In addressing the central problem of economics previously, we understand that in order to produce goods and services, an economy needs to have resources. The more amount of resources an economy has, the more the amount of goods and services it can produce. Human wants are unlimited and scarcity of resources requires us to make choices. Now, what if there is too much resources to the extent that the economy is becoming imbalance?
As discussed previously in The Central Problem of Economics (Oil), the world could be drowning in an oversupply of approximately 1.5 million barrels of oil. The allocation of resources in the market system is determined by the market forces of demand and supply. Some 8 years ago, there was a fear of shortage of oil. How did we come to a situation where there is now an oversupply? We’ll address that in this series of economics application.
The demand for a good is the quantity of the good that consumers are able and willing to buy at each price over a period of time, ceteris paribus. The law of demand states that there is an inverse relationship between price and quantity demanded. When the price of a good falls, the quantity demanded will rise. The converse is also true. However, it seems that even when the price of oil falls, quantity demanded did not seem to rise by the same proportion. Let’s find out why later.
As such, the quantity of a good that consumers are able and willing to buy at each price can be shown by the demand curve. The demand curve shows the quantity demanded at each price and is downward sloping due to the law of demand.
2.1 Movements along VS Shifts in Demand Curve
A change in quantity demanded occurs when quantity demanded changes due to a change in price. This is shown by a movement along the demand curve.
A change in demand occurs when the quantity demanded changes due to a change in a non-price determinant of demand. In other words, quantity demanded changes at the same price and is shown by a shift of the demand curve.
2.2 Non-price Determinants of Demand (WET PIGS)
For example, in winter, the demand for coats and sweaters will increase and the demand for ice cream may decrease. The opposite is true in summer.
Expectation of Price Changes
If consumers expect the price of a good to rise, they will bring forward the purchase to avoid paying a higher price in the future. If the good can be resold such as residential properties, consumers will also purchase only to sell it at a higher price later. When these happen, the demand for a good will increase.
Tastes and Preferences
A change of tastes and preferences towards a good will lead to an increase in the demand for the good. For example, healthy living campaigns have led to a change in tastes and preferences from non-organic produce to organic produce, causing the rise in demand for more organic produce.
An increase in the size of population will lead to an increase in the demand for certain goods and services. If the population is aging such as that of Japan, then demand for pharmaceutical products (drugs/health supplements) will increase.
When consumers’ income rises, the demand for most goods will increase. These goods are called normal goods. However, there are also some goods that will face a decrease in demand when income rises and these goods are called inferior goods.
As the government is the biggest spender in every economy, the demand for certain goods and services will increase if the government were to increase expenditure. The government can affect private expenditure by changing interest rates and tax rates. For example, if the government cuts taxes, consumers will experience a rise in their disposable incomes which will lead to an increase in the demand for certain goods and services.
Substitutes and Complements
Substitutes are goods which are consumed in place of one another such as Coke and Pepsi. A rise in the price of substitutes for a good will induce consumers to buy less of the substitutes resulting in a decrease in the demand of the good.
So if the prices of crude oil increase for example, consumers may start looking at substitutes such as solar energy, wind power, hybrid cars and shale formation natural gas, just to name a few. Of course, a simpler example would be, should the price of Pepsi rises, consumers buy less Pepsi and more Coke. Complements are good which are consumed in conjunction with one another such as car and petrol. So if the prices of cars fall, consumers will buy more cars and more petrol.
An increase in the number of substitutes for a good will also lead to a decrease in the demand for the good and vice versa. An increase in the number of complements will lead to an increase in the demand for a good and vice versa.
The supply of a good is the quantity of the good that firms are willing and able to sell at each price over a period of time, ceteris paribus. The law of supply states that there is a direct relationship between price and quantity supplied. When the price of a good falls, the quantity supplied will fall. Conversely, when the price of a good rises, the quantity supplied will rise.
The law of supply can be explained with the concept of profit maximization. Over the past five years when prices of oil hovered around $110/barrel, firms rushed in hoping to take a share of the large pie of profits that oil can offer. Firms which are profit-oriented has almost completed 20,000 new wells since 2010.
3.1 Movements along VS Shifts in Supply Curve
A change in quantity supplied occurs when quantity supplied changes due to a change in price. This is shown by a movement along the supply curve.
A change in supply occurs when quantity supplied changes due to a change in a non-price determinant of supply. This is shown by a shift in the supply curve.
3.2 Non-price Determinants of Supply
Price of Alternate Goods
If a seller produces more than one product, a change in the price of one product can change the supply of another product.
Changes in technology result in superior productivity. Increased productivity can reduce the cost of production and thus, increase supply.
Tax: A required payment to a local, state, or national government
Subsidy: A payment made by a government to individuals, businesses, or an industry to encourage certain activities that are considered essential or desirable.
Expectation of Price Changes
If the firm expect the price of a good to rise, they will hoard some of the output that they currently produce only to sell it at a higher price in the future. This will lead to a fall in the supply of the good.
