuelson and Nordhaus, 2004) CONCLUSION The consumption of fuel is a lot greater than its production. Fuel is an important commodity used in homes, industries and transport sector without which the whole work comes to a halt.
The rising fuel prices are having an adverse impact on all the industrial sectors of the country which are facing increased costs of production. Because of this the prices of other commodities have also risen internationally. The local consumer is faced with problems of availability of cash because the costs of the basic necessities have increased. Thus, the country must take some actions and policies to control the existing upward pressure on the fuel prices as it affecting the US economy adversely.
Bell, Brendan (2005, Aug 26). Rising Gas Prices. Retrieved June 3, 2008, from washingtonpost.com Web site: http://www. washingtonpost. com/wp-dyn/content/discussion/2005/08/25/DI2005082500756. html Lynneon , (2004, March 23). WHY ARE GAS PRICES HIGH AND RISING?. Retrieved June 3, 2008, from Knowledge Problem Web site: http://www. knowledgeproblem. com/archives/000748. html Mussa, Michael (2000, Dec 08). The Impact of Higher Oil Prices on the Global Economy . International Monetary Fund, Retrieved June 03, 2008, from http://www. imf. org/external/pubs/ft/oil/2000/index. htm Samuelson, Paul A, & Nordhaus, William D. (2004). Economics . McGraw-Hill/Irwin.