Question

You are an analyst covering the oil and gas markets. You know from experience that natural gas and fuel oil are competing fuels; they are substitutes in certain production processes. A new technology has made it more cost-effective to extract natural gas from hard-to-reach geological formations. Using the supply and demand model, explain how this technological development will change (1) the market for natural gas and (2) the market for fuel oil.

Answer 1

(a) The market for natural gas - When a new technology has made it more cost-effective to extract natural gas from hard-to-reach geological formations, the supply of natural gas would increase with the advancement of new technology. With the increase in supply, the price will fall. When the price falls, the quantity of natural gas demanded increases.

In the diagram below, the initial demand curve is DD and the initial supply curve is SS. The supply curve after the technological advancement is S^'S^'. The initial price is P and the initial quantity is Q and after the increase in supply, the price falls to P^' and the quantity demanded increases to Q^'.

(b) The market for fuel oil - When a new technology has made it more cost-effective to extract natural gas from hard-to-reach geological formations, both the supply and demand for natural gas would increase and with the increase in demand for natural gas, the demand for fuel oil would fall because it is a substitute product. Since there has been no change in the market for fuel oil, the price of fuel oil would remain the same as before, and with the price of the substitute good i.e. natural gas decreasing, the demand for fuel oil would decrease and the demand for natural gas would increase. So, with the decrease in demand, the price of fuel oil would also fall and the quantity demanded of fuel oil would also decrease.

In the diagram below, the initial demand curve is DD and the initial supply curve is SS. The demand curve after the decrease in demand is D^'D^'. The initial price is P and the initial quantity is Q and after the decrease in demand, the price falls to P^' and the quantity demanded decreases to Q^'.