A rise in resource/input prices will increase the cost of production. This will lead to a decrease in supply as firms will increase the price at each quantity to maintain profitability. There are several factors that can lead to a change in the cost of production. For example, a fall in factor prices such as wages can lead to a fall in the cost of production and vice versa.
Labour productivity refers to output per hour of labour. When labour productivity rises, which may be due to an increase in the skills and knowledge of labour or the improved efficiency of capital, firms will need a smaller amount of labour to produce any given amount of output. Therefore, the cost of production will also fall in this case.
Number of Sellers
If the production capacity in the industry increase, which may occur due to an increase in the number of firms in the industry or an expansion of the production capacities of existing firms, then the supply of goods will increase. Similarly, if more firms had joined the oil industry in an attempt to share its profit, then it is likely that the supply of oil would increase as well.
4.1 Equilibrium Price and Equilibrium Quantity
An equilibrium is a state where there is no tendency to change. The equilibrium of a market is determined by the market forces of demand and supply. If consumers demand more of a good than what firms supply at a particular price, the quantity demanded will exceed the quantity supplied. The resultant shortage will push up the price. This is because when firms do not produce enough to sell, they can raise price without losing sales. Therefore, they will do so to increase their profits. A rise in the price of the good will incentivise firms to increase the production due to the higher profitability and consumers to decrease the consumption due to the higher relative price and the lower real income. Therefore the quantity supplied will rise and the quantity demanded will fall. The price will continue rising until the quantity demanded is equal to the quantity supplied, at which point the shortage is eliminated and an equilibrium is established.
When the quantity demanded = quantity supplied, there is neither surplus nor shortage and hence there is no incentive for firms to change the price.
4.2 Effects of a Change in Demand on Price and Quantity
Increase in Demand / Decrease in Supply
An increase in demand will result in a shortage where if firms do not produce enough to sell, they can raise the price without losing sales. This will allow their profits to increase as well. As price rises, quantity demanded falls while quantity supplied rises, and this process continues until the new price rises to where quantity demanded = quantity supplied.
Decrease in Demand / Increase in Supply
A decrease in demand or an increase in supply will lead to a fall in price and quantity and this results in a surplus. When firms cannot sell all the output they produce, their stocks will build up, and hence causing them to lower the price to reduce stocks. As the price falls, the quantity demanded rises and the quantity supplied falls until an equilibrium point is reached.
The Demand and Supply Imbalance
This is exactly what is happening in the world now where demand for oil stagnated as major economies started slowing, causing oil prices to fall into a vicious downward spiral. Despite this, OPEC remains determined to pump aggressively. In Jan 2016, oil prices had even settled below $30 as turmoil in Chinese markets and the expected increase in Iranian crude exports added to concerns of an oversupply. If according to the law of demand and supply from above, then it has proven that oil prices have been descending and will continue to do so up and until a point where supply can be controlled.
On 16 Feb 2016, large oil producers such as Saudi Arabia, Russia, Qatar and Venezuela met in Doha, Qatar to discuss measures to tackle a supply glut that has sent prices to 13-years low. Outcome? An effort to freeze output at January levels instead of cutting supply. Saudi Arabia oil minister, Ali al-Naimi has made it clear at the CERAWeek energy conference in Houston, Texas that the global oversupply of oil is going to keep flowing. It is pointless to cut production and it will be easier for them to freeze production instead. Will this close up the demand supply imbalance? In the short term, no. Should demand not be able to catch up, the world will continue to swim in some 1-2 million extra barrels of oil every day, even more so if Iran refuses to back down.
Olivier Jakob, managing director of consultant Petromatrix GmbH in Zug, Switzerland has also said that by holding supplies at January levels and not increasing when their domestic requirement for power generation is at its peak, will result in approximately 500,000 barrels lesser Saudi crude making its way to global markets. This means that the production freeze will be equivalent to a cut in Saudi Arabia’s crude exports. However, what remains to be seen is that this biggest member of OPEC ramped up output last year to intensify pressure on U.S. shale producers and to mark its territory before Iran’s return to the oil markets. It was pumping 10.2 million barrels a day in January – a level that has already exceeded the summer production peak in almost all of the past 10 years, according to data compiled in Bloomberg.
In the short term, the world is still likely to be stung by low oil prices. If according to the law of demand and supply, with oil prices settling at their lowest level in almost 13 years, why is demand not as responsive as it should be?
We’ll find out in our next topic – Elasticity of Oil Demand and Supply.
Backman, M. 2016. “Freeze is the new cut in global oil markets.” Quartz.
Barteau, M. A. 2016. “Why a Production Freeze Won’t Fix the Oil Collapse.” Fortune Insiders.
Puko, T. 2016. “Oil Prices Tumble Below $30 a Barrel.” The Wallstreet Journal.
Quek, E. 2015. “Demand and Supply.” Economics Café.
Smith, G. 2016. “What a Saudi Oil-Supply Freeze Would Really Mean for Markets.” Bloomberg Business.