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The Oil Import Premium

The Oil Import Premium. -imported oil costs US society more than the market price. Two Main Components. Demand Component: effect of changes in import demand on the world price of oil Direct Cost: The last barrel demanded will increase the price of all the previously demanded barrels.

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The Oil Import Premium

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  1. The Oil Import Premium -imported oil costs US society more than the market price.

  2. Two Main Components • Demand Component: effect of changes in import demand on the world price of oil • Direct Cost: The last barrel demanded will increase the price of all the previously demanded barrels. • Indirect Cost: effect of rising oil prices on exchange rates, capital formation, income distribution and factor productivity • Disruption Component: the economic cost of an interruption of imports • Direct Costs: Increase in wealth transfer abroad, reduction of domestic production of goods and services, reduction in total output. • Indirect Cost: Loss of aggregate income because non-oil markets cannot adjust efficiently to the oil price shock.

  3. Macroeconomic Costs of Disruption • Supply side • Caused by rigid wages and prices • Redistribution of Income • Changes the composition of demand

  4. Rigid Wages Cause Inefficiencies in the Labor Market • Disruption in the oil supply will cause oil prices to rise- but wages may not decline in response. • Causes: Long-term contracts, hiring/firing costs, social pressures.

  5. Why Should Wages decline? • Wage of workers is the marginal productivity (MP) of labor. • Decreased oil imports lowers the MP of labor. • Because production function is Y(K,L), labor is a joint input with oil. • With less oil, the marginal productivity of an extra unit of labor declines, lowering the demand for labor. • If nominal wages do not change in response to this decrease in demand, firms will trim labor costs by reducing the level of employment. • Workers become involuntarily unemployed- people would be willing to work for lower wages. • Price of labor does not reflect the cost of unemployment • Reduction in employment implies a reduction in output in addition to that directly caused by an increase in the price of oil

  6. Redistribution of Income • On the demand side: an oil price shock will change the level and composition of aggregate demand. • Lag between receipts and expenditures will temporarily reduce aggregate demand. • This will also aggravate the adjustment problems on the supply side. • Income will shift from domestic oil consumers to foreign producers (and domestic producers). • Because of oil taxes, income will also shift to the government. • One solution would be to alter the timing of federal expenditures and receipts, i.e., tax receipts could be temporarily deferred.

  7. Potential Solutions • 1st Best: correct market inefficiencies • 2nd Best: turn to the stimulus for the problem- oil prices. • Disruptional effect of income transfer to foreigners is directly related to the quantity of oil imports.

  8. Questions/ Criticisms • Tariff may not reduce the percentage of oil imported from high-risk countries. • Bathtub model suggests that it does not matter where you import oil from- how to reconcile this?

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