Supply and Demand Uncertainty

Jim Hamilton at econbrowser explains large recent fluctuations in oil prices.

Amid all the crazy explanations for the wild ride in oil and other commodity prices, I think Hamilton nails this one:

World real GDP increased by 9.4% between 2003 and 2005. That growth in world income was the primary cause behind an increase in world petroleum consumption of 5 million barrels per day between 2003 and 2005, a 6% increase over the two years. The next two years (2006 and 2007) saw even faster economic growth (10.1% cumulative two-year growth), with Chinese oil consumption alone increasing 870,000 barrels per day. Yet between 2005 and 2007, global oil production stagnated.

What persuaded residents outside of China to reduce petroleum consumption in the face of booming levels of income? The answer is that the price of oil had to increase. How much the price should have risen depends on the price elasticity of demand. Consider the following illustrative calculations. It seems reasonable to maintain that the economic growth in 2006 and 2007 would have resulted in at least as big a shift of the demand curve as resulted from the slightly weaker GDP growth of 2004 and 2005. Adding in the first half of 2008 (when global GDP continued to rise), consider then the consequences of a rightward shift of the demand curve of 5.5 million barrels per day. With production only increasing by 0.5 mb/d over this period, a demand elasticity of ε = 0.06 would imply that the price should have risen from $55/barrel in 2005 to $142/barrel in 2008:H1.
But why then did the price subsequently collapse even more dramatically? A shift of the demand curve back to the left as a result of the impressive global economic downturn is certainly part of the answer. Note, however, that even if global real GDP were to fall by more than 10%-- which so far fortunately it has not-- that would only put us back to where we were in 2005 (at $55 a barrel), and the price was observed to fall even more than this....
If we say that one elasticity (0.06) is to be used to account for the 2008:H1 price and another higher elasticity for 2008:H2, there is an implicit claim that market participants were learning imperfectly about the price elasticity of demand (my emphasis).
[I]n order to reconcile a proposed speculative bubble story with the observed behavior of the physical quantities demanded, supplied, and going into inventories, it is necessary to postulate a very low price elasticity of demand through 2008:H1-- precisely the same conditions one would need in order to attribute the price moves entirely to fundamentals.
One sees a lot in the economics literature about uncertain supply and demand. But one doesn't see so much about uncertain elasticities of supply and demand. But surely this is true--the market doesn't know any better than any econometrician about the true elasticities. And surely these elasticities change over time in hard-to-predict ways when prices increase 4-fold in just a few years. So, price volatility can feed on itself for important, fundamental reasons.

I think this is a clear and relatively simple way to reconcile some of the ways prices don't fluctuate quite like economists expect them to.


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