Market Failure in the Oil Industry

Market Failures in the oil industry.

Oil is the most important raw material in the world, in both economic and political terms. Many countries' industries depend on oil and gas's producing and pricing; therefore, as more increasing the oil dependency, monopoly power and externalities could arise. Eventually, monopoly, externality, and pricing oil in the oil industry cause market failures. Market Failures occur when markets don 't allocate goods and services efficiently. They also arise when market forces fail to serve the perceived public interest. We can easily see how market failure becomes a reality in the oil industry. Sometimes it could be government failure because oil industry follows by government regulation in a lot of parts. Therefore, new government regulations are influenced the oil industry again. Due to pollution, such as BP oil spill, government planned Keystone pipeline project as government regulation to prevent oil spill. So, government regulation in oil industry is related to market failure and government failure as well.

First, pricing of oil is one of the most important factors to a lot of business, which are related to oil industry, in the world. Low oil prices of crude oil can be caused imbalance between supply and demand - too much supply, or too little demand. High crude oil price could be due to a shortage of oil supplies. High prices for oil products - as purchased by end consumers such as motorists - are more likely to reflect other factors, such as taxation. Crude oil prices react to the balance of demand and supply in the short term, and the rate of investment in the longer term. If investment is not made far enough in advance, oil supplies could be limited in the longer term, thus raising prices. Sentiment is also an important factor: if traders in the oil market believe there will be a shortage of oil supplies, they may raise prices before a shortage actually occurs. Other factors influencing the price of crude oil include accidents, bad weather, increasing demand, halting transport of oil from producers, labor disputes (strikes) as well as other disruptions to production including war and natural disasters.

Crude oil now represents less than a quarter of the price of oil products in many countries. Therefore, taxes have more influence over the price of oil products. When oil taxes are raised, end consumers often mistakenly blame the oil producers, but it is really their own governments that are responsible. If oil prices are too high, then these goods and services become more expensive and economies experience inflation. Alternative forms of energy would also become more cost-competitive, but oil producers would eventually increase their supplies and prices would come back down. If oil prices are too low, consumers would waste this non-renewable resource, investors would not be attracted to the industry and oil producers would suffer - especially the developing countries that produce oil, such as the OPEC Member Countries. If prices were too low, supplies would eventually fall until there was a price shock - leading back to inflation.

The supply of oil is determined by the volume of both previously developed and newly discovered reserves and by the rate of extraction, both determined by prices offered for the oil. Oil demand is determined by the efficiency and rate of use of gas and oil burning machinery. Again, efficiency and rate of use are influenced by the price of oil. The market is in equilibrium when increases or decreases in production and demand together result in no additional price movement. Current trends in oil prices reflect increasing conflict in the Middle East and diminishing domestic oil production. There have been temporary upward spikes corresponding to the first Gulf War. More recently, the second Gulf War and hurricanes have caused glitches in supply and subsequent price spikes. The most significant cause of price increases in the last few years has been increased demand from developing Asian countries such as China and India. Global oil demand can have dramatic effects on domestic oil prices.

Secondly, monopoly power is the key of market failure and compare the actual situation to a hypothetical competitive world oil market or to a market in which OPEC's market power is significantly reduced. However, at 1970's, there's historical case about oil embargo by OPEC. Also, there were political factors as well. According to 'Understanding Global Conflicts and Cooperation', Nye said that after 1973 there was a major change in the international regime governing oil. The producing countries set the rate of production and therefore had a strong effect in price, rather than price being determined solely by the market in the rich countries. There was an enormous shift of power and wealth from rich to relatively poor countries (Nye, P259). According to the economic theory of partial monopolies, the market power of the OPEC cartel depends on three key factors : first, the cartel's share of the world oil market, second, the price elasticity of world oil demand, and third, he price elasticity of non-OPEC oil supply. In a dynamic market, market power also depends on the rate of growth of oil demand and the rate of change, if any, of non-OPEC supply. There are many issues affecting oil supply and demand. In the 1970's OPEC instituted an oil embargo by restricting supply to the point that there were long lines in the United States at gas stations and it posed a major threat to the U.S. economy. During the October 1973 Arab-Israeli War, the Arab members of OPEC announced an embargo against the United States in response to the U.S. decision to re-supply the Israeli military during the war. OPEC members also extended the embargo to other countries that supported Israel. The embargo both banned petroleum exports to the targeted nations and introduced cuts in oil production. Several years of negotiations between oil producing nations and oil companies had already destabilized a decades-old system of oil pricing, and thus the OPEC embargo was particularly effective. Implementation of the embargo, and the changing nature of oil contracts, set off an upward spiral in oil prices that had global implications. The price of oil per barrel doubled, then quadrupled, leading to increased costs for consumers world-wide and to the potential for budgetary collapse in less stable economies. Since the embargo coincided with a devaluation of the dollar, a global recession appeared imminent. U.S. allies in Europe and Japan had stockpiled oil supplies and thus had a short term cushion, but the longer term possibility of high oil prices and recession created a strong rift within the Atlantic alliance. European nations and Japan sought to disassociate themselves from the U.S. Middle East policy. The United States, which