Readers question: Should the Government intervene to deal with the problem of Oil Shortages or is it better to leave it to a free market?
As oil runs out, supply will shift to the left and the price will increase. Because demand is inelastic, oil firms will make increased profits. This creates an incentive for oil companies to discover new oil supplies. This research is often expensive, so the higher profits is beneficial for encouraging investment. There are many oil reserves which are difficult to access, e.g. oil in the Antarctic and Siberia. Therefore, the cost of production maybe $100 a barrel. Therefore, now oil prices have risen over $100, it has become profitable. Therefore, the market can respond to the changing market signals and try and increase supply. Also, firms have an incentive to develop and promote alternatives to oil, such as solar panel cars; the more expensive oil becomes the more attractive these options are.
In theory, the free market should respond to shortages and rising prices through increasing supply or developing alternatives. However, the free market may not be able to deal with the oil shortages in a timely manner.
Firstly, demand is rising very rapidly because of economic expansion in Asia (China and India). Therefore, prices are rising rapidly, even though supply is still increasing. If we had a combination of falling supply and rising demand, prices could skyrocket. Investing in new supplies or alternatives to oil could take several years. By the time the free market has provided alternatives to oil, the world economy may have suffered several years of very high oil prices.
High oil prices will create the following problems.
- Increased cost of production
- Cost push inflation
- Lower living standards, especially amongst oil importers.
- A shifting economic power from oil consumers to oil producing countries.
There is market failure in developing alternatives. – Firms may be reluctant to take risks. Firms may not have sufficient funds to invest in risky innovation. Finding alternatives to oil may not be so easy. IT may take many expensive failures before suitable alternatives are found. Markets respond to crisis rather than anticipating them.
How Government Can Help
The government can subsidise firms who are developing alternatives. The government could even initiate schemes themselves. This helps to overcome the problem of finance for risky investment. However, government subsidies may be targetted at the wrong firms, and it may be misused. But, oil is such an important commodity can we leave it to the free market?
If we do leave it to the free market, there may be several years of uncomfortably high oil prices as the market struggles to respond to the price signals. Therefore, government intervention can be justified on the grounds of overcoming market failure.