Question

Key objective: exemplifying the limitations of the power of oligopoly due to short-term and long-term elasticities.

Setting: Imagine you are representing one of the members of the OPEC, and you are motivated by an increase of your revenue from the sale of crude oil. You have to compromise on current decision on possible output decrease as to stimulate the world price of gas. Please consider the historical relation of the reaction of the gas price at the pump to the world price of the crude oil per barrel. Please resort to the NYU STERN case on The Petroleum Market: 1970 – 2000 (via link provided below the assignment), but most of all to the research on the following issues in the summer of 2008 in the US and now, and the political debate on the energy crisis, environmental protection and renewable sources of energy.  

Instruction: As usually, please complete the assignment discussing the relevant economics concepts and applying economic tools with supporting data for problem solving in this real-life imitating simulation, and include also a memo summarizing the points of agreement to be reached and followed by OPEC unanimously, and with the compliance in the forthcoming months.

Outline: Include in the discussion the following issues with data, as the basis for your common decision to be made:

•      demand patterns for crude oil in the World

•      the price elasticity of demand for gas in the US

•      the factors influencing the price elasticity of demand for gas in the US, and possible changes in this respect (behavioral patterns)

•      the impact of price changes (on different price levels) on the revenue of crude oil exporters

•      the income elasticity of demand for gas

•      the price elasticity of supply of gas

•      the effect on the market outcome, on the market equilibrium, and on the efficiency of the market

•      the effect on the international trade, state policies, and on the economy.

Answer 1

Solutions :

Crude oil has been refined to make fuels, like petrol and diesel, lubricants, and industrial chemicals since the 1850s. Industrialisation owes its development to oil. By 2019, the world’s second, third and fourth largest companies – the Sinopec Group, Royal Dutch Shell, and China National Petroleum Corporation (CNPC), parent of PetroChina – were oil and gas producers. Six of the world’s top ten companies by revenue were oil and gas producers. (2019) Oil is an essential scarce resource, and there are still no cost effective alternatives to oil for producing vehicle fuels like petrol and diesel.

Total global revenues from oil and gas exploration and production were $3tr in 2019.

Demand patterns for crude oil in the World

The demand for oil has a number of important characteristics.

1. Demand is increasing in the advanced, OECD economies, which make up approximately 66% of total world demand. Between 1980 and 2008, world demand increased by 40%, from 60m barrels per day to over 85m barrels.
2. The demand for oil is relatively inelastic with respect to price, given that oil has few direct substitutes.
3. Similarly, demand for oil is relatively inelastic with respect to income in the advanced, OECD economies. However, income elasticity of demand (YED)in developing economies like China and India is likely to be higher, with estimates suggesting that YED is close to 1.

The price elasticity of demand for gas in the US

The price elasticity of the demand for gasoline has been extensively studied over the last 40 years, and for good reason. It is critical for determining gasoline tax rates and evaluating alternative policies that target the negative externalities associated with automobile use (pollution, road congestion, etc.).

A number of recent empirical studies examining gasoline demand have concluded that demand has become highly price inelastic, at least in the short run. This lack of demand response suggests that more extreme price fluctuations may be necessary to balance markets following supply shocks, and that taxes and other price-based policy mechanisms may not be as effective in achieving desired consumption or pollution reduction goals.

Factors influencing the price elasticity of demand for gas in the US, and possible changes in this respect

Increases in natural gas supply generally result in lower natural gas prices, and decreases in supply tend to lead to higher prices. Increases in demand generally lead to higher prices, and decreases in demand tend to lead to lower prices. In turn, higher prices tend to moderate or reduce demand and encourage production, and lower prices tend to have the opposite effects.

Three major demand-side factors affect prices:

• Variations in winter and summer weather
• Level of economic growth
• Availability and prices of other fuels

Impact of price changes on the revenue of crude oil exporters

Generally, oil price fluctuations significantly affect oil importers’ production costs and, therefore, price levels, while in energy exporting countries oil price movements mainly affect energy export revenues and government budget revenues. Nevertheless, it was widely accepted that energy price volatility is not only an important cause of macro-economic fluctuations, but also affects the fiscal and monetary policy of different economies.

The income elasticity of demand for gas

The short-run price elasticity of gasoline demand is significantly more inelastic today than in previous decades. In the short-run, consumers appear significantly less responsive to gasoline price increases.

The income elasticity of gasoline demand ranges from 0.47 to 0.49 for the period from 1975 to 1980 and from 0.53 to 0.54 in the period from 2001 to 2006.

The price elasticity of supply of gas

The price elasticity of supply is the measure of the responsiveness in quantity supplied to a change in price for a specific good. The inelastic supply requires substantial price movements before production levels change. Excess supply resulting from the increased availability of shale gas in the marketplace has been blamed for falling gas prices. Yet as prices continue to decline, the production overhang continues.

Effect on the market outcome, on the market equilibrium, and on the efficiency of the market

Market equilibrium in this case is a condition where a market price is established through competition such that the amount of goods or services sought by buyers is equal to the amount of goods or services produced by sellers. This price is often called the competitive price or market clearing price and will tend not to change unless demand or supply changes, and quantity is called the "competitive quantity" or market clearing quantity. But the concept of equilibrium in economics also applies to imperfectly competitive markets, where it takes the form of a Nash equilibrium.

The effect on the international trade, state policies, and on the economy.

As the price of gas increases and falls with the international market, the demand (the distance driven by the population) rises and falls in near direct correlation. Gasoline has an elasticity quotient of one or greater and has a flatter slope on a graph.