The aim of this version is to examine how volatility in the supply of a key input to the production of a final good, affects the equilibrium in the market for that final good. You will also consider how a tax in the market for the final good affects the equilibrium and whether the effects of the volatility are dampened or amplified. One of the strengths of economics is that it traces the consequences of one event on various markets and groups in society.
Consider the market for petrol. Oil is a world commodity and the primary input into the production of petrol. In most developed economies, petrol is also heavily taxed. Demand for petrol tends to be relatively very inelastic in the short run. Supply of petrol is also very inelastic in the short run, and is subject to international political events.
We will distinguish between the market for the final good, petrol, and the market for the input, crude oil. Within each economy, the market for petrol is an oligopolistic market of a few major multinational firms, such as Chevron, BP, ExxonMobil, Royal Dutch Shell, Conoco Phillips, and Total, and several others, including several state-controlled companies. In an oligopoly, each firm faces its own downward-sloping demand curve, much like a monopolist does. The difference is that the monopolist faces the market demand whereas each oligopolist faces a residual demand. Although the market is oligopolistic, for our purposes, consider the market for petrol to be perfectly competitive. The market for crude oil is controlled largely by OPEC – an extralegal cartel Organization of Petroleum Exporting Countries – and a few others, such as Russia, Canada, Mexico, Norway, and the United States.
Task 1: Describing the Equilibrium in the Market for Petrol
Construct two graphs that exhibit equilibrium in the petrol market – assume that there are no taxes. Clearly label the equilibrium values.
(a) Graph the AFC, AVC, ATC, and MC functions and demand curve faced by a typical firm in this industry, and
(b) Graph the industry demand and supply – show the consumer’s surplus and producer’s surplus for the industry.
Task 2: Elasticity
Explain the concept of elasticity and describe why the supply of petrol in the short run is relatively inelastic.
Task 3: Adverse Supply Shock
The aim of this task is to explore the effects of a supply shock on a firm and thereby on the industry.
Suppose that war breaks out in the Middle East, where a considerable portion of the world’s oil is produced.
(a) Describe, in words and on your graphs, any changes to (i) demand, (ii) supply,
(iii) The petrol manufacturer’s optimal quantity, (iv) the short-run equilibrium industry quantity, (v) the short-run equilibrium price, (vi) the short-run consumer’s surplus, and (vii) the short-run profits.
(b) Some countries that supply oil to petrol manufacturers are located in or near the Middle East; others are not located in or near the Middle East.
(i) Does the war benefit or harm countries located in or near the Middle East if they are directly involved in the war?
(ii) Does the war benefit or harm countries located in or near the Middle East if they are not directly involved in the war?
(iii) Does the war benefit or harm countries located outside the Middle East?