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You are here: Home > Current Topics > Mind your Business > 6 October 2003 |
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Petrol prices are likely to be on the rise again. This time the reason is the government putting up the duty on petrol; their reasoning is that this was something that had been announced in the Budget back in April but postponed because of the uncertainty over the war in Iraq. The increase in duty of 1.28p per litre means that petrol prices at the pumps are likely to rise by around 7p per gallon. Since the budget, the decision by the Chancellor to postpone the rise in duty has cost the Treasury around £300 million in lost tax revenue. The move comes on the heels of a decision by the Organisation of Petroleum Exporting Countries (OPEC) to cut production of oil by 900,000 barrels per day to offset a predicted fall in the price of oil. OPEC delegates from the eleven member states estimated that they would have a surplus of 2.5 million barrels per day. The aim of OPEC is to maintain a degree of price stability in the market - the price being around $25 per barrel - price stability is important, they say, for both producers and consumers. Petrol retailers are not happy about the rise in duty. The blockade of distribution depots by members of the Fair Play on Fuel campaign two years ago highlighted the high cost of duty on petrol in the UK. The Treasury claim that the proportion of tax on petrol has fallen by 5% from 78% since labour first came into power in 1997. Oil companies point to the efficiency that exists in the industry. Figures quoted by Murco (http://www.murco.co.uk) Suggest that the average price of a litre of petrol minus the duty in 1980 was 15.1 pence per litre, this compares to a figure of 17.1 pence per litre in 2003. Had petrol prices risen in line with inflation it would cost around 40 pence per litre. When you then add on the VAT (around 13p) and the duty (about 50p) it means that a litre of petrol could be costing UK drivers over a £1! Petrol is a product that comes from oil, as such the two goods are in joint supply, increases in the supply of one implies an increase in the supply of the other. Oil has many other constituent parts however, and exactly what is produced depends on the country where the refining is taking place. The diagram below shows the products obtained from a barrel of oil in the US. The total is more that the 42 gallons in the original barrel because of additional chemicals that are added in the processing of the oil. 
Source: American Petroleum Institute (http://api-ec.api.org).(Reproduced by kind permission of California Energy Commission, Sacramento, California, USA. from http://www.energy.ca.gov/) Changes in oil prices have a significant effect on world economies, the reason why oil is such an important commodity is that it is used in so many applications: as a source of energy in cars, lorries, ships, aircraft, to lubricate machinery and act as a cooling agent in machine tools production, it is a constituent parts of waxes used in all sorts of areas including the coating of plastic and paper coffee cups and drinks cartons, corrugated card board and so on as well as waxes used in polishes and protective sealants. If you are sitting on a plastic chair then oil will have been used in the production of it, the quilting of your coat and the filling in your sleeping bag, drinks bottles, carrier bags, cable insulation, buckets, bowls, accelerator pedals in cars, Perspex glazing (useful information for David Blaine??) glues, cling film.........the list goes on. Any changes in the price of oil overall therefore will not only affect drivers but also almost every aspect of industry. Announcements by the likes of OPEC and the Treasury therefore do have far reaching effects on the economy as a whole not just in the UK but overseas as well. |
There are two key areas of theory related to this case. Elasticity and market power.Price elasticity of demand is the responsiveness of demand to changes in price. We know that demand is negatively related to price - when price rises demand falls and vice versa. Elasticity gives us some measure about the strength of the relationship between price and demand. To measure elasticity we use a formula;
| Price Elasticity of Demand (Ped) = | % Change in Quantity Demanded % Change in Price |
The figure we get has no units - it is not centimetres, litres or anything else, just a number but what that number is tells us a great deal. Part of the problem here is in getting used to the terminology used. There are certain things to remember:
Businesses regularly have to think about the price that they charge for a product or service. The decision they make can have far reaching effects. Let us take a scenario to highlight the issue. A fast food outlet business charges £2.00 for its burger. Sales are at 5,000 per week. If it wants to increase its profits what should it do? If it drops its price then it would need to consider how much the price fall should be - 5%, 10%, 20% or more? Or, should it raise the price? Again, if so, how much by? It will know that if it drops its price demand would be likely to rise, but again how much by? If the price is dropped by 10% but demand only rises by 4% then it will actually see its revenue fall. But if the fall in price of 10% leads to a rise in demand of 15% then its revenue would rise. Equally, if it raised the price by 15% but demand only fell by 11% then its revenue would rise. Prices may need to change because of cost pressures. Assume that the price of beef rises, should the business pass on the rise in costs to the consumer as a higher price? If it does what will happen to demand and therefore revenue. It might actually be more appropriate to leave price as it is and absorb the rise in costs through lower margins. If the increase in cost is 5% and the business decides to increase prices by 5% but as a result demand falls by 12% then the strategy will lead to revenues falling. The decisions therefore can be more informed if the business knows the price elasticity of demand for its product.
The 'rule' is as follows:
The combined effects of the rise in duty and OPECs quota cuts could put rural petrol stations under increased threat.
