1. What has happened to the price of crude oil in 2015? What has happened to the demand for crude oil in 2015? Is there an economic theory that supports this relationship?
2. In the last 6 months of 2015 oil prices fell by 30% and oil demand has risen by 2%. Based on this data what type of price elasticity does oil demand have?
3. Do you agree with the opinion expressed in Source 1 on the price elasticity of demand? Why or why not?
4. Would you advise an oil producer to increase oil prices or decrease oil prices based on your analysis in previous questions? Explain and justify your answer with a diagram. (Hint: Think of Topic 4 tests)
5. Based on Source 2 how would the price elasticity of supply have changed since the introduction of shale oil production in 2008? Support your answer with economic theory.
Answers:
The crude oil at the beginning of 2015 was too low, but as can be deducted from the provided by DeHaemer (2015), the price continued falling until March where it rose a little. However it reached a peak on May and started falling again; the Peak was also at low price level. On the demand side, DeHaemer noted that low oil price had resulted in an increased consumption of oil. The economic theory exhibited by this fall in price and rise in demand is an inverse relationship which gives a negatively sloped demand curve. It also tell us that crude oil is a normal good.
With an assumption that initially the oil price was very high at price P, the quantity demanded corresponding to that price was Q. A decline in price from P to P1 stimulates demand since consumers are able to demand extra units if their income is held constant. The new demand level rises to Q1.
Price elasticity of demand is derived by dividing the % change in the quantity demanded by the % change in the product’s price
PED =
Decline in oil price = -30%
Increase in demand = 2%
PED = =
= -0.07
The negative sign results from the negative relationship. The PED for oil is price inelastic since the rise in demand resulting from a big decrease in its price is too small (Tabarrok, 2011).
I do not agree with the source one’s opinion since it is defining an elastic demand. It is on an elastic demand that consumers demand more when price falls and lesser when price is increased. However, in the case of the demand for crude oil, it has been deducted from sub-question 2 that it’s inelastic. This means that it would take a very big change in the crude oil price for a very small change in its demand to be realized. When crude oil price falls, people may increase their demand by a small percentage, but when price goes up, people may not necessarily cut their demand; it would take a very big increase in price for such a cut to be realized.
The advice to be given to the producers is to raise price but not to lower price. The advice would be the basis of the inelasticity of crude oil demand to price will be determined by the level of competition facing the producer. This is because if I advise the producer to increase his price when competition is high, the producer will end up losing his market share since consumers will prefer buying to the competitors selling at lower prices. However, if competition is low, I would advise this producer to raise his price since revenues collected would increase even if demand falls since the fall in demand would be insignificant. Similarly, even at a high competition situation, I would not advice a producer to lower his price since revenue would be lost owing to the fact that demand increase would be insignificant.
If we assume that at the initial price of $5 the quantity demanded was 30 units, the revenue raised PQ = 5*30 = $150. After the price increase from $5 to $10, the quantity demanded falls from 30 to 27 units. The new revenue raised PQ = 10*27 = $270. Due to the price inelasticity, the producer is able to raise more revenue by raising prices.
The introduction of U.S. shale oil has resulted in greater decline in oil prices. However, this decline has not resulted in a cut of supply by the producers meaning that their responsiveness to price fall is low. This means that they have a low price elasticity of supply (PES); the introduction has resulted in the PES for crude oil. The economic theory behind this rigidness in supply is because the oil market possesses an oligopoly market structure. Konrad (2012) noted that there is a limit for the adjustment of oil supply to its price. In such a market, competition is mainly on output but not on prices. Therefore, even at low prices, the players are forced to produce more to cover their variable costs even if losses are being made (Taylor, 2015).
The supermarket industry in Australia possess an oligopoly market structure. This is evident from the two sources provided. From source one, there are two major competitors in this industry who dominate the market. From source two, the market share of few firms is more than 80% of the whole market i.e. Woolworths, Coles and IGA. The economic theory is that in an oligopoly market, dominance in the market gives the giant players monopoly powers of prices and outputs. They therefore dictate the price that products sell in the market.
Yes. The war on price discount between Coles and Woolworths is of their best interest. The war is meant to increase their market share. They are trying to kick others out of the market and gaining their market share. This is irrespective of the profits they make with such wars.
