Question

case:

After the mid of 2014, the oil prices started declining due to many factors, like political issues in different countries, alternative source of oil industries started coming up, more producers started investing in this sectors all these creates, large quantities of oil. This decline in oil prices affects the demand and the supply side of the economy, ultimately affects the revenue of this industries. They have to go for different marketing structures in different counties to boost this industry.

Questions:

1-Briefly explain the suitable model of market structure for this industry.

2-Illustrate the relationship between average revenue and marginal revenue in relation to the marketing structure.

3-Explain the concept of Law of supply and its applicability in oil industries.

4-Relate law of demand in oil industries and how it can be used to explain the pricing of a product .

Answer 1

As mentioned in the question above oil prices started declining after mid 2014 due to various pilitical and economic factors, such as slowing down of economies such as China, increase in oil production by non-traditional oil producers such as Canada and the United States.

1. Oilgopoly is the best model of market structure that could be possibly related to the oil industry. In an oligopoly market structure, there are large number of buyers and very small number of producers or sellers.

As we know crude oil is not available in abundance in all the countries. There are only selected countries such as Saudi Arabia, other mid-east countries, Russia and recently due to shale gas boom, the US and Canada, that are net producers of crude oil. Whereas all the countries in the world are consumers of crude oil in the form of fuels such as, petrol, diesel etc. Thus, we can say that there are very small number of producers of crude oil and very large number of buyers. Therefore, oligopoly is the most suitable market structure that relates to oil industry.

However, mechanisms should be there to ensure that the formation of cartels are not harming the buyers or consumers. Traditionally since 1973, OPEC ( Organization of petroleum exporting countries ), a cartel of oil producing countries have, influenced oil prices by significantly cutting down the production of crude oil which creates artificial shortage in supply of oil, that helps these counrties to earn more profits due to higher prices.

2. In order to illustrate the relationship between average revenue and marginal revenue, we need to first understand the terms- total revenue, marginal revenue and average revenue.

Total revenue refers to the sum of sale proceeds of all the items of a firm by selling its total output at a given price.

Total Revenue = P*Q, where TR = Total Revenue, P = Price, Q = Quantity sold.

Average revenue is the revenue per unit of the item sold.

AR can be calculated by dividing the total revenue by the number of units sold.

AR = TR/Q; where AR = Average revenue, TR = Total revenue and Q = Quantity sold.

Finally, marginal revenue is revenue earned by selling one more unit of the commodity.

MR = TRn – TRn-1

TRn = Total revenue of n units

TRn-1 = Total revenue of n-1 units

In perfect competition each firm takes the market price as given and sell its quantity at the ruling market price.

Therefore, AR = MR.

In oligopoly market structure as there are two or more firms existing, an oligopoly market forms pure or perfect competition. Therefore, the relationship between marginal revenue and average revenue in oligopoly market is same as it is under perfect competition.

AR = MR

3. The law of supply states that, keeping all other factors constant, increase in price leads to increase in quantity supplied.

As oil prices rise, the oil exporting countries want to sell more and more quantity of crude oil at higher prices and when the prices go down, oil exporting countries may want to supply less. However, oil industry does not perfectly follow the law of supply. As mentioned above, these countries artificially create shortage of crude oil in order to ramp up prices to earn higher profits.

4. Law of demand states that there is an inverse relationship between price and demand of an item.

With higher prices, demand for the commodity falls down and vice versa.

   When oil prices increase, demand for oil and its consumption falls down. Most of the countries saw higher economic growth after the year 2000, which led to higher prices of oil in the decade.