The Chancellor of the Exchequer and OPEC have a pretty good understanding of price elasticity. They know that one of the determinants of elasticity is the number and closeness of substitutes - and that oil and petrol have very few substitutes in the short term. The Chancellor knows that taxing petrol will yield tax revenues because the price elasticity of demand for petrol is relatively low. The rise in duty will be passed on to the consumer but the number of people finding an alternative to petrol is likely to be very low so demand hardly changes at all. Some people may of course be persuaded to now use public transport (if it is available) or decide to walk or cycle to their destination but in most cases the number changing their behaviour in this way is going to be very small.
This process is explained using a PowerPoint presentation - [74K].
Goods, which have duty on them such as petrol, tobacco and alcohol, are likely to have an inelastic demand; it would make little sense for a government to place a tax on a good, which increases its price and leads to a reduction in tax revenue!
The second issue relates to market power. A business will have market power if it is in a position to influence the price of a product. It can do this through affecting the supply of the product on the market or it could simply set price and then look to set its output levels to meet demand.
OPEC was set up to represent the interests of countries for whom oil is a key product and the export of which represents a major proportion of their national income. The eleven countries are:
Iraq has not taken a full part in the OPEC discussions in recent months for obvious reasons but is a member. OPEC account for around 40% of total global oil production. What is as important is that different oil has different qualities and is therefore useful for different purposes, the oil produced by the OPEC countries are an important part of total world oil supplies therefore. OPEC acts as a cartel. A cartel is a group of businesses, individuals or companies who agree to influence the price in a market through controlling supply. OPECs reasons for acting as a cartel is to protect members interests - they aim to 'stabilise' oil prices so that both producers and consumers are in a better position to plan ahead and in the case of producers to know what their revenues are going to be. Each country has a quota, which they are obliged to adhere to - this highlights the problems that cartels can face - there is always an incentive for one or more of the group to break the agreement to secure some personal gain. Despite this, OPEC has been relatively successful in maintaining member relations during its existence. It was established as a permanent institution in 1960 but there had been discussion between oil producing states since 1949. OPEC is able to exert influence on the market partly because it accounts for such a large proportion of oil production but also because it knows that the price elasticity of demand for oil is low. If it chooses to cut supply therefore, it knows that the price will be likely to rise but as the price rises, the demand for oil will fall by a very small amount; this helps to maintain or to boost their revenue. Attempts to maintain price stability can be difficult because there is no telling what the level of demand is going to be for oil. This winter, for example, could be a hard one throughout Northern Europe and North America, if so the demand for oil for heating and so on is likely to be far higher than expected. See the associated PowerPoint presentation [54K] to see a diagrammatic explanation of how OPEC might operate to maintain the price of oil at $25 per barrel following a fall in the demand for oil.
Question 1.
This one will require a bit of thinking about! You have got a number of bits of information which you have got to make sense of here so logical thinking is the order of the day as well as a good understanding of elasticity. Your task is to raise £100 million. Basically this means that you will have to work out the rise in the duty for the product concerned and multiply by the amount of sales. The figure needs to come out at £100 million or above. The complicating factor is that you will have to consider the impact of the increase in the duty on the demand. You are given information about the elasticity of demand for the two possible candidates for the duty increase. The success of your answer will depend on how well you can manipulate this information and interpret what it is telling you. The key to really understanding elasticity is to put it in these contexts and to be confident in using the formula and in interpreting the results in relation to the effect on revenues. The two potential areas both have different elasticities but the issue is complicated further by the fact that the elasticities may be changing - don't forget that the time period is one factor that does affect the degree of elasticity! For alcohol, you are given the total tax revenue generated and the current duty so you will have to do a bit of manipulation to get the sales figures that you can then use to help with your eventual calculations. Marks will be awarded for the following:
Knowledge of elasticity - 4 marks
Application to the question - 8 marks
Analysis- 9 marks
Evaluation - your final recommendation - 4 marks.
Question 2.
You can use the web here to get an on-line brochure or do some action research and get a brochure from your local travel agent - or even go in a make an enquiry! You will find that prices per week do differ depending on the time of year you might choose to go. The same holiday will be far more expensive at certain times of the year. You have to explain why this is and it is no big surprise that elasticity has a good deal to answer for in this respect. Again, use your knowledge of elasticity to the full here - use examples where appropriate and don't be afraid to suggest some possible values for the elasticity of demand for skiing holidays at different times of the year - we are looking to develop your understanding and use of the concept.
Research of the issue - 2 marks
Application of elasticity to the issue - 4 marks
Analysis - 4 marks.
Question 3.
Another situation that you should be familiar with if you have used a train! Peak hour prices much higher than off-peak, lots of special offers to encourage train use during the middle of the day - question is why? Use diagrams to show the elasticities at different times of the day and use the actual examples you research to give some hypothetical numerical examples to highlight and demonstrate your understanding.
Research - 4 marks
Application - the use of diagrams and the numerical answers - 6 marks
Analysis - the quality of your argument and how coherently you present it - 5 marks.
