EMF OP 51: Energy Disruptions, Interfirm Price Effects, and the Aggregate Economy

In an economy with many imperfectcompetitors (monopolistic competition), firms that pass through higheroil prices during a disruption will affect the demand for firms inother industries. Firms that charge higher prices for their finalproduct will include the effect on their own final product in theirprivate decisions but will exclude the effect on the final products ofother firms. Although a pecuniary externality, these actions willreduce society’s welfare, unlike the case of a perfectly competitivemarket. This situation creates a societal risk that is much wider thanan externality in any single market. Policy interest shifts from one ofpunishing Persian Gulf oil producers to one of cushioning anindustrialized economy from sudden disruptions caused by political andmilitary conflicts. Although the value of reducing oil use depends upona number of unknown parameters with wide distributions, arepresentative numerical example suggests that it may approach $5 perbarrel.