Demand for Petroleum over Time

A conventional downward-sloping demand curve is not, in my opinion, sufficient to explain the interaction of oil prices and quantity demanded over time. In studying the dynamics of international oil markets, I introduce a new type of statistical demand curve, which differentiates between upward and downward trends in prices.11 I may argue that a small rise in the price of oil, from its low, pre-1973 level, will not change the quantity demanded, for demand at such a low level may he regarded as perfectly inelastic. Yet, as oil prices are substantially increased, quantity demanded must be somehow reduced. Such a response makes the demand curve at higher prices less inelastic than before. This suggests that as prices are increased over time, the demand curve becomes concave in relation to the original axis. Yet as oil prices fall in response to a glut or for other reasons, a conventional downward-sloping demand curve could be applicable, as illustrated in Figure 2.

As oil prices rise slowly from PA to PC, the demand curve is inelastic as it moves from point A to point C. Quantity of oil demanded is perhaps slightly reduced from QA to QC. For a small rise in the price, however, demand is perfectly inelastic, as consumers may not be willing to change their consumption patterns in response to only small increases in price, especially for a necessity such as oil. After a certain period in applying a time series analysis, demand could move from point C to point E, with substantial increase in the price of oil as price moves from PC to PE. As it moves upward, the demand curve becomes less inelastic, which means that quantity demanded becomes more responsive to higher changes in price. Quantity demanded is then reduced from QC to QE, as consumers may change their pattern of consumption by driving small and more fuel-efficient cars, insulating their homes, converting their home-heating and air-conditioning fixtures, and adopting numerous substitution and conservation measures. At higher prices, demand for oil is reduced while supply is increased, resulting after a certain interval in all excess supply or an oil glut. If a glut occurs at point E, market forces will dictate a drop in the price so long as no monopolistic market power exists to reduce the supply substantially through a carefully designed policy or contrived scarcity. Nevertheless, it may be observed that a small decrease in the price of oil will not increase quantity demanded. If the price drops from PE to PG, quantity demanded will only be increased from QE to QG. If the price drop is even smaller, the demand curve may be perfectly inelastic, since consumers will not alter their consumption habits by adopting anti-conservation measures for a small reduction in oil prices. If, however, the drop in price is substantial, as from PG to PI, an increase in quantity demanded from QG to QI becomes evident, as consumers eventually resume some of their former consumption patterns. A theoretical derivation of a demand for oil from a utility surface can be based on conventional income and substitution effects using either a Hicksian or Slutskyian approach.12

In the right hand side of the Slutsky equation, the first term refers to substitution effect while the second refers to the income effect, both of which determine a response of quantity demanded to changes in price.

(Q/P)=( Q/P) - Q(Q/Y)

constant utility constant prices

where Y = Income

In an upward trend of prices in the demand curve we presented for oil, the algebraic addition of the two terms must be equal to zero if demand is perfectly inelastic as prices increase from a low level. However, as quantity demanded responds to a further rise in the price of oil, the addition of the two terms must be negative.

Similarly, in a downward trend of prices, the addition of income and substitution effects must be equal to zero if demand is perfectly inelastic. As quantity demanded increases with further decline ill the price of oil, the algebraic addition of the two effects must be negative while the resulting amounts, in absolute terms, keep increasing as prices fall farther.

Back to Index