Economics For Crude Oil In The Global Economy

Part 1

Discuss about the Economics for Crude Oil in the Global Economy.

The price of crude oil has been falling over a considerable period of time. In 2015, the opening price of crude oil was relatively low as compared with the previous years and by the end of the year, the price was even lower – the lowest since 2009 (Cunningham, 2015).

The demand for crude oil in the global economy has been rising in the year 2015 though the growth in demand has slowed down thereafter (Ellyatt, 2015). This rising demand is mainly due to the rise in crude oil demand by the largest consumer of the product, that is, the U.S. where the oil demand is driving up due to falling prices and rising incomes (Clemente, 2015).

The economic theory of the Law of Demand supports this relationship between the prices and the demand for crude oil. The law of demand states that the demand for a commodity is inversely related to its price. In 2015, the price of crude oil has dropped and the demand for the same has increased which reflects the inverse relationship given by the law of demand.

This is illustrated in the following diagram:

Figure 1.1 shows the inverse demand curve DD which represents the relationship between the price of crude oil and the quantity demanded of crude oil. When the price falls from P’ to P”, the quantity demanded increases from Q’ to Q”; hence the quantity demanded of crude oil increases as the price falls in the year 2015 (Krauss, 2016). 

Oil prices fell by 30%. Oil demand has risen by 2%.

The price elasticity of the demand for oil will be given as,

€ = – (2 / 30) = – 0.067

The elasticity is negative because of the inverse relationship between price and demand. From the given data, the absolute price elasticity of demand is 0.067. This implies that the price elasticity of demand for crude oil is very low, that is, the demand for crude oil is relatively price inelastic – the proportional increase in the demand for oil is much less than the proportional fall in the price of the same (Varian, 2009). 

The opinion stated in Source 1 is generally true, that is, when a commodity is cheap the demand is very high whereas when the same commodity is more expensive, the demand is much lower. However, this is not true in case of crude oil. This is because crude oil is a necessary or an essential commodity and hence the price elasticity of demand for crude oil should be generally low (Pindyck and Rubinfeld, 2009). As the price of crude oil falls the demand for crude oil increases, but not by a very large extent. Similarly, as the price of crude oil increases the demand for crude oil falls, but not significantly. The proportional change in the quantity demanded of crude oil is much lower relative to the proportional change in the price since crude oil is an essential commodity in the global economy (Mankiw, 2014). Hence the given statement does not hold true for crude oil. 

Part 2

The decision of increasing or decreasing oil prices would depend on the given circumstances. However, an oil producer should be advised to increase oil prices from the profit-maximisation perspective. This is because the price elasticity of demand for oil is low. When the price of oil increases, the demand for crude oil will fall but less than proportionately. Hence, the total revenue which is given as the product of the price and the quantity will ultimately increase thereby increasing the profits of the oil producer (Krugman and Wells, 2014). This can be explained with the following diagram: 

The inelastic demand curve in Figure 1.4 represents the inverse demand function for crude oil. When the price is P’, the quantity demanded is Q’. The total revenue is hence given by the area (B + C). When the price increases to P”, the quantity demanded falls to Q”. The new total revenue is given by the area (A + B). Thus, the total revenue falls by the area C and increases by the area A. Clearly, the area A is greater than the area C. Hence, the total revenue ultimately increases by the area (A – C); A > C.

Thus, an oil producer should increase the oil price to increase his revenue and profits from oil production (Kreps, 2012). 

The introduction of shale oil production in 2008 has improved the productivity in the oil industry. This should result in an increase in the price elasticity of supply of oil (Colander, 2012). This is because when shale oil is introduced, the production of oil will increase considerably given that other resources in oil production are constant. With improved productivity, the production and supply of oil will be able to readily adjust to changing prices. The price elasticity of supply is positive because supply increases with a rise in the price (Varian, 2009). When the price of crude oil increases, given the demand, the supply will increase more than it would before the introduction of shale oil production. 

The supermarket industry as a whole represents an Oligopoly market structure. However, Coles and Woolworths being the two major firms in the industry, the contribution of the others are so less in aggregate that the industry can be termed a Duopoly market. The prices in the market are determined according to the two supermarkets. Their price decisions influence the price and the quantity demanded and supplied in the entire industry, that is, they control the entire industry with respect to farming as well as dairy products. Coles and Woolworths account for 80% of the market share of the Australian food sector. Entry of new firms into the supermarket industry is restricted because of the two existing giants. The demand curve faced by the industry is downward sloping. Hence the supermarket industry is essentially an Oligopoly market though effectively a Duopoly where Coles and Woolworths are the two firms (Pindyck and Rubinfeld, 2009). 

