Supply and Demand
Gas prices at record high
West Texas Intermediate (Bbl) Prices of Oil
10.000 happens if
0.000 Iranian oil is
August 25, 2005
Rising Price of Oil Pushes S.&P. to Negative
By ERIC DASH
Oil prices climbed to another record yesterday,
driving stocks lower and leaving the Standard &
Poor's 500-stock index down for the year.
All three major market gauges closed lower
yesterday; the S.&. P.'s loss meant that for the first
time since July 7, all three were in negative territory
for the year. "Once oil decided that it was going to
move higher and stay higher, that just took the
starch out of any buyers in the stock market," said
Joseph Liro, the chief equity strategist at Stone &
McCarthy, an economic research firm in Princeton.
"Oil is just the biggest single depressant on the
market except for the oil stocks."
To think about commodity prices,
economists first think about the theory
of competitive markets
• Competitive Markets have many buyers and
many sellers who compete without barriers
preventing rivals from entering or leaving
• Participants in competitive markets are
price takers, agents who behave as if their
own behavior has no effect on market
Law of Demand: There is always an inverse
relationship between the price of a good and the
quantity that consumers would like to purchase.
• Consumers have limited income.
• The price that consumers will pay for an extra
good will be no greater than the extra benefit
that they receive from it.
• People face diminishing returns from consuming
any given good.
• Each extra good consumed generates less
marginal benefit than the good before
• Consumers will be willing to pay less for each
extra good than they were willing to pay for the
Representation of a Hypothetical Oil
US$/bbl Mil. Bbl 120
30 31867.11 100
40 31312.77 80
75 30134.8 20
85 29905.6 0
90 29801.51 29000 29500 30000 30500 31000 31500 32000
Law of Supply: There is a positive relationship
between the price of a good and the quantity
producers bring to the market.
• In a competitive market place, producers are
willing to sell an extra good as long as the price
is at least as large of the extra cost of producing
it (marginal cost).
• Producers have decreasing returns to production
and therefore increasing costs. To induce them
to produce greater amounts, they must be
compensated for these increasing costs with
Why do supply curves slope up?
• Firms will only increase supply when prices
rise because their costs as production increases.
• Producing extra goods generates increasing
costs because some inputs are fixed and the
flexible factors of production will have
– Example: A busy McDonalds can sell more burgers
by adding more McWorkers, but effectiveness of
workers is limited by amount of Cash registers,
Ovens, and ultimately Space.
Representation of a Hypothetical Oil Supply
US$/bbl Mil. Bbl 120
30 29893.38 100
65 30832.36 40
75 31009.35 20
85 31164.99 0
100 31368.24 Q
• Equilibrium in the competitive market occurs
when the price is set at a level (P*) such that the
amount that consumers want to buy is equal to
the amount that sellers want to sell (Q*).
Excess Supply If P were above equilibrium, sellers
would want to sell more goods than buyers would
want to buy. Competition between sellers would
force prices down.
Excess Demand If P were below equilibrium,
customers would want to buy more goods than
people would want to sell. Competition between
buyers would force prices up.
Competitive Market Equilibrium
P D S
P D S
P D S
30 29893.38 31867.11
35 30078.28 31568.86
At what price and quantity (to
40 30239.36 31312.77 closest $5) will the oil market
45 30382.16 31088.6 clear?
50 30510.48 30889.43
55 30627.02 30710.37
60 30733.8 30547.8
65 30832.36 30399.01
70 30923.89 30261.9
75 31009.35 30134.8
80 31089.51 30016.4
85 31164.99 29905.6
90 31236.32 29801.51
95 31303.95 29703.39
100 31368.24 29610.59
Elasticity: The Concept
• How strong is the effect of a change in price
on the change in quantity supplied or
• If the price effect is strong, we say the
supply/demand schedule is elastic.
• If the price effect is weak, we say it is
Strict definition to come
Shifting Curves/Changing Equilibrium
• Changes in equilibrium result from shifts in
either the demand or supply schedule. We
think of shifts in the curves as changes in
supply or demand that are caused by factors
other than changes in the price of the good.
– Shifts in the demand curve lead to movements
along the supply curve resulting in changes in
prices and quantities that move in the same
– Shifts in the supply curve lead to movements
along the demand curve resulting in changes in
prices and quantities that move in different
What shifts a demand curve?
1. Changes in consumer preferences
2. Changes in consumer income
3. Changes in the prices of other goods.
Hypothetical Demand Shift
• Consider that there is an increase in consumer income
sufficiently large that oil demand would increase by 5% if
the price level stayed the same. This event will increase
the demand for oil at any given price level. Demand
schedule shifts out/up.
• Equilibrium price and quantity rise.
• At the old price level, there is a situation of excess
demand. As consumers, scramble to get more oil,
producers are able to raise prices.
• Higher prices induce i) some cutbacks in oil use; and ii)
some additional production until supply is equal to
A Shift in the Demand Curve: A parallel increase in
the demand schedule at every price point.
Equilibrium Effect: Movement along the supply curve
Shift in the
A shift in the demand schedule
A 5% shift in the demand
Supply Demand Demand'
30 29893.38 31867.11 33460.47
35 30078.28 31568.86 33147.31 If price stayed constant,
40 30239.36 31312.77 32878.41 demand for oil would
45 30382.16 31088.6 32643.03
50 30510.48 30889.43 32433.9
55 30627.02 30710.37 32245.88
60 30733.8 30547.8 32075.19 But to get producers to
65 30832.36 30399.01 31918.96 produce more, price must
70 30923.89 30261.9 31774.99
75 31009.35 30134.8 31641.54 go up which will have a
80 31089.51 30016.4 31517.22 counter-veiling effect on
85 31164.99 29905.6 31400.88
90 31236.32 29801.51 31291.59
95 31303.95 29703.39 31188.56
100 31368.24 29610.59 31091.12 What is the new equilibrium
Shifts in Supply Curves
• Supply curves represent the extra cost of
producing a good which increases in the
number of goods produced. But other factors
may affect cost besides scale.
• Cost Shifters
1. Changes in resource prices
2. Changes in Technology
3. Nature and Political Disruptions
4. Changes in Taxes on Producers
A Shift in the Supply Curve is a Movement
along the Demand curve-
Price and Quantity Move in opposite Directions
P D S
Q** Q* Q
Equilibrium Effects of an Decrease in
• When there is some disruption, oil companies
produce less at any given price. Supply schedule
• Equilibrium price rises/Equilibrium quantity falls.
• At the current price level, there is a situation of
excess demand. As consumers, scramble to get
more oil, producers are able to raise prices.
• Higher prices induce i) some cutbacks in oil use;
and ii) some additional production from other
sources; until supply is equal to demand.
Quantity of Oil Use Accelerating
Growth in World Oil Consumption
2000 2001 2002 2003 2004 2005
World OECD ROW
Source: BP Statistical Review 2005
• Use observed information on oil prices and
quantities to assess strength of supply and
demand shocks in context of world events.
• Solve for equilibrium price and quantities
using graphical supply and demand model
or spreadsheet supply and demand
• Explain qualitatively the likely
consequences of exogenous shifts in supply
and demand the likely causes of shifts in
equilibrium prices and quantities.
Negative Supply Shock
• Negative supply shock like embargo on
Iranian oil would raise prices and reduce
quantity of oil available.
– But how much?