6/24/11

Why are gas prices so high? The basics of Supply and Demand.


Everyone is feeling the pinch of high gas prices, but what is the cause?  People blame the middle east, claiming that OPEC (Organization of the Petroleum Exporting Countries) is limiting production.  Others blame the speculators, saying that they are investing money into oil that they never plan on buying which is increasing prices.  And finally, some blame developing countries like China, India and Brazil for increasing the demand of oil, making the price go up.  No one really knows what is causing the volatility of prices, but each of these examples do play a role.

Let’s begin with a simple supply and demand graph for the World market of gasoline (or oil).  On our Y axis we have the price of oil, and on the X axis, the quantity of oil.  We can set our equilibrium quantity will be set at around 7 million barrels/day and the equilibrium price at $100.




Here the S curve is for supply of oil, and D is for the demand of oil (remember, d is for down, we don’t like upward sloping demand curves).  



So this is our market equilibrium, but what if we think that OPEC is limiting quantity?   This would be a decrease in supply (moving from S to S1), or a leftward shift meaning that at any given price level, OPEC is willing to supply less Oil then they were before.  The new equilibrium price would be higher than before because of the cutback.  The new equilibrium quantity would be lower as well.  These results are shown below:



Or we could interpret how the introduction of spectators (or more spectators) could affect the market.  Here the main cause for a shift in demand would be an increase in the number of buyers.  Because there are now more buyers in the market, we would see an increase in demand (or a rightward shift).  This is represented by a shift from D to D1.  As you can see in the graph below, the increase in the amount of spectators causes equilibrium price and equilibrium quantity to rise.






Finally we can analyze how an increase in economic growth of the rest of the world would affect this market.  This would have the same effect as the increase in spectators, increasing demand.  Perhaps the reason would be a little different because other countries could have more income, thus it would be an income effect, or perhaps countries are entering the market for the first time so there is an increase in the number of buyers.  Either way we get an increase in demand, with the results shown below:


 Now we can look at the depressing scenario of gas prices with all three of these events occurring at once (which is probably what is happening in the real world today).  This requires three different shifts, one to the supply curve, and two to the demand curve.  The result is a significantly higher price for gas, but an ambiguous change for quantity (it could result in higher, lower, or the same quantity depending on the magnitude of the shifts).  One example outcome is shown below:


So now you understand how basic economics can be used to explain the high and growing higher prices of gas.


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