Elasticity, Market Forms, And Production Costs

Read Source 1 and 2 and answer the following questions:

http://www.energyandcapital.com/articles/best-potential-returns-from-oil/5131

The new oil revolutions

Beginning less than a decade ago, the shale oil revolution has turned the long run declining oil production trends in the United States into rises of 73% between 2008 and 2014. [Shale oil extraction is a method of unconventional oil production which converts rock into shale oil which is then used or purified by adding hydrogen and removing impurities]. An exceedingly high rate of productivity improvements in this relatively new industry promises to strengthen the competitiveness of shale output even further.

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? Support your answer with a diagram.

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?

4. Do you agree with the opinion expressed in Source 1 on the price elasticity of demand? Why or why not?
5. 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.

Read Source 1 and 2 and answer the following questions:

Source 1- Supermarkets Price War

Fruit, veg prices slashed in supermarket price war

Fruit and vegetables have just become the latest battleground in the discount war between supermarket giants Coles and Woolworths. Coles' bid to get a bigger share of Australia's grocery market kicked off today with a flurry of ads spruiking discounts on fresh produce.

Source 2- Supporting Diagrams

1. What type of market structure is the supermarket industry? Explain why with reference to Sources 1 and 2 and economic theory.

2. Is it in the interests of Woolworths and Coles to have a price discount war? Why? What would be a better strategy for Coles and Woolworths to take in regards to pricing? (Refer to the kinked demand curve and game theory in your answer.

3. What type of market structure is the market for vegetables provided by farmers? Explain why with reference to Sources 1 and 2 and economic theory.

4. How would falling prices for their products due to the price war affect the individual vegetable producer? Demonstrate your answer with reference to a diagram showing only an individual farmer’s cost curves.Would small farmers be forced to leave the market in the long-run? Why?

Part 1: Elasticity

1. The law of demand ‘expresses a relationship between the quantity demanded and its price’.( Economicsdiscussion.net, The Law of Demand) . For any good the law states state that as price rises the quantity demanded will fall, ceteris paribus assuming other things remain unchanged. The latter include the following  determinants of demand. We give examples for oil in brackets):

• Income of the buyer of oil
• price of substitute goods, ( solar energy can be one possible example)
• price of complementary goods( cars that run on petrol is an example here)
• changes in preferences, tastes, fashion ( it is becomes fashionable to use solar cars, then demand for oil will be lesser)

The first chart is for price, shown for different months –May 2014 to Sep 2015. It shows that prices have fallen significantly especially after June 2015, as shown by the straight down sloping line. The second chart is for demand levels on yearly basis since 1987. A close look shows us that demand has been rising after 2014. Ideally we must have monthly data for the periods in chart 1. However in broad terms we can see that the demand graph curve after 2014 is upward sloping. Combine the two graphs and we conclude that price fall has been accompanied by a rise in demand. This satisfies the law of demand.  

2. Price elasticity is defined as the ‘degree of responsiveness of demand to changes in price of a good’( Economicsonline.co.uk, Price elasticity)   It is expressed as the ratio of percentage change in demand of a good and the percentage change in price of good.

percentage change in demand of oil = 2% rise or +2

percentage change in price of oil  =30% fall or -30

 Price elasticity = +2/-30=-1/15 = -0.06

The nature of demand is based on value of elasticity. As it is less than 1 ( ignoring the sign) demand is INELASTIC.

3. ‘Commodities are the ultimate definer of price elasticity of demand. When stuff is cheap, you use more of it. When it is expensive, you save it.’. ( Economicsonline.co.uk, Price Elasticity).   Consumers are flexible in terms of demand- they can change the quantity they demand based on price, as well as other factors that were mentioned in answer 1.  The extent of flexibility is captured in quantitative terms by the concept of price elasticity of demand. The statement in the source refers to this flexibility and argues that consumers are responsive to changes in price.  Different values to elasticity define the extent of flexibility.

A value of elasticity that is above 1, means demand is elastic. A value of elasticity less than 1 is inelastic demand. For a value of elasticity  of zero demand is perfectly inelastic, while a value of infinity implies perfectly elastic demand.

