The Oil Import Premium -imported oil costs US society more than the market price.

Two Main Components Demand Component: effect of changes in import demand on the world price of oil –Direct Cost: The last barrel demanded will increase the price of all the previously demanded barrels. –Indirect Cost: effect of rising oil prices on exchange rates, capital formation, income distribution and factor productivity Disruption Component: the economic cost of an interruption of imports –Direct Costs: Increase in wealth transfer abroad, reduction of domestic production of goods and services, reduction in total output. –Indirect Cost: Loss of aggregate income because non-oil markets cannot adjust efficiently to the oil price shock.

Macroeconomic Costs of Disruption Supply side –Caused by rigid wages and prices Redistribution of Income –Changes the composition of demand

Rigid Wages Cause Inefficiencies in the Labor Market Disruption in the oil supply will cause oil prices to rise- but wages may not decline in response. –Causes: Long-term contracts, hiring/firing costs, social pressures.

Why Should Wages decline? Wage of workers is the marginal productivity (MP) of labor. Decreased oil imports lowers the MP of labor. –Because production function is Y(K,L), labor is a joint input with oil. –With less oil, the marginal productivity of an extra unit of labor declines, lowering the demand for labor. If nominal wages do not change in response to this decrease in demand, firms will trim labor costs by reducing the level of employment. Workers become involuntarily unemployed- people would be willing to work for lower wages. –Price of labor does not reflect the cost of unemployment –Reduction in employment implies a reduction in output in addition to that directly caused by an increase in the price of oil

Redistribution of Income On the demand side: an oil price shock will change the level and composition of aggregate demand. –Lag between receipts and expenditures will temporarily reduce aggregate demand. –This will also aggravate the adjustment problems on the supply side. Income will shift from domestic oil consumers to foreign producers (and domestic producers). Because of oil taxes, income will also shift to the government. –One solution would be to alter the timing of federal expenditures and receipts, i.e., tax receipts could be temporarily deferred.

Potential Solutions 1st Best: correct market inefficiencies 2nd Best: turn to the stimulus for the problem- oil prices. –Disruptional effect of income transfer to foreigners is directly related to the quantity of oil imports.

Questions/ Criticisms Tariff may not reduce the percentage of oil imported from high-risk countries. Bathtub model suggests that it does not matter where you import oil from- how to reconcile this?