Question

Gas prices fell in the last three months. What will be the reaction to this by buyers and sellers? Will buyers be better off in six months? In one year? Explain using supply and demand graphs.

Answer 1

Lower gas price will increase its quantity demanded, following the law of demand, and decrease the quantity supplied, following the law of supply. Higher quantity demanded and lower quantity supplied will lead to a market shortage.

As time passes, the shortage starts to put an upward pressure on prices such that price starts rising, therefore decreasing the quantity demanded and increasing the quantity supplied. The farther we are in time, the closer the market price will be to the equilibrium price, therefore after one year, price of gas will rise closer to market equilibrium price than after 6 months. The process will continue until market price equals market equilibrium price at which quantity demanded equals quantity supplied.

In following graph, as price falls from (equilibrium price) P0 to P1, quantity demanded rises to Qd (> Q0) and quantity supplied falls to Qs (< Q0), leading to a shortage equal to (Qd - Qs). With passage of time, there is upward pressure on price such that P1 starts rising until it reaches P0 at original equilibrium point A.