Question

Explain why in the medium run an increase in the price of oil will cause an increase in the unemployment rate.

Answer 1

Oil price plays a very important role in an economy of every country. Oil is a vital cog in the wheels of the economy, it is the main source of energy, a crucial contributor in the production process of many industries, it generates growth in the economy as it enables the function of various economic activities. Oil price fluctuation causes many problems in an economy such as high inflation, unemployment, and decline in GDP. Industries are dependent on oil. An increase in the price of oil will have a major impact on production. Oil price increase contributes to the increase in the cost of production, which effects the number of employees as when the cost of inputs increases the employer will adopt cost cutting measures which entails reducing the wages, laying off workers. When the cost of production/ marginal cost increases due to increase in the price of oil, companies will layoff workers and reduce wages to reduce the cost as a counter measure for the increase in the cost of production due to increase in the price of oil. For firms to survive it is imperative for them to minimize their costs and since they cannot control the price of oil they minimize the cost of factors which they can control and the liquidity crunch caused by the increase in price of oil will adversely impact the ability of the firm to retain and attract workers.

When the cost of production increases apart from adopting cost cutting measures the producers also transfer the burden of increase of  cost to the consumers by increasing the price of the products. This increase in the price level can cause people's rate of consumption to decrease. Thus the aggregate demand contracts as the price of products increases due to increase in the cost of production whose burden the producer will transfer to the consumers. Employees are also dependent on aggregate demand as the producer produces based on the demand, for the product hence when the demand for the product reduces it will cause the production and supply to contract and when the producer produces less his demand for labor reduces. When the aggregate demand and aggregate supply fall the demand for labor falls contributing to rise in unemployment.

Low wages and Low job creation- The producer will lower the wage level to cut costs and due to liquidity crunch arising from the rise in oil prices  and the low wage levels will further augment the unemployment rate as the labor is not attracted by the low wages. No/ Minimum new jobs will be generated as firms will not make new investments to expand their production capacity due to contracted demand and increased cost of production thus no new opportunities for employment.