Supermarket firms like Coles and Woolworths engage in a discount price war in order to increase their market share. When the demand for a certain commodity is relatively price inelastic, reducing the price will lead to a fall in the overall revenue. Hence, a price discount war is healthy from the business perspective of the supermarkets as long as a fall in the price increases the demand considerably such that the overall revenue increases. When one reduces its price, the other will immediately follow so as to maintain its market share or avoid incurring losses. Thus, price discount war is healthy up to a certain level beyond which it should be avoided (Mankiw, 2014).

This can be explained with the help of the following diagram:

Figure 2.2 represents a kinked demand curve faced by each of the firms. At higher prices, a firm faces a relatively elastic demand curve and at lower prices the firm faces a relatively inelastic demand curve. Prices will stabilize and an equilibrium can be established at the point where the discontinuous MR curve intersects the MC curve, that is, at price P* with a quantity Q*. Once the firms charge the price P*, there will be little or no incentive to reduce or alter prices any further without losing out on profits. During such periods of relative price stability it will be in the interest of Coles and Woolworths to engage in non-price competition to boost their profits. A price discount war is a short term phenomenon under the kinked demand curve theory (Pindyck and Rubinfeld, 2009). 

The market for vegetables provided by farmers is a perfectly competitive market structure. As is evident from the given data, the number of farms supplying vegetables to the market is considerably huge and they cater to almost the entire mass of population via retain markets and supermarkets. All farmers produce and supply homogenous products and the price at which they supply the vegetables to the market is fixed at determined at the industry level, that is, it is given to them. Any new farmer can begin vegetable farming and supply it to the market without incurring any additional costs and if existing farmers make losses, they can stop vegetable farming to avoid further losses. Hence, the market for vegetables provided by farmers operates under perfect competition (Pindyck and Rubinfeld, 2009). 

Individual vegetable producers would incur losses as a result of falling prices for their products. This is illustrated with the help of the following diagram:

Figure 2.4 represents the market structure for an individual vegetable farmer. When price is P*, the profit maximising output is Q*. Due to the price discount war adopted by the supermarkets, whenever the price falls to P’, the profit maximising output for the individual firm falls to Q’. This results in a reduction of profits and in fact a loss for the individual producer. However, at this price, the producer is still being able to cover the average variable cost and hence will continue producing (Varian, 2009). But if the price falls further, say to P” < AVC, the vegetable farmer would stop production completely.

For the farmers whose cost structure is such that a fall in price reduces the price below the average variable cost, the production of vegetables will have to be stopped to incur further losses (Kreps, 2012). Hence, in the long run, small farmers who operate at the margin will be forced to leave. 

If significant improvement in technologies can be made, individual farmers can overcome the price falls and stay in business in the long run (Krugman and Wells, 2014). This is because technological improvements reduce the costs incurred by the individual firms. This is illustrated in the following diagram:

Improvements in technology reduce the costs faced by individual farms such that the MC curve shifts to MC’ and the AVC curve shifts to AVC’. Thus when the price falls to P’ the profit-maximising quantity increases. The fall in price may still reduce the profit but not as much as when the costs were high (Mankiw, 2014). Hence, firms will be able to recover the average variable cost and will stay in business over the long run. 

References

Colander, D. (2012). Microeconomics. 9^th ed. New York: McGraw-Hill Education. 

Kreps, D. (2012). Microeconomic Foundations I: Choice and Competitive Markets. New Jersey: Princeton University Press. 

Krugman, P. and Wells, R. (2014). Microeconomics. 4^th ed. New York: Worth Publishers. 

Mankiw, N. (2014). Principles of Microeconomics. 7^th ed. Boston: Cengage Learning. 

Pindyck, R. and Rubinfeld, D. (2009). Micreconomics. 7^th ed. New Jersey: Prentice Hall. 

Varian, H. (2009). Intermediate Microeconomics: A Modern Approach. 8^th ed. New York: W. W. Norton & Company. 

Clemente, J. (2015). Rising U.S Oil Demand in 2015 – and Beyond. [online] Forbes. Available at: https://www.forbes.com/sites/judeclemente/2015/06/21/u-s-oil-demand-in-2015-and-beyond/#4f02212c2737 [Accessed 27 September 2016]. 

Cunningham, N. (2015). Top Five Factors Affecting Oil Prices in 2015. [online] OILPRICE.COM. Available at: https://oilprice.com/Energy/Energy-General/Top-Five-Factors-Affecting-Oil-Prices-In-2015.html [Accessed 27 September 2016]. 

Ellyatt, H. (2015). Oil demand growth to slow, IEA says, but is OPEC listening? [online] CNBC. Available at: https://www.cnbc.com/2015/10/13/oil-demand-growth-to-slow-iea-says-but-is-opec-listening.html [Accessed 27 September 2016]. 

Krauss, C. (2016). Oil Prices: What’s Behind the Drop? Simple Economics. New York Times, [online] Available at: https://www.nytimes.com/interactive/2016/business/energy-environment/oil-prices.html?_r=0 [Accessed 27 September 2016].