What Happens When Petrol RON97 price increases?

In the article “RON97 is now RM3 per litre, petrol dealers say”, dated 6th September 2012, The Star had reported that the price for premium petrol RON97 has gone up by 30 cents, which is from RM2.70 to RM3.00 per litre. According to Datuk Hasim Othman, the president of the Malaysian Petrol Dealer Association, the increment of petrol price is due to the increase of the world fuel price market. And what affects the market forces? Adam Smith’s “invisible hand” idea in the Wealth of Nations implied that the competitive markets that sends the resources to their highest value use affects the market forces. A market is any arrangement enables buyers and sellers to get information and to do business with each other and a market price is the price when equilibrium has reached.

Demand is something that we want, can afford it, and plan to buy it. The law of demand states that when other things remain the same (ceteris paribus), the higher the price of a good, the smaller the quantity of a good demanded; and when the price of good decreases, the quantity demanded will increase. In this situation, when the price for the premium petrol, which is the RON97 increases, the quantity demanded for it  will automatically decrease because of the law of demand.

The graph above illustrates the quantity demanded when the price of a good changes. For instance, the price of good is at P1, the quantity demanded is at Q1. When the price increase from P1 to P2, quantity demanded decreases from Q1 to Q2. This is because of the law of demand. This same goes to the increase of Petrol RON97 price. When the price increase from RM2.70 to RM3.00, the quantity demanded dropped just like the above graph illustrates, which is from Q1 to Q2 because of consumer behavior.

             

The decrease in quantity demanded due to the increase of price is because of the substitution effect. Substitution effect is when the price of a good rises, the demand for substitute goods will increase. The graph above shows that when the price of petrol RON97 increases the quantity demanded decreases because consumers seek alternatives to substitute petrol RON97 and therefore, the quantity demanded decreases from Q1 to Q2. This leads the consumers to decrease their usage in petrol RON97 and increase the demand for petrol RON95.

   

Besides that, income effect also affects the decrease in quantity demanded when the price of a good increases. When the price of goods increases relative to income, people cannot afford to purchase all the things that they bought previously and hence, the quantity demanded decreases. The income of the consumer still remains the same although the price of petrol RON97 increases. The purchasing power of the consumer becomes weaker and they could no longer afford to buy the same amount. Therefore, consumers substitute petrol RON97 with the cheaper RON95 and able to consume more of it.

Petrol RON95 is the substitute for RON97. When the price of petrol RON97 increases, the quantity demanded decreases. This leads to an increase in demand for RON95 because it is a close substitute to RON97. The graph below is an example of demand for petrol RON95 when the price for RON97 increases.

When the price of RON97 hikes, the quantity demanded for RON97 will decrease. This leads to consumers change to consuming RON95 and therefore, the demand for RON95 increases. This leads to the demand curve for RON95 shifts to the right from D0 to D1 and the demand rises from Q1 to Q2, although the price for RON95 remains unchanged at P1.

We know that according to the law of demand, when other things remain the same, the price of a good rises, the quantity demanded will fall and vice versa but does the price increase by a large amount and the quantity demanded falls by a little? It depends on the responsiveness of the quantity demanded to a change in price or the elasticity of demand. Price elasticity of demand is a units-free measure of the responsiveness of the quantity demanded of a good to a change in its price when all other influences remain constant.

For instance, the graph above depicts that when the price of petrol RON97 increases, which is fromP1 to P2, the quantity demanded drops at a large amount from Q1 to Q2. This is because petrol RON97 is elastic demand. Elastic demand is when the percentage of changes in price is lesser than the percentage of changes in the quantity demanded. Petrol RON97 is an elastic demand because it has a close substitute. The closer the substitute, the more elastic is the demand for it. When the price increases, consumers will find an alternative to substitute it and it can be easily substituted because RON95 is available and cheaper.

         However, petrol RON95 is an inelastic demand good because it has no close substitute besides RON97, which is far more expensive than RON95. The graph below shows the inelastic demand for petrol RON95.

From the graph above, although the price of petrol RON95 increases at a large amount, which is from P1 to P2, the quantity demanded drops only slightly from Q1 to Q2. This is because petrol RON95 is an inelastic demand good. Inelastic demand is when the percentage of changes in price is exceeds the percentage of changes in the quantity demanded. Although the price of petrol RON95 hikes at a large amount, the quantity demanded diminish slightly. The faster the time that has elapsed since a price change, the more inelastic the demand is. Consumers have no choice but to accept the new price and continue to consume petrol RON95 because of the inelasticity of demand.

            Therefore, the demand for a certain goods is determined by consumer behaviour as well as the elasticity of demand. It is rational that when the price of good increases, the quantity demanded will decrease when other things remain unchanged. 

             

By Hoh May Yen