Question

In recent years, companies have used fracking, or hydraulic fracturing, in drilling for oil and natural gas that previously could not be profitably recovered. According to an article in the New York Times, "horizontal drilling has enabled engineers to inject millions of gallons of high-pressure water directly into layers of shale to create the fractures that release the gas. Chemicals added to the water dissolve minerals, kill bacteria that might plug up the well, and insert sand to prop open the fractures." Experts are divided about whether fracking results in significant pollution, but some people worry that chemicals used in fracking might lead to pollution of underground supplies of water used by households and farms. a. First, assume that fracking causes no significant pollution. Use a demand and supply graph to show the effect of fracking on the market for natural gas. b. Now assume that fracking does result in pollution. On your graph from part (a), show the effect of fracking. Be sure to carefully label all curves and all equilibrium points. c. In your graph in part (b), what has happened to the efficient level of output and the efficient price in the market for natural gas compared with the situation before fracking? Can you be certain that the efficient level of output and the efficient price have risen or fallen as a result of fracking? Briefly explain.

Short answer

In the scenario without significant pollution, fracking would increase the supply of natural gas, lowering its price, and increasing the quantity demanded. If fracking does lead to significant pollution, it represents an external cost that would decrease the effective supply of natural gas, likely leading to higher prices and lower quantities. However, the magnitude of these changes would depend on the specific cost of pollution.

Step-by-step solution

Fracking with no pollution

Draw a supply and demand graph for natural gas. The vertical axis represents the price of natural gas, and the horizontal axis represents the quantity. Plot the initial supply and demand curve. Supply is a positive slope, and demand is a negative slope. Label the intersection of these curves as the equilibrium (E1) with corresponding price P1 and quantity Q1. {$ \newline $} After the introduction of fracking, the supply of natural gas increases, resulting in a rightward shift in the supply curve. Label this new curve, and the new equilibrium (E2) with corresponding price (P2) and quantity (Q2). P2 is lower than P1, and Q2 is larger than Q1.

Introduction of pollution

Now, if fracking does result in pollution, it represents an external cost not accounted for in the supply curve. Graphically, this can be shown as a leftwards shift in the supply curve (as the cost of production has effectively increased). Label this new curve, and the new equilibrium (E3) with corresponding price (P3) and quantity (Q3). P3 is likely higher than P2, and Q3 is likely less than Q2.

Analysis of output and price changes

Analyze the changes in the equilibrium position after considering the impact of pollution. The impact on price and output level will be uncertain and depends on the specific costs of pollution and how much the supply curve shifts. In general, if the external cost of pollution is high, it might cause a significant leftward shift of the supply curve, leading to increased prices and reduced output.

Key concepts

Supply and Demand Graph Analysis

When it comes to understanding market economics, a supply and demand graph is a fundamental tool that displays the relationship between the price of an item and the quantity of that item that consumers are willing and able to purchase at various prices.

Supply represents the quantity of a good or service that producers are willing to sell at different prices, usually depicted by an upward sloping line, indicating that higher prices motivate producers to supply more. Demand, on the other hand, shows the quantities that consumers are willing to purchase at different prices, shown as a downward sloping line, suggesting consumers buy less as the price increases.

In the context of fracking and natural gas markets, initially, the application of fracking technology increased the supply of natural gas, effectively shifting the supply curve to the right—that is, for any given price, suppliers are willing to provide more natural gas. This leads to a decrease in the price of natural gas and an increase in consumption, moving the equilibrium point where the supply and demand curves intersect to a position with a lower price and higher quantity.

Externalities in Economics

Externalities in economics refer to the costs or benefits that affect parties who did not choose to incur those costs or benefits. They can be either positive or negative. A negative externality occurs when the production or consumption of a product leads to costs that are not reflected in the price of the good or service—think of pollution from factories that affects the health of people living nearby.

In our scenario with fracking, the negative externality is pollution, which might include contamination of groundwater. This pollution is an external cost not accounted for in the natural gas market price. From an economic perspective, the socially optimal level of production would be lower than what is determined by the market, because the market doesn’t factor in the costs of pollution. If regulations or taxes are introduced to account for this externality, the supply curve would shift leftward, indicating a reduced supply at any given price due to the higher production cost, which includes the cost of managing the environmental impact.

Equilibrium Price and Quantity

The equilibrium price and quantity in a market are determined by the intersection of the supply and demand curves. They represent the most efficient allocation of resources at that particular time, given the existing supply and demand conditions, where the quantity supplied is exactly equal to the quantity demanded.

With the introduction of fracking technology—assuming no pollution—the supply of natural gas increases, leading to a lower equilibrium price and a higher equilibrium quantity. When pollution is accounted for, it is represented as an external cost which causes a leftward shift in the supply curve. The new equilibrium, with this leftward shift, will likely have a higher equilibrium price and a lower equilibrium quantity compared to the situation without accounting for pollution.

It is important to note that the new equilibrium reflects a more socially optimal point, where the true costs of production, including those of the negative externalities, are being considered. However, the exact change to equilibrium price and quantity will depend on the magnitude of the externality costs and the market's sensitivity to price changes. The uncertainty lies in these variables as they dynamically interact with the consumers’ willingness to pay and producers’ costs.