Transcript Supply and Demand

Commodity Markets
Chap. 3, 4
Oil
Prices
Link
Brent North Sea Price
Oil Prices Rise,
Production Stays
Flat
120.00
100.00
US$/BBL
80.00
Link
60.00
40.00
Total World Oil Production
90000
80000
70000
60000
50000
40000
30000
20000
10000
0
0.00
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
20
01
20
02
20
03
20
04
20
05
20
06
20
07
20
08
20
09
20
00
Thousand barrels daily
20.00
BP Statistical Review 2010
Why are commodity prices so
volatile?
• Prices are shifted by changes in supply and
demand.
• The less price sensitive are supply and
demand, the more volatile prices will be.
What determines price elasticity?
Availability of Substitutes
• A price increase will lead to a shift away from
the use of a product and toward other products.
– Price elasticity will be stronger if there are readily
available substitutes for a good.
World Bank Tobacco Download
• A price increase for one good reduce income
available for purchases for all goods
– Price elasticity will be stronger if a good makes up a
big chunk of income.
Comparisons of Demand Price
Elasticities
• Commodities have
very inelastic
demand.
Price Elasticities of Other Goods
Salt
– Estimate of elasticity
Coffee
of demand for oil in
Tobacco
the US is .061
J.C.B. Cooper, OPEC Review, 2003)
Movies
– Estimate of elasticity
of world demand for Housing
copper is .03 Vial, Columbia Restaurant Meals
Earth Institute
.1
.25
.45
.9
1.2
2.3
Elasticities Extreme
P
Perfectly Inelastic
Demand (Insulin)
D
Perfectly Elastic
Demand (Clear Pepsi)
D
Q
A demand curve is classified as INELASTIC
if the elasticity is between 0 and 1
Unit elasticity (elasticity equal to 1) is
the cutoff point
A demand curve is classified as
ELASTIC if the elasticity is less than 1
Demand Curves
Elastic
Unit
Inelastic
Prices and Revenue
•
•
Revenue in a market is Revenue = P∙Q
If prices change, revenue will change for two
reasons:
1. Direct Effect of the Price Change (positive)
2. Indirect Effect of the Price Change on Quantity
Demanded (negative)
•
Rule of Thumb: The percentage change in the
product of two variables is the sum of the %
change in each variable.
Price Elasticity of Revenue
% Revenue  % P  %Q
% Revenue
%Q
 1
 1  elasticity
%P
%P
• If demand is elastic, a price rise reduces revenues
• If demand is inelastic, a price rise increases revenues
Elasticity of Supply
• Elasticity of supply curve depends on the
ability of production sector to ramp up
supply without increasing the marginal cost
of production.
• A good that is produced with readily
available factors w/o a need for time
consuming investment will have an elastic
supply curve.
Elasticities: Supply
P
Perfectly Inelastic Supply
(Van Gogh Paintings)
Perfectly Elastic S
Supply (Foot
Massage)
S
Q
Price Elasticity and Time
Elasticity of Demand
Short-term vs. Long-term
• It takes time to find substitutes for goods or
to adjust consumption behavior in response
to a change in prices.
• The long-run demand response to a price
rise is larger than the short-run. Price
elasticity of demand is more negative in the
long run than in the short run.
.
Oil Demand much more elastic in
long run than short-run
Short-term
Germany
0.024
Japan
0.071
Korea
0.094
USA
0.061
Long-term
0.274
0.357
0.178
0.453
–(J.C.B. Cooper, OPEC Review, 2003)
Copper too…
Price Elasticity
ST
LT
Canada
0.118
0.229
USA
0.061
0.274
UK
0.098
0.638
Italy
0.03
0.1
Price Elasticity of Supply
• Firms also find it easier to adjust production in
the long-run than the short run. Long-run price
elasticity of supply is typically greater than
short-run
• OECD study suggests price elasticity of oil
supply is .04 in short run and .35 in long run.
• Columbia study suggests price elasticity of
copper is .05 in the short run and .15 in the long
run.
Demand Curves
P
Short-term
Long-term
Q
Oil Supply Curves
P
Short-term
Long-term
Q
Changing Equilibrium
Income Elasticity/ Cross Price
Elasticity
What shifts a demand curve?
1. Changes in consumer preferences
2. Changes in (current or future) consumer
income
3. Changes in the prices of other goods that
are complementary to or substitutes for
other goods.
