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Supply and Demand.ppt

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					Supply and Demand
                     Gas prices at record high
        West Texas Intermediate (Bbl)   Prices of Oil
                                        and Gasoline
      80.000
      70.000
                                        continue to
                                        climb!
      60.000
      50.000
US$




      40.000
      30.000
      20.000                            What
      10.000                            happens if
       0.000                            Iranian oil is
                                        taken
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                                        offline?
August 25, 2005
Rising Price of Oil Pushes S.&P. to Negative
Territory
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
  the market.
• Participants in competitive markets are
  price takers, agents who behave as if their
  own behavior has no effect on market
  prices.
   Law of Demand: There is always an inverse
relationship between the price of a good and the
quantity that consumers would like to purchase.
Reason:
• 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
   good before.
 Representation of a Hypothetical Oil
 Demand Schedule
US$/bbl     Mil. Bbl        120
P           Q
                        P
       30    31867.11       100
       35    31568.86
       40    31312.77       80
       45     31088.6
       50    30889.43
                            60
       55    30710.37
       60     30547.8
                            40
       65    30399.01
       70     30261.9
       75     30134.8       20

       80     30016.4
       85     29905.6        0
       90    29801.51        29000 29500 30000 30500 31000 31500 32000
       95    29703.39
                                                                  Q
     100     29610.59
 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
  higher prices.
   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
  diminishing returns.
  – 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
Schedule
  US$/bbl     Mil. Bbl        120
  P           Q
         30    29893.38       100
         35    30078.28
         40    30239.36
                               80
         45    30382.16
         50    30510.48
                               60


                          P
         55    30627.02
         60     30733.8
         65    30832.36        40
         70    30923.89
         75    31009.35        20
         80    31089.51
         85    31164.99         0
         90    31236.32
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         95    31303.95
                              29


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       100     31368.24                                       Q
                  Equilibrium
• 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
           (Geometry)

 P     D                     S




 P*

                        Q*       Q
     Excess Supply
P    D               S


P


P*


              Q*         Q
     Excess Demand
P    D               S




P*
P
              Q*         Q
                  Market Equilibrium
                  (Spreadsheet Problem)
      Supply      Demand
 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
  quantity demand.
• If the price effect is strong, we say the
  supply/demand schedule is elastic.
• If the price effect is weak, we say it is
  inelastic.

              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
    direction.
  – Shifts in the supply curve lead to movements
    along the demand curve resulting in changes in
    prices and quantities that move in different
    directions.
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
  demand.
A Shift in the Demand Curve: A parallel increase in
      the demand schedule at every price point.
Equilibrium Effect: Movement along the supply curve
        P                             S

                                       Shift in the
                                       demand curve
    P**
                                          D′
       P*

                                               D
                         Q*      Q**
                                               Q
  A shift in the demand schedule
             (Spreadsheet)
                                         A 5% shift in the demand
      Supply      Demand     Demand'
                                         schedule
 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
                                         increase 5%.
 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
                                         demand. .
 95    31303.95   29703.39    31188.56
100    31368.24   29610.59    31091.12   What is the new equilibrium
                                         price?
           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
                          S′



  P**
   P*

                 Q** Q*                  Q
Equilibrium Effects of an Decrease in
              Supply
• When there is some disruption, oil companies
  produce less at any given price. Supply schedule
  shifts in/up.
• 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

  7.00%
  6.00%
  5.00%
  4.00%
% 3.00%
  2.00%
  1.00%
  0.00%
  -1.00%
           2000     2001           2002     2003       2004   2005

                           World     OECD   ROW

                  Source: BP Statistical Review 2005
                 Analysis
• Use observed information on oil prices and
  quantities to assess strength of supply and
  demand shocks in context of world events.
         Learning Outcomes
• Solve for equilibrium price and quantities
  using graphical supply and demand model
  or spreadsheet supply and demand
  schedules.
• 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?

				
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