The price of petrol and airfares are set to rise

The basic model of supply and demand is one of the most commonly used models in economics. That's because it does such a good job of explaining many of the things we see in the real world. Every day, you could pick up the newspaper and see an example that can be explained with this simple model. Take this example from the New Zealand Herald yesterday:

Motorists could see high petrol prices within days following Saturday's drone attacks on Saudi Arabia's oil facilities by Iranian-backed Yemini [sic] rebels.

"It's not a good sign," said Automobile Association spokesman Mark Stockdale.

"It remains to be seen what impact it will have, how markets respond. But certainly a reduction in the supply in oil could have a negative impact on commodity prices which could result in higher prices at the pump."

The drone attacks by Yemeni rebels will reduce the supply of oil. In this diagram below, this is represented by the shift from S0 to S1. The equilibrium price of oil will rise, from P0 to P1.

That's not quite the end of the story, though. The higher price of oil leads to higher costs of production for petrol and jet fuel (because crude oil is an input into the production of those refined fuels). Higher costs of production reduce the supply of those products too (because the supply curve shows the costs of production, higher costs shift the supply curve upwards, as in the diagram above). That leads to higher prices for petrol and jet fuel.

You can take it a step further even. Higher jet fuel prices increase the costs for airlines. They pass those higher costs onto passengers in the form of higher prices as well. [*]

If you ever wondered why oil prices are important to all economies, not just the economies of the oil-producing nations. This is a good example of why - those prices flow through to the prices of lots of other goods (and services) throughout the economy.

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[*] We could refer to the diagram above again. However, because airlines don't operate in perfectly competitive markets, it isn't quite correct to show their response in a supply-and-demand diagram. Having said that, the impact of an increase in input costs is qualitatively the same regardless of whether you use a model of perfect competition or a model of a firm with market power - prices increase and the quantity decreases. I make this point in my ECONS101 class - the standard supply and demand model is quite robust, if all you are interested in knowing is the expected direction (but not necessarily the magnitude) of changes in price and quantity.