Question

(Related to the Apply the Concept on page 203) An article in the Wall Street Journal notes that although U.S. oil production has increased rapidly in recent years, the increase has still amounted to only 5 percent of world production. Still, that increase has been "enough to help trigger a price collapse." Briefly explain under what circumstances a small increase in supply can lead to a large decline in equilibrium price.

Short answer

A small increase in supply can lead to a large decline in equilibrium price when the demand for the product is inelastic. In the case of the oil industry, a 5% increase in supply can decrease global prices significantly due to the inelastic nature of oil demand, as consumers continue to buy oil products even with price variations, due to the lack of substitutes.

Step-by-step solution

Understanding Equilibrium

Equilibrium is the state where supply equals demand. When supply increases, while demand remains unchanged, a surplus occurs, leading to a lower equilibrium price. This step involves understanding the basic principles of supply and demand.

Applying Supply Increases

An increase in the supply of a product usually results in a decrease in its price. In the exercise, the supply of oil has increased by a small percentage (5%). Apply this concept to understand the changes in the oil market scenario.

Understanding Price Elasticity

Price elasticity of demand refers to how changes in price will affect the quantity demanded. The greater the elasticity, the larger the impact of a change in supply on price. In the exercise, the demand for oil is usually inelastic though, because consumers continue to buy oil products even when prices increase, due to the lack of substitutes.

Relating Elasticity and Supply Increase

The small increase in supply and the inelastic nature of demand for oil could mean that any increase in supply can lead to significant changes in price. Here, it's important to understand that although the increase in supply is 5% of world production only, it can have a significant effect on global prices because of the relative inelasticity of demand for oil.

Key concepts

Supply and Demand

Supply and demand are two fundamental concepts in economics, painting the picture of the market for goods and services. The supply curve represents how much producers are willing to sell at different prices, while the demand curve depicts how much consumers are willing to buy. The point where these two curves intersect is known as the equilibrium, where the quantity supplied equals the quantity demanded.

In cases where supply increases, but demand remains constant, a surplus is created. This surplus means more products are available than people wish to buy. To clear the surplus, prices must fall, leading to a new lower equilibrium price. Conversely, if demand increases but supply is constant, prices rise. This simple interaction shows how shifts in supply and demand affect market prices.

Understanding these principles helps explain why even a small increase in supply, like the 5% increase in U.S. oil production, could cause a price collapse. In this scenario, the market adjusts to find a new equilibrium, driving prices down.

Price Elasticity

Price elasticity is a concept that explains how responsive the quantity demanded is to a change in price. It offers insights into consumer behavior when prices fluctuate.

When demand is elastic, a small change in price causes a large change in the quantity demanded. In contrast, inelastic demand means that a change in price results in a small change in quantity demanded. This is typically the case for essential goods, like oil, where consumers continue purchasing despite price changes due to limited alternatives.

The oil market often exhibits inelastic demand because oil is a necessary commodity for many aspects of daily life and industry. As a result, even a small increase in supply can lead to a significant price drop. This is because the relative inelasticity of demand means that it does not greatly decrease when prices drop, allowing the increased supply to push prices down.

Oil Market Dynamics

Oil market dynamics are influenced by a unique mix of supply, demand, and external economic and geopolitical factors. Understanding these aspects is crucial for grasping how global oil prices are determined.

One of the key dynamics is the inelastic nature of oil demand. Most consumers and industries are heavily reliant on oil, leading to consistent demand regardless of price fluctuations. However, when supply increases, such as a 5% increase in U.S. oil production mentioned in the exercise, prices can dramatically decrease due to the inelasticity of demand.

Another factor is the global nature of the oil market. Oil is traded worldwide, meaning changes in one region can have worldwide impacts. Political stability, technological advancements, and discoveries of new oil reserves can also shift supply dynamics, adding to the complex interactions that define oil market dynamics.

Ultimately, these dynamics illustrate why even minor shifts in supply or demand can have outsized effects on oil prices, making the oil market particularly sensitive to changes.