The best pricing strategy for oligopoly firms is at point z since the MR is greater than MC. Otherwise the firms would be forced to sell at a lower price where MR = MC. At point z the demand curve has a kink (the demand curve for an oligopoly seller is d’D’) because, other sellers do not follow a price rise by a single firm and thus at high prices demand is elastic; this is because some of the market share initially held by the price increasing firms is added to the non-price increasing firms (Arnold, 2010). The increasing firm follows zd’ segment. If a firm cuts its price, other sellers follow since the price reducing firm will steal some of their market share (Jbdon.com, 2017). The firms follow zD’ segment. The MR curve is also kinked to creating a gap UV where a change in MC does not affect quantity (Gottheil, 2013).
The market structure for the Australian vegetable market provided by farmers is a perfect competitive market. This is confirmed from analysis and observation of the two sources. From source one, the analysis shows that the farmers are price takers and hence have no control over the prices they sell their products to the supermarkets. From the second source, it can be observed that there are so many farmers who sell their products directly to the supermarkets. 13 % of 136,800 farms giving 17,784 farms that directly sell vegetable clearly show that this is a great competition for a market. The economic theory noted that some of the characteristics of competitive competition is that the sellers are small and many, selling homogeneous products and are price takers (Besanko, Braeutigam & Gibbs, 2011).
Due to the low prices the supermarkets offer to the farmers, losses will result on the farmers side since the revenue they make might be lower than costs of production incurred.
The vegetable farmers are selling quantity level Q at price P and incurring a cost ATC. The profit maximizing level is at MR = MC. Since the farmers are selling at a price lower than their ATC, they are making losses is the short run. Since entry and exit is free in this market, many farmers will exit to avoid the losses (they may shift occupations) and thus losses will be eliminated in the long run since the competition on market share will fall. The remaining firms will make only normal profits.
The MC is the long run will cut the ATC curve at its minimum level. Firms will make normal profits.
The improvement in technology would mean an innovation that may lead to a farm introducing more efficient production means that would lower the costs of production (De Loecker & Collard-Wexler, 2016). A reduction in production costs would lower the impact of the low prices offered by the supermarkets. This will enable firms that introduce the new technology to absorb some of the shock and thus will be able to sustain their operations to the long run. The other argument on how production would be impacted by new technology was posed by Boundless.com (2017); the argument was that new technology would result in improved quantity production which may somehow offset the loss margin. A conclusion can therefore be drawn that, new technology is the only solution for any firm that wishes to continue operating in the long run.
References
Arnold, R. A. (2010). Economics. Australia: South-Western Cengage Learning.
Besanko, D., Braeutigam, R. R., & Gibbs, M. (2011). Microeconomics. Hoboken, NJ: John Wiley.
Boundless.com. (2017). Impacts of Technological Change on Productivity. Boundless. Retrieved 12 May 2017, from https://www.boundless.com/economics/textbooks/boundless-economics-textbook/economic-growth-20/productivity-98/impacts-of-technological-change-on-productivity-370-12467/
DeHaemer, C. (2015). Best Potential Returns from Oil. Energyandcapital.com. Retrieved 12 May 2017, from https://www.energyandcapital.com/articles/best-potential-returns-from-oil/5131.
De Loecker, J. & Collard-Wexler, A. (2016). The productivity impact of new technology: evidence from the US steel industry. Microeconomic Insights. Retrieved 12 May 2017, from https://microeconomicinsights.org/productivity-impact-new-technology-evidence-us-steel-industry/
Gottheil, F. M. (2013). Microeconomics. Mason, Ohio: South-Western.
Jbdon.com. (2017). Pricing under monopolistic and oligopolistic competition. JBDON.com. Retrieved 12 May 2017, from https://www.jbdon.com/pricing-under-monopolistic-and-oligopolistic-competition.html.
Konrad, T. (2012). The End of Elastic Oil. [Online] Forbes.com. Retrieved 12 May 2017, from https://www.forbes.com/sites/tomkonrad/2012/01/26/the-end-of-elastic-oil/#20e13a1d36d6.
Tabarrok, A. (2011). The Price Elasticity of the Demand for Oil. Marginal REVOLUTION. Retrieved 13 May 2017, from https://marginalrevolution.com/marginalrevolution/2011/04/the-price-elasticity-of-demand-for-oil.html
Taylor, S. (2015). The oil price and short and long run supply. Simon Taylor's Blog. Retrieved 12 May 2017, from https://www.simontaylorsblog.com/2015/01/18/the-oil-price-and-short-and-long-run-supply/ [Accessed 11 May 2017].
