Posted in: Ideas in Finance

Fuel Prices: Some Basic Economics

As everybody knows by now, fuel prices have risen substantially since the beginning of March 2026. There is a possibility that the circumstances that have led to this situation may worsen before they get better. While there is lots to discuss, there are three interesting things that can be analysed with some basic economics. First, should governments put a cap on petrol and diesel prices? Second, should governments reduce or remove fuel excise taxes? Third, are rising oil prices inflationary? For each question, there is room for debate.

Assuming that supply is possible, though at higher prices, and does not completely dry up, the government could put a cap on fuel prices, making it illegal to sell above a particular price. Economics depicts this as installing a ceiling below what would be the equilibrium price determined by the market. It should be noticed that higher market prices act as a natural rationing mechanism. People cut back on marginal car trips, for instance. A ceiling or cap somewhat undermines this, making what was a marginal trip that was abandoned because it was marginal no longer marginal. The cap leads thereby to a shortage. The result is so-called “gas lines”. The most likely outcome is that we would have a capped/lower price at the expense of having to queue for our turn to use the petrol pump. To see the logic of this, assume there is cyclone that ruins a banana crop. Banana prices rise. People buy a few bananas rather than a whole bunch. If the government capped the price, people would continue to buy a whole bunch and there would be a shortage that would result in people queueing to get their bananas. Supermarkets could allow first-in-first-served. Those who line up longer and get in first (run fastest to the fruit section), can buy what they want at the capped price. Since this will quickly be viewed as unfair, rationing will be implemented (4 bananas each, say, until they run out). So, you would have to queue to get your 4 bananas or risk missing out.

Leaving aside the wisdom or fairness of a fuel excise tax, once it is installed there is always the option to remove or reduce it temporarily. In Australia, 52.6 cents per litre is the fuel excise tax on petrol and diesel. The government could reduce the cost of fuel to the consumer by reducing or removing this tax. In all likelihood, reducing the tax by half, say, would not make a big difference to the market, but decisionmakers should give some thought to the possibility that it would have the effect, temporarily perhaps, of making viable the use of fuel that had been unviable at the higher price. If such a course of action were to be pursued, it might be best implemented gradually. Of course, politics plays a significant role and can overwhelm economic reasoning in some cases.

Lastly, it is commonly believed, even among professional economists, that rising oil prices are inflationary. The source of this belief is the 1973 oil shock, which coincided with the notorious inflation experienced in that period. However, another school of thought argues that the monetary expansion post-1971 inflated all prices, including the US dollar price of oil. The embargo exacerbated the situation. The core of the inflation, according to some, was a monetary phenomenon. Because oil price increases can lead to reduced output (an economic contraction), they are often accompanied by monetary stimulus, making the effect of the oil price increase on the price level somewhat difficult to parse. During the 1973 oil price shock, the Japanese central bank met the shock with a monetary expansion and there was inflation. In 1979, they did not meet the oil price shock of that year with monetary expansion, and an inflation was not experienced. Indeed, they raised interest rates as oil prices rose. Again, the logic can be demonstrated in plain terms. Oil price increases do result in increased prices for some consumer items. However, inflation refers to an increase of the price level, not an increase in particular prices. When prices for some items, including petrol, rise, people reduce their demand for other items. The price of these other items, in response to lower demand, may fall. The overall price level may, therefore, not show an increase. But if the central bank injects money into the system to counter what they feel will be an oil shock induced slowdown, the overall price level will almost certainly rise. If one views the RBA’s March decision in these terms, it looks prudent. Time will tell.

Possibly, therefore, the best thing the government can do in the short run is attempt to secure as much fuel supply as possible, calling on as much influence as they can muster internationally. The government’s announcement that it will introduce changes to the Export Finance and Insurance Corporation Act to allow the Commonwealth to underwrite purchases of fuel on the international market appears to be along these lines. Longer term, of course, there are lessons to be learned.

Discussion Questions

What should the government do in response to rising fuel prices and what are the possible consequences?

Fuel Prices: Some Basic Economics

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