WHEN discussing oil prices, it is common to encounter two views that are confused: the first is that Opec, the cartel to which many of the world’s oil-producing countries belong, sets the price of oil, the second is that it can cause inflation by increasing the price of oil through restriction of the quantity it releases to the global market. While both views do certainly have kernels of truth, they can also be misleading.
Genuine monopolies are extremely rare in market economies, and therefore any producer is in competition with others. Indeed, even if a market had a single seller the price the seller can charge is also a function of demand. Therefore it is impossible for any supplier to set prices – only the market can.
What Opec members do control is their output, and this is a large part of global supply (although it has fallen from about 50 per cent in 1973 to 33 per cent today). As the chart (right) shows, Opec can influence price by restricting supply, but it is supply that it is controlling, not the price. This can seem like a pedantic point, since the result is the same. But it is the process that counts.
When the oil price does rise, many consider this to cause inflation. The idea is that oil constitutes an important part of the cost structure of the economy, and an upward pressure on costs leads to upward pressure on prices. But this is wrong. If the prices of goods that include oil increase then consumers will indeed end up paying higher prices. But this leaves less income available for goods that are not made using oil. There would be a change in relative prices, but not in general prices.
The only way that general prices can change is if something is affecting the demand for or supply of money. If rising oil prices occur alongside an expanding money supply then it is the latter that creates the inflation, not the former. Rising oil prices are not the cause of inflation, they are its manifestation.
It is true that oil prices may influence the demand for money, and this has the potential to be inflationary. But only in terms of its relation to the money supply. However you look at it Milton Friedman was correct – inflation is always and everywhere a monetary phenomenon.
Anthony J. Evans is associate professor of economics at London’s ESCP Europe Business School.