Reply To: Oil prices


Technological innovation requires capital investment which entrepreneurs determine by economic calculation. Entrepreneurs consider all the different lines of investment in all the stages of production and invest in that set of lines which they anticipate will prove to be the most profitable. But the profitability of each line of investment can be traced to its contribution to satisfying consumer demands.

So, the scenario would be: (1) Because of rising consumer demand for gasoline (and government restrictions on production and supply) the price of gasoline rises. The high price of gasoline makes investment in new technologies for producing oil more profitable. Entrepreneurs investing in fracking technology and then the drilling equipment and land rights, etc. They expand oil production capacity to the point at which they anticipate that the lower than otherwise price of oil and the higher than otherwise prices of drilling equipment and land rights, etc. will make further investment in oil production capacity unprofitable. The reason oil prices fall with increased supply is that entrepreneurs know that gasoline prices will fall with increased production and supply of gasoline from the increase production and supply of oil.

The costs of oil production by fracking are higher not lower than with other methods already in use.

What justifies investment in higher cost techniques of oil production is the higher price of gasoline. The innovations in fracking techniques made extraction of shale oil cheaper than with the techniques previously used, but even with the new techniques fracking costs are higher than methods already in use. That’s why they haven’t been adopted until now when the higher price of oil justifies their use.

Even if for some reason the price of an input fell in the market, lowering costs of production of output, the new, lower price of the input depends on entrepreneurial demand which depends, in turn, on consumer demand for the output. For example, let’s say that demand for cigars vanishes causing tobacco prices to fall. The new, lower price of tobacco is still determined by entrepreneurial demand for tobacco, which is determined by, the now lower, consumer demand for cigars, cigarettes, and other consumer goods using tobacco as an input.