The source does not mention the value but calls it responsive demand. This is not supported by answer 2, where demand was very inelastic as its value was close to zero.

4. The option of increasing price is considered in terms of the effect on profits and revenues of oil firms.  Profits are revenues- costs. If costs are unchanged then any change in revenues will be mirrored in profits. We have no information on costs, so we assume that they are unchanged, and focus on revenues only.

‘Firms can use PED estimates to predict the effect of a change in price on total revenue of sellers’ ( Tutor2u.net, Price elasticity of demand). As per theory if demand is elastic then price and revenues are inversely related, and if demand is inelastic then price and revenues are directly related.

When demand is inelastic as in our case, any price rise will see revenues rise, benefitting oil firms. We would advise them to increase price, rather than reduce prices. A reduction in prices will lead to lower revenues only.

1. As per source 1 there is mention of only two firms. In source 2 we can see that these firms take up 80% of total market share in food retail sector. This makes this an oligopoly structure.  This structure has the following features:
   1. There are limited / small number of firms that dominate the market. In our case two firms dominate 80% of market.
   2. The products sold by firms are similar but not same. The differences in products can be based on quality, advertising or service levels.
   3. All firms are interdependent on one other. The price policies of one firm are closely watched and followed by rivals. This explains why it makes sense for firms to collaborate/collude and then take action on pricing in the market. However, in our case this dependence is taking the form of price wars. Each firm is following the other firm’s price cutting policy.
   4. ‘Barriers to entry, but less than monopoly’ ( Economicshelp.org, Oligopoly). The source does not mention this but the small number of firms is a sign that entry is tough.  
2. NO it is not in the interest of any firm to do a price war. This is because it will cause them to make losses from low prices. A better strategy is given in game theory and the kinked demand model.  Game theory  is ‘abranch of applied mathematics that studies strategic situations in which individuals or organisations choose various actions in an attempt to maximize their returns’ ( Boundless.com, Game theory applications to Oligopoly) . Assume each firm has two options- high and low price. Game theory tells us that it is better for both of them to keep prices higher, as this delivers higher profits to both. A low price by both leads to losses. If one follows low price then the other will follow as the low price firm will take up all the customers. The high price firm won’t get any customers, and will start dropping prices. So the two stable options are that both keep high prices or both keep low prices. The latter is worse as it causes lower total profits for both. The issue is how to coordinate and keep prices high, if collusion is barred by law.
3. Vegetables market resembles a monopolistic structure. This is evident as they are worried about falling prices. This means they have no power to control the prices they sell at. Coles and Woolworths have more power, the sellers of vegetables have to accept whatever prices they are handed out.  This lack of power at individual level to set prices makes it a monopolistically competitive market structure. An association gives them better bargaining power than individual control over selling prices.

Falling prices for their produce means that the revenues they get are falling. Revenues equal the product of price and quantity. Profits= revenues – costs. As the costs have no reason to come down, lower prices translate into lower profits or at worst, losses. This explaiNs why they are worried.

4. In the diagram below assume price was P1 before the price war among retail markets. Farmers made profits as shown in pink . As prices are lowered to P2 this area will shrink, till profits are zero. Any further price fall will lead to losses and farmers ill stop producing.  Notice that due to the nature of competition among vegetable growers price P2 and P1 are not in their control. They are price takers.       

5. Now we allow for technical improvements. These will have the effect of lowering costs, leading to a shift down of average cost and marginal cost curves.

As shown the new equilibrium is at the point where new MC equals P2. The green area shows profits made at this level now. Clearly the farmers are producing more as shown by the green arrow.  They are producing more than what they produced at initial point when profits were being made. The new profits are in green- they are lesser than earlier but at least the firms are not making losses.  Technology has helped overcome loses for them.  

However the technology cannot be free of cost. The cost of technology is assumed to be such that the overall total cost have come down. This reduction leads to down shift of Ac and MC curves. The higher productivity of new technology allows substantial savings in average costs of production even after accounting for the cost of acquisition of new technology.

References

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