Microeconomic Effects of an Increase in Gas Prices

When considering the ever-changing and highly competitive global landscape of business today, it is striking how many firms continue to rely on fossil fuels (particularly gas) as a primary means of facilitating operations. The functional inputs of countless organizations in countless industries are at the mercy of gas providers. Transportation mechanisms, factory machinery, construction equipment and climate control systems almost always require a petroleum-based source of fuel. And such operational instruments are absolutely vital to the market success of a myriad of small and large businesses. While some businesses have recently begun to realize and actively combat the drawbacks of this type of critical dependence, the actual market share of such firms is truly miniscule. For the majority of companies, an increase in gas or fuel prices has the potential to cause massive profitability and sales damages. What is more, being that petroleum is a global industry subject to various sources of fluctuation, firms at the microeconomic level have very few options available to protect themselves from the devastating fiscal effects of increases in gas prices. In fact, aside from switching to alternative energy mechanisms (which typically presents a very large up-front investment), there are no risk-free ways for firms to hedge or safeguard themselves in such an instance. This presents a unique situation, in that it is one of the only times that a firm cannot actively create security in the event of a profitability threat. Other threat sources can be managed through strategic productive and operational tactics. Thus, in such cases internal management would be ultimately responsible for the downfall of a company resulting from this type of threatening situation. Conversely, the collapse of an organization resulting from rapid spikes in fuel prices would seemingly be out of the company’s control. And as implied, from the microeconomic perspective, increases in gas and fuel prices always seem to have very negative operational consequences for almost all firms.

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In order to better understand the true scope of potential victims in the case of an increase in gas prices, it is important to determine the origins of why such spikes occur. The simplest answer is that such surges in gas prices occur as a result of increases in the price of crude oil. While gas is a very commonly used fuel, it is also a secondary source of energy. The diagram below illustrates the typical composition of an average gallon of liquid gas, which is the most commonly utilized of all gas fuels .

(Chevron Corporation, 2005-08, p. 1)

Therefore, as is easily ascertainable from the above depiction, gas prices are simply a result of crude oil prices. And knowing the evern greater amount of companies that utilize oil in their operations, the potential microeconomic effects are truly massive.

These injurious microeconomic effects are caused by the absolute essentiality of petrochemical fuels like gas in many production processes. And while other energy alternatives do exist, they often require permanent systematic restructuring and thus cannot be simply and quickly substituted to combat a sudden gas price increase . This reality creates a large degree of inelasticity in the microeconomic demand for gas. And when dealing with such inelastic demands, price increases do not equate to demand decreases, as would be the case in a normal economic situation of supply and demand. Rather, inelastic demand scenarios exemplify an organization’s necessitation for a given product (in this case, gas). Thus, firms are solely responsible for absorbing the increased cost of gas. This upsurge in fuel price is typically represented by a hefty increase in operating costs, which usually amounts to an equally significant decline in profits . The microeconomic graph below elucidates the concept of inelastic demand.

(University of Rhode Island, 2009)

As illustrated, when the price goes from “B” to “A” the quantity produced does not decrease very substantially. This is a result of the inelasticity of demand. For, companies must continue to operate and produce in order to meet the unchanged demands of their customers (Krichene, 2002). Therefore, assuming that a firm will not be able to adequately raise the price of their products or services to sufficiently meet the price increase of gas (this is typically a result of pre-existent contracts or fear of the loss of their market position), the shaded area labeled “A” in the figure would ultimately represent the company’s absorbed loss.

Furthermore, supply seems to be relatively inelastic as well in the case of gas. The figure above also heeds this reality. Though while this diagram actually depicts a supply shift resulting from a decrease in price, the effects of a supply price increase could easily be ascertained by simply working backwards. Beginning at price level “B/C” with the dotted line representing the supply curve, and moving to price level “A” with the red line representing the supply curve. Once again, while the price increase seems to be quite substantial, the decrease in supply is relatively nominal . This situation results from the recently soaring levels of fossil fuel consumption, which are accompanied by the rapidly declining rates of oil discovery sites . Consequently, the quantity of gas supplied to these firms remains at very close to the maximum attainable in response to the incessant demand .

As a result of this unique situational reality, in which both supply and demand are relatively inelastic, increases in petroleum-based fuel prices must originate from other areas. This is unlike normal economic inputs which fiscally fluctuate in response to demand and supply shifts. Crude oil prices, on the other hand, often increase as a result of natural disasters, increases in costs of extraction, locational difficulties or geopolitical developments . Therefore, relevant firms must be constantly aware of world oil trends and market price fluctuations. Such extensive knowledge will allow microeconomic entities to strategically approach the drafting of contracts and securing of future market positions . In doing so, companies must make additional considerations concerning potential future operating cost fluctuations in order to appropriately price their goods and services. These extra preparatory steps are the few available protective (though also highly speculative) mechanisms at every business’ disposal. This will also help to avoid sudden harmful surprises in the form of expense increases and subsequent revenue losses.

