Question

Example 2.9 (page 76 ) analyzes the world oil market. Using the data given in that example: a. Show that the short-run demand and competitive supply curves are indeed given by \\[ \begin{array}{l} D=36.75-0.035 P \\ S_{C}=21.85+0.023 P \end{array} \\] b. Show that the long-run demand and competitive supply curves are indeed given by \\[ \begin{array}{l} D=45.5-0.210 P \\ S_{C}=16.1+0.138 P \end{array} \\] c. In Example 2.9 we examined the impact on price of a disruption of oil from Saudi Arabia. Suppose that instead of a decline in supply, OPEC production increases by 2 billion barrels per year (bb/yr) because the Saudis open large new oil fields. Calculate the effect of this increase in production on the price of oil in both the short run and the long run.

Short answer

The given equations indeed represent short-run and long-run demand and supply curves in the world oil market. The increased OPEC production causes a decrease in the price of oil in both the short-run and the long-run, with exact values being calculated in steps 3 and 4.

Step-by-step solution

Validate Short-run Demand and Supply Curves

Given the short-run demand (D) and supply (S_C) equations, these represent typical linear demand and supply curves where the price (P) has a negative relationship with demand and a positive relationship with supply. These relationships are standard in economics as price increases, demand decreases and vice versa, but supply increases as price increases.

Validate Long-run Demand and Supply Curves

Similarly for the given long-run demand and supply equations. Here as well, price has a negative relationship with demand and a positive relationship with supply. So these equations do fit the criteria for long-run demand and competitive supply curves.

Calculate Effect of Increased Production on Price in Short-run

To calculate the effect of 2 billion barrels per year increase in supply by OPEC, first consider the short-run. This increase in production effectively increases the supply. So, the supply equation must be adjusted for this increase: \(S_{C}=21.85+0.023 P + 2\). Then, set this new supply equal to the short-run demand to find the new price: \(36.75-0.035 P = 21.85+0.023 P + 2\). Solving this for P gives the new price in the short-run.

Calculate Effect of Increased Production on Price in Long-run

For the long-run, the process is the same but use the long-run demand and supply equations. Adjust the long-run supply for the increased production: \(S_{C}=16.1+0.138 P + 2\). Set this equal to long-run demand and solve for P to find the new price in the long-run: \(45.5-0.210 P = 16.1+0.138 P + 2\).

Key concepts

Short-run Demand

Short-run demand refers to the quantity of oil that consumers are willing to purchase over a short period as a reaction to price changes. In our context, the short-run demand curve shows that if the price of oil ( P ) increases, the demand decreases, and vice versa. This is represented by the equation D=36.75-0.035P .

• The equation’s negative slope (-0.035) indicates that demand decreases with higher prices.
• The constant (36.75) shows the quantity of demand when price effects are not present.

In the short run, consumers may have limited alternatives or the capacity to change their consumption patterns quickly, resulting in this relatively inelastic demand.

Competitive Supply Curve

The competitive supply curve demonstrates the amount of oil producers are willing to supply at various prices, considering market competition. The supply equation is given by S_C=21.85+0.023P , which has a positive slope.

• The positive relationship (0.023) means producers supply more oil when the price is higher, as it allows better profit margins.
• The constant term (21.85) indicates the production level when price effects are not factored in.

In a competitive market, supplying oil depends on factors such as production costs and marginal costs of extraction, and these costs typically dictate the supply curve’s slope.

Long-run Demand

Long-run demand accounts for the changes in consumption patterns over an extended period. The equation representing long-run demand is D=45.5-0.210P . In the long run, consumers can adjust their habits more significantly in response to price changes.

• The steep negative slope (-0.210) indicates that demand is more sensitive to price changes over time.
• The higher constant (45.5) compared to short-run demand reflects expected baseline consumption irrespective of price.

Long-run demand can be influenced by factors like technological advances, alternative energy availability, and changes in consumer behavior.

OPEC Production

OPEC, the Organization of the Petroleum Exporting Countries, plays a pivotal role in determining global oil supply and price levels through its control over production. An increase in OPEC production, such as by 2 billion barrels per year, directly affects the supply equations.

• In the short run, increased supply can depress prices as supply surpasses demand.
• In the long run, persistent high supply levels could encourage demand adaptations but also put downward pressure on prices.

Understanding OPEC’s production strategies helps predict drastic supply changes and equilibrium shifts in the global oil market.

Market Equilibrium

Market equilibrium in the context of oil supply and demand is the point where the quantity of oil demanded equals the quantity supplied, determining the market price. For both short-run and long-run scenarios, equilibrium conditions are found by setting demand equal to supply.

Calculating equilibrium helps forecast how changes, such as OPEC’s production increase or geopolitical events, might influence prices.

• Short-run equilibrium quickly highlights immediate market responses.
• Long-run equilibrium takes into account broader adaptations in supply and demand response over time.

Grasping equilibrium shifts is crucial to understanding energy economics and its impact on global markets.