Question

In a recent year, a long, hard winter gave rise to stronger-than-normal demand for heating oil. The following summer was characterized by strong demand for gasoline by vacationers. Show what these two events might have done to the short-run \(M C, A V C\), and \(A T C\) curves of Continental Airlines. (Hint: How would these events affect the price of oil?)

Short answer

The increased demand for heating oil and gasoline, leading to raised oil prices, will cause the MC, AVC, and ATC curves of Continental Airlines to shift upward in the short-run due to increased costs for jet fuel.

Step-by-step solution

Impact on Oil Prices

First, consider the effects of the hard winter and strong summer demand for gasoline on the oil market. Both heating oil and gasoline are derivatives of crude oil. An increase in demand for both will likely cause the price of crude oil to spike upward due to the inelastic short-term supply of oil.

Impact on Airline Costs

Next, consider the impact of higher oil prices on Continental Airlines. Jet fuel, a significant variable cost for airlines, is also derived from crude oil. As the price of oil rises, the cost of jet fuel will also rise. This will increase both the variable and total costs for the airline.

Shifts in Cost Curves

Finally, consider how these cost increases translate into shifts in the cost curves. A rise in variable cost due to more expensive fuel will cause the AVC and MC curves to shift upward. Since ATC is also affected by changes in variable costs, the ATC curve will also shift upward.

Key concepts

Cost Curves

Cost curves are vital in understanding how costs change with output in microeconomics. In particular, we look at curves like Marginal Cost (MC), Average Variable Cost (AVC), and Average Total Cost (ATC). Each curve describes a different aspect of costs.
In short, MC shows the cost of producing one more unit of output, while AVC displays the average cost of variable inputs per unit. ATC combines both fixed and variable costs averaged over all units.

• MC Curve - Represents change in total cost from producing an additional unit.
• AVC Curve - Shows the average of variable costs per unit of output.
• ATC Curve - Reflects the average total cost including both fixed and variable.

When oil prices increase, these cost curves shift. Specifically, both AVC and MC rise because producing each unit now costs more due to higher input costs like fuel. Consequently, ATC rises as variable costs form a part of total costs.

Variable Costs

Variable costs are expenses that change in proportion to the level of production. These include inputs that can vary, such as fuel, materials, and labor. For airlines, fuel constitutes a substantial variable cost.
When there's a rise in oil prices, the cost of jet fuel increases. This affects the variable costs directly. As variable costs go up, so does the cost of producing one more unit, which is a direct implication on the Marginal Cost (MC) curve.
The sudden rise in variable costs will impact an airline's overall cost structure. It makes day-to-day operations significantly more expensive, especially for airlines, where fuel is a key component of cost.

• Variable costs fluctuate with production output.
• Jet fuel for airlines is one major variable cost.
• High oil prices drive variable costs up, affecting profitability.

Price of Oil

Oil prices exert significant influence on the economy due to oil's role as a critical input in many industries. Its price is primarily determined by supply and demand dynamics in the market.
In this scenario, a harsh winter and an increased summer demand for gasoline spurred demand for crude oil. This heightened demand likely pushed oil prices up because short-term adjustments in oil supply are limited.
Understanding the inelasticity of oil supply in the short term is crucial. Often, oil production cannot quickly accommodate sudden spikes in demand. Hence, any surge in demand can lead to a notable price increase. This volatility affects all oil-dependent sectors, like airlines, inducing shifts in their cost structures.

• Oil is a crucial input with extensive economic influence.
• Prices rise when demand spikes and supply remains inelastic.
• Sudden demand changes can cause significant cost impacts on industries reliant on oil.

Demand and Supply

The concepts of demand and supply are central to microeconomics. Demand refers to the quantity of a product or service consumers are willing to purchase at various prices, while supply covers the amount producers are willing to sell.
When the demand for heating oil rises during a harsh winter, and for gasoline during the summer vacation period, it affects the overall demand for crude oil. These seasonal changes can shift the demand curve to the right, indicating higher demand at all prices.
Since oil supply can't quickly adjust upwards due to infrastructure and investment constraints, the short-run price of oil spikes. This shift in demand and relatively static supply results in higher market prices.

• Demand Curve - Shifts right with increased demand.
• Supply Curve - May remain static in the short term.
• Supply-demand imbalances drive price changes.

Factors impacting demand and supply include seasonal demands, economic conditions, and technological changes that can all influence these curves.