Income Elasticity
• We measure the effect of income on
demand for a good as % effect on demand
of a 1% increase in income.
• For normal goods, income elasticity is
positive.
• For inferior goods income elasticity is
negative.
Luxuries vs. Necessities
• There are two types of normal goods.
• Luxuries take up an increasing share of income as
your income grows.
– Luxuries are income elastic - the income elasticity of
luxuries is greater than 1.
• Necessities take up a declining share of income as
your income grows.
– Necessities are income inelastic – the income elasticity
of luxuries is less than 1.
China’s Emerging Middle Class Download
Inferior Goods
Range of Income
Elasticities
Normal Goods
1
0
Income Inelastic
(Necessities)
Income Elastic
(Luxury Goods)
Income Elasticity of Oil
Region
China
Income
Elasticity
0.7
OECD
0.4
ROW
0.6
Source: OECD study
• Assume a world
income elasticity
of .5 and an
increase of world
income equal to
10%. Demand
shifts out by 5%.
• Would oil
production supplied
increase by 5%?
Market Equilibrium
(Spreadsheet Problem)
At what price and quantity (to closest $10) will the oil
market clear?
Note: Did not use midpoint method
P
60
70
80
90
100
110
120
130
140
150
Q
P
80,059.86
81,303.55
82,396.49
83,372.72
84,255.78
85,062.66
85,806.03
86,495.60
87,138.99
87,742.26
60
70
80
90
100
110
120
130
140
150
Q
83,033.06
81,762.92
80,678.38
79,733.70
78,898.04
78,149.63
77,472.59
76,854.95
76,287.50
75,762.98
Q'
87184.72
85851.07
84712.3
83720.39
82842.94
82057.11
81346.22
80697.7
80101.88
79551.13
Expected Income Effect
• Households are forward looking.
If they expect income in the
future they will increase spending
today.
• Optimism (or pessimism) about
future income will shift demand
curve.
Changes in Prices of Other Goods
•
For any good there are two types of other
goods which are relevant to its demand
1. Substitutes: Those other goods which can
take the place of the good of interest
(bacon vs. ham)
2. Complements: Those other goods whose
use will enhance the value of the good of
interest. (bacon and eggs)
What are substitutes and complements for oil
Substitutes vs. Complements
• A good is defined as a “Substitute”
when a rise in its price leads to a shift
out/up in the demand curve for the
good of interest.
• A good is defined as a “Complement”
when a rise in its price leads to a shift
in/down in the demand curve for the
good of interest.
Cross Price Elasticity
• Cross price elasticity is the % effect on the
quantity demanded of a % change in another
price.
– Goods with positive cross-price elasticities are
called substitutes
– Goods with negative cross price elasticities are
called complements
0
Complements
Substitutes
Cross Price Elasticity of Copper
Cross Price Elasticities
Aluminum
Energy
Germany
0.11
South Korea
0.29
France
-0.1
Italy
0.089
-0.076
What Shifts the Supply Curve
•
•
Supply curves represent the extra cost of
producing a good which increases in the
number of goods produced. But other factors
may affect cost besides scale.
Cost Shifters
1.
2.
3.
4.
Changes in resource prices
Changes in Technology
Nature and Political Disruptions
Changes in Taxes on Producers
Speculation & Supply
• Some commodities have a time dimension.
Producers have a choice about when to
bring goods to market. If producers believe
prices will be higher in the future, they have
an incentive to delay shipment to the future.
• Higher price expectations will shift the
supply curve inward.
Note: This won’t work for apples, oranges or other
perishable commodities.
Expectations of Increased Prices in the
Future Lead to Higher Prices Today!
P
S′
D
S
P**
P*
Q** Q*
Q
Speculation and Demand
• For some storable commodities (e.g. gold)
or durable goods, expectations of future
price hikes might also lead consumers to
start buying immediately.
• Higher price expectations will shift demand
curve outward.
Even higher prices!
P
D
D'
S'
S
P***
P**
P*
Q** Q*
Q
Bubbles
• If current prices can be driven by
expectations of even higher prices in the
future…and…investors pile into
commodities whose price has risen, then
this could generate a feedback loop
featuring rapidly rising prices
Think about for fun. Too
theoretical for exam.
Learning Outcomes
• Distinguish substitutes/complements,
luxuries/necessities/inferior goods.
• Identify the impact of demand & supply
elasticity on price and quantity volatility in
the short and long run.
• Identify the impact of expectations of the
future on current prices.