Another means of intricately examining the effects of an increase in gas prices would be to analyze some specific microeconomic organizational situations. By using a shipping or transportation organization as a framework, the specific corporate effects can be easily recognized and highlighted. Firms in the shipping business are among the largest consumers of petro-fuels like gasoline . Knowing this, spikes in gas prices can represent a monumental source of revenue losses for a shipping company. The primary revenue generators for a transportation-based firm come in the form of trucks, planes or cargo ships, each of which normally travels great distances and requires massive amounts of fuel . Also, such organizations almost always engage in contractual agreements with there clients. These contracts are often set a fixed price for the customer, which is typically valid for months or years at a time. Therefore, while the client is protected from fluctuations in price, the firm providing this critical service is poised for monumental losses at the hands of gas price increases.

Nevertheless, there are some means of protection available to shipping organizations. Although, while such measures would ultimately be taken as a way to provide future insurance, the implementation of many of these strategic securities comes with several operational risks. Most of these instruments would be incorporated into the contractual process with the customer. One such mechanism would be the integration of order minimums. By ensuring maximum capacity loads on each trip, transportation agencies can guarantee that they will at least be making the best use of the fuel they do consume. Another safeguarding apparatus would be to integrate renegotiation clauses into contracts. This would allow transportation companies to periodically manipulate prices according to fluctuations in operating costs. However, as mentioned above, these firm-friendly tools could also cause the loss of customer accounts and the future deference of new clients. Thus, firms should certainly strive to protect themselves from the unwelcomed microeconomic effects of gas price increases, though high levels of diligence are required to ensure that such protections do not backfire.

Another usable template for analyzing the microeconomic effects of fuel price increases would be to examine the workings of a traditional factory-oriented manufacturing organization. Production facilities are typically comprised of large amounts of complicated machinery and mechanical devices. These items themselves require large amounts of fuel to function efficiently, though this type of advanced equipment also must be housed in a climate-controlled environment . The grand scale of many factories requires an extremely complex and expansive climate control systems, which are yet another source of fuel consumption . Thus, while a firm in this industry may not use as much gas or oil as a firm in the transportation industry, the fact that such fuels are necessitated in multiple areas of production implies an equally significant fuel dependence. In other words, a manufacturing firm also stands to lose a great deal as a result of a sudden increase in the price of gas .

Though like a transportation-based firm, manufacturing companies do have a few strategic security tools at their disposal. However, in this case the implementation of such protective mechanisms usually occurs on a reactive basis as opposed to the preemptive approach available to transportation firms. For instance, manufacturing facilities can increase production and accumulate large inventories when fuel prices are low and slow production when fuel prices increase . This tactic allows factories to fill the orders from customers using the inventory they have compiled during more profitable operational circumstances. However, this technique also limits the firm’s capacity to secure new customers or new products.

Ultimately, there is little any firm can do to truly protect themselves from the potentially devastating microeconomic effects associated with increases in gas and fuel prices. While market knowledge and strategic operational and contractual tactics can be useful, they are often highly speculative and risky. Therefore, a macroeconomic shift (which would presumably encompass all relevant microeconomic inputs) away from the crippling dependence on gas and other fossil fuels certainly seems like the best solution to this fundamental problem. For with the necessity for energy generation throughout many vital industries and the unpredictability of current fuel prices, the present microeconomic structure seems destined for failure. Dependability is often considered to be a core competency required of almost all product and service providers. Thus, it seems only fair that the firms that are relied upon by citizens should have equally reliable operating cost structures.

Bibliography

Berkmen, P., Ouliaris, S., & Samiei, H. (2005, September). The Structure of the Oil Market and Causes of High Prices. Retrieved April 20, 2011, from http://www.imf.org/external/np/pp/eng/2005/092105o.htm

Cabedoa, J.D., & Moya, I. (2003). Estimating Fuel Price ‘Value at Risk’. Energy Economics, 25 (3), 239-253.

Chevron Corporation. (2005-08, January 1). What Affects Fuel Pricing – Basics of Supply & Demand. Retrieved February 11, 2011, from The Price of Fuel: http://www.thepriceoffuel.com/whataffectsfuelpricing/

Dahl, C. (2001). Analysing Gasoline Demand Elasticities. Energy Economics, 13 (3), 203-210.

DeCicco, J., & Mark, J. (2000). Meeting the Energy and Climate Challenge for Transportation in the United States. Energy Policy, 26 (5), 395-412.

Energy Information Administration. (2000). Fuel Oil Use in Manufacturing. Retrieved April 20, 2011, from http://www.eia.doe.gov/emeu/consumptionbriefs/mecs/fueloil/mecs_fueloil_use.html

Krichene, N. (2002). World Crude Oil and Natural Gas: A Demand and Supply Model. Energy Economics, 24 (6), 557-576.

Leigh, P.J., & Geraghty, E.M. (2008). High Gasoline Prices and Mortality From Motor Vehicle Crashes and Air Pollution. Journal of Occupational & Environmental Medicine, 50 (3), 249-254.

Nicol, C.J. (2003). Elasticities of Demand for Gasoline in Canada and the United States. Energy Economics, 25 (2), 201-214.

Silverman, B.S., Nickerson, J.A., & Freeman, J. (1999). Profitability, Transactional Alignment, and Organizational Mortality in the U.S. Trucking Industry. Strategic Management Journal, 18, 31-52.

University of Oregon. (1999). Fossil Fuel Production and Consumption. Retrieved April 20, 2011, from http://zebu.uoregon.edu/1999/ph161/l10.html

University of Rhode Island. (2009). Elasticity. Retrieved April 20, 2011, from http://www.uri.edu/artsci/ecn/mead/INT1/Mic/Elast/index.elast.html

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