Thursday, August 24, 2006

Supply, Demand and the Oil Market

The Latest New York Times "Economics Scene" Column contains a good article discussing oil prices It illustrates some basic concepts in supply and demand we will be learning, but are worth a post on this site because they are topical.

This first quote illustrates a classic supply curve shift

"So when BP announced this month that it might have to suspend as much as 8 percent of the nation's oil production because of corrosion in pipes on the North Slope of Alaska, the price of crude oil immediately shot up by 3 percent and wholesale gasoline prices simultaneously increased by about 2 percent"

That is, when BP cuts the amount of oil production there is less oil to sell. This shifts the supply curve to the left, increasing price and lowering quantity in the market. The reason why quantity declines is easy: it is because there is less oil on the market. Price increases due to economic theory: since there was no shift in the demand curve this creates a temporary shortage. Realizing this suppliers increase the price until the quantity demanded equals the quantity supplied.

However, the article lists one major complication with this analysis: supply will be cut in the future, it will not immediately change the quantity supplied now. Why, then, did prices rise?

To spell out the argument, imagine that you own a storage tank full of gasoline that is currently worth $2 a gallon at wholesale prices. It is widely believed, however, that the price of gasoline will be $2.10 next week. You would be crazy to sell your gasoline now: just wait a few days and the higher price will be yours. But if everyone waits a few days, there is no gasoline to be sold now and the resulting shortage pushes the price of gasoline up. How high does it have to go? The answer is $2.10 a gallon. That is the price necessary to induce those who have gasoline to sell it now rather than to wait till next week.

There are a few things that I want you to get from this.

1) Markets are usually forward looking. Producers and consumers try and anticipate and make their plans accordingly.
2) Thus, the expectation that the supply will decline causes the entire market to adjust.
3) The article later points out that the oil market has a lot of people in it, making the adjustment quick (literally changing current oil prices overnight). This is related to the economic concept of liquidity. The more participants there are--who know what they are doing--the better the price adjustment in.
4) As part of his analysis, he points to two possible complications (one directly one indirectly). One is that not all the participants know what they are doing. This is one criticism of basic supply/demand theory that we will be discussing in this class. The second is implied indirectly in that there may not be a lot of people in the market. What this suggests is that basic supply/demand may not describe all markets (we will be talking about monopoly/oligopoly markets later in this class, which function differently)

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