Short term effect on the average consumer as oil prices drop. (Theoretical approach)

Most economists agree that Oil is considered to be a normal good, by normal we mean that as your income goes up you would buy more of that good, that is a basic definition. As  oil prices fall you would expect that oil consumption would increase, however in the short-run that is not the case. Oil in fact is inelastic in the short run, inelastic means that its consumption is not sensitive to price. Companies still need to operate at the same rate to satisfy their operations and people still need to drive to get to work. It takes time for markets to adjust and people to change their way of living. The long run is a different topic by itself and is out of the scope of this post. You are not going to buy a 8 cylinder pick up after you hear oil fell this month are you?

We can then agree that oil consumption would not change in the short run. Now we can check the graph that I have made to illustrate a theoretical approach of what consumers are going through at this point of time.

Lets say that you pay $500 rent a month for 5 years. Suddenly rent became $300, means you have $200 more to spend on other things other than rent or you could decide to save it. So in simple terms lower oil prices has caused income to increase, which means people can consume or save more than they previously could.

Check below for technical details on how I reached this conclusion using Consumer behavior theory.

The graph you see is the consumer theory diagram.

First be noted of the following.
  • The Vertical Axis labeled “A.O.G”(All Other Goods)- In terms of Quantity. (The farther up means more)
  • The Horizontal Axis labeled “Oil”.- In terms of Quantity (Further right is more)
  • The red line depicts a budget. Where “I” is the starting point. The Horizontal intercept of the Budget at I & I*, to be known as (Income/Price of Oil). The Vertical Intercept is unchanged since their prices are presumed to be constant,Ceteris Paribus.
  • U-shaped curve depicts the indifference curve.
  • The green dotted line is Hicksion line, a line parallel to the new Budget line and tangent to the old Indifference curve.

A decrease  in the price of oil would shift the Horizontal-intercept on the Oil axis to the right, meaning that “Income has risen”, as indicated  I —> I*, where I*>I. Using the Hicksion method we find that initial change for the substitution effect, for as Income goes up we would have to consume more, for the normal good condition. Moving oil Consumption from X*—>X and shown on the original indifference curve Point (A) to point (C). Since we have established that oil is inelastic in the short run, so that would mean that consumption levels of Oil would go back to its initial starting level X* but on the new Indifference curve on the new budget line resulting in tangency of Point (B), which satisfies the inelastic condition, where consumption for oil does not change. However that results in A.O.G consumption  increase from Y —> Y1. Which satisfies that a drop in oil prices in the short run leads consumers to spend more on other goods, Ceteris Paribus.


In summary

A—->C = Substitution Effect

C—->B = Income Effect

A—->B= Total Effect

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