It is important to understand the relationship between prices and inflation. Real prices in the United States are derived by accounting for the effects of inflation, or changes in purchasing power of US dollars over time.
For example, in 1976 a gallon of unleaded gasoline could have been purchased for 61 cents (in 1976 dollars). In 2008 the price of unleaded gasoline climbed to well over 4 dollars per gallon.
How do we account for such a disparity in the price of fuel over time? Well, there are certainly a lot of factors that determine price levels. The most important factor is the supply and the demand of a product. In the case of petroleum products such as gasoline and diesel fuel, the Organization of Petroleum Exporting Countries – OPEC – attempts to artificially control the supply of oil to maximize the price per barrel of oil that OPEC members receive. Perhaps a more important consideration in evaluating prices of a specific product or commodity over long periods of time is to look at inflation adjusted prices. The effects of inflation can be quite dramatic over a multi-year period of time. Inflation essentially is the erosion in local purchasing power of a currency, in this case the US dollar.
When we look at inflation adjusted prices we find that the 61 cents that we paid at the pump for a gallon of unleaded gasoline in 1976 is equivalent to 1.53 2008 dollars. When we adjust for inflation, we call the results REAL dollars. It is useful to evaluate changes in price over time in real dollars to determine what is really going on with prices and purchasing power. Of course, even at $1.53 a gallon in real dollars, gasoline in 1976 was still a real bargain. The REAL price of a gallon of unleaded gasoline in 2007 was $2.38 per gallon. So what accounts for the difference? Real price increases have occurred as the price per barrel of oil has increased in recent years to record levels. This REAL price differential is a result of
A. The increased demand being experienced for gasoline, diesel, heating oil and other petroleum products as countries such as China and India consume enormous quantities of fuel products to support their high growth economies.
B. The finite supply of oil. Oil is a non-renewable resource. Once it is consumed it is gone forever.
C. The success of OPEC in restricting output (the global supply of oil) to maintain or increase price levels
D. The relative weakness of the US dollar abroad
