The concept of expectations was initially introduced by John Muth in 1951 and it is used to describe many economic situations in which the outcome is influenced by what people expect to happen. John Keynes referred to this as the “waves of pessimism and optimism” that helped determine the level of economic activity. Through their expectations, people try to forecast what will actually happen; have strong reasons to use accurate forecasting measures as someone who forecasts correctly is able to reap profits due to such a deduction. According to the concept of rational expectations, outcome does not change systematically form people had foreseen them to be. (Stefan 2004).
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Along with the outcome, the prices are also affected by expectations. For example, when a study was carried and manipulation was done of expectations of rising prices, the perception was that of rising prices even though actual prices remained stable. On the other hand, when the real prices actually increased while stable prices had been configured; the real price trend was underestimated.
In this particular paper, the case under study is that of the “oil market”; how expectations play a role in the decision of the oil prices. Since oil is a resource, it can be stored. If the owner of oil expects the oil price to rise faster than the interest rate that he can earn on the money obtained from selling the oil then oil would kept in storage. While the “real” price of oil may rise faster and slower than has been expected, but whether it actually gets sold depends on the expected price rise.(Feldstein 2008).
However, other factor come into play including that of risk, the long-term effect of consumer behavior which further make difficult the behavior of the owner –and eventually, the behavior pattern of prices also gets affected. According to the basic concept of the theory of expectations, the oil owners will be expected to adjust their production and inventories until the price of oil is “expected” to increase at a rate which is that of the rate of the interest, adjusted for risk. As described above, when the owners expect oil prices to rise, then they would not sell the oil but keep it in storage. On the other hand, if the prices of oil are not expected to increase at a rate greater then the interest rate, then oil would be extracted and sold. (Fair 1989).
From what can be deduced from the above scenario, the relationship between the future and current oil prices show that whenever an expected change in the future price of oil would in fact have an immediate impact on the current price of oil. Looking at the example of China, where production has increased substantially in the last decade, when the demand of oil would increase in order to meet this higher production level; the inference can be drawn that that the future oil price would be higher due to the higher demand level. The response to this situation was that supply was reduced which resulted in increasing the “spot” price enough to bring the expected price level back to the initial rate.
Therefore, as a result of no change in the “present” level of oil the current price rose due to the “expectation” of a greater future demand and a higher future price. There also been speculation about the oil reserves drying up in Russia and Mexico which could result in a higher future oil price-and in order to meet that the current oil price could rise to maintain the initial expected rate of increase in oil price. It can hence, be understood that that rumors, rumors or speculation as it is called, can have a significant impact on the price levels. (Feldstein 2008).
As per the economic theory of demand and supply; an increase in the spot price of oil as a result of the expectations concerning the future prices can result in the decline in the current level of oil produced. In 2007, the OPEC decreased the supply of oil due to a rise in the expected future demand of oil. However, there still lies a possibility of a lower current oil price by implementing certain policies that have an impact only in the future e.g. Government subsidies that develop such technology that make oil using products more efficient or introduce oil-substitute products on a wider scale. Thus, any such steps that are taken at present to increase the supply or reduce demand of oil will have an impact of lower prices and increased consumption at present.
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Feldstein, Martin. We can lower the Oil Prices Now. 2008.