Report on Events Impacting the Supply and Demand of Oil

Graphing Supply and Demand

Supply and demand are so important for both consumers and producers because both of these concepts work together to determine the overall price

of an item, as well as the total quantity sold in a market. To see how this

works, we can show both on a graph such as you see in the header image

above.

Remember that demand is a relationship between price and the quantity that

consumers are willing and able to pay. This is an inverse, or negative,

relationship, in which the variable's price and quantity move in opposite

directions. This would be depicted as a downward sloping curve on a graph.

Similarly, supply is a relationship between the price of an item and the

quantity that producers are willing to supply. This is a direct, or positive,

relationship, in which the variable's price and quantity move in the same

direction. This would be depicted as an upward sloping curve on a graph.

Since both curves use the same variables, prices, and quantities, they can be

combined on the same graph to yield some very useful information. Price will

always be on the vertical axis, or the y-axis, while quantity will be on the

horizontal axis, or x-axis. Notice the point where the supply curve and the

demand curve intersect. This is called the equilibrium point. From this point,

we can draw a line to the price axis to find the equilibrium price, labeled as

"P." A line drawn to the quantity axis will yield the equilibrium quantity,

labeled as "Q." When we are selling at the equilibrium price, the market is

referred to as being in equilibrium.

We can also determine equilibrium by analyzing a table of values. Looking at

the table below, you see a few things that are immediately apparent. As the

price of an item increases, the quantity demanded decreases. This is

consistent with the law of demand. As the price of an item increases, we see

the quantity supplied increases as well, which is consistent with the law of

supply. The point of equilibrium is at the price of $4, since the quantity being

supplied is equal to the quantity being demanded of 500,000 units.

Price Quantity Demanded Quantity Supplied

$1 900,000 100,000

$2 800,000 250,000

$3 600,000 400,000

$4 500,000 500,000

$5 350,000 600,000

$6 200,000 750,000

$7 100,000 800,000

You could also plot these numbers out to create corresponding demand and

supply curves, and you would reach the same conclusion. The two curves

would intersect at an equilibrium point giving an equilibrium price of $4 and an

equilibrium quantity of 500,000 units.

Shortages and Surpluses When the market is in equilibrium, this means the quantity supplied is equal to the quantity demanded. There is no unused product sitting on store

shelves, nor is there product being demanded and not produced. The first

situation is referred to as a surplus. Have you ever seen a product collecting

dust on store shelves? This is a surplus in action. The quantity produced was

greater than the quantity being demanded, so there was no one that was

willing and able to purchase the additional product at the given price. The

second scenario is called a shortage. An example of this would occur when

producers underestimate the quantity consumers will demand of an item at a

given price. This happens every year around the holiday season. There are

always a few toys which will be in very high demand. If producers do not

accurately predict the demand for an item, a shortage will occur, and these

toys will be difficult to find.

The interesting thing about economics is that the market will autocorrect to

eliminate most shortages and surpluses—given enough time—so long as the

market is allowed to operate freely and without influence from the

government.

In the mid-1700s, an economist named Adam Smith formulated the now

famous "invisible hand" theory. He postulated that markets will autocorrect

when resources are not put to their most efficient use. Individual consumers

will demand the goods and services that they most need and want, while

individual producers will supply those goods and services which will provide

them with the most available profit. While each individual consumer and

producer acts in his or her own best interest, the market as a whole will

operate in such a manner so that resources will be used efficiently. The

supply and demand essentially acts as an "invisible hand," guiding the market

to the equilibrium price and the equilibrium quantity.

Let us take a look at the graph below where the equilibrium price of a good or

service is $4. However, producers of the item have initially set the price too

high at $5. Producers will want to sell quite a bit, with consumers demanding

very little at this high price, resulting in a surplus. The point where the price

line intersects the demand curve tells us the quantity demanded at that price,

which is 150 units. Continue to follow the price line until it intersects the supply

curve to find the quantity supplied, which is 250 units. The difference between

these two figures is the amount of the surplus, or 100 units.

We know that the surplus will result in this product sitting on store shelves or

hidden away in a warehouse. However, a producer's incentive is to make a

profit and revenue will not be earned by unsold products. The producer will

start to decrease the price until the equilibrium price of $4 is reached. At this

point, 200 units will be supplied, 200 units will be demanded, and the market

will be in equilibrium.

What happens when the opposite occurs, and the producer sets the price too

low? In the example below, producers initially set the price at $3, below the

equilibrium price of $4. This results in a shortage, with consumers demanding

250 units, but only 150 are being produced at this low price. This results in a

shortage of 100 units. Producers see that they can charge more for the item

due to the high quantity being demanded at the current price, so they will

increase the price until the equilibrium price of $4 is reached. The market will

then be in equilibrium, with 200 units being supplied and demanded, with no

resulting shortage or surplus.

Price Ceilings and Price Floors

We know that the market will autocorrect to eliminate most shortages and surpluses. However, this will only happen in a free market which is allowed to

operate independently and without influence from the government.

Sometimes, the government does feel the need to get involved in market

affairs in order to protect a segment of the population. They do this by

enacting price floorsand price ceilings. However, this can lead to an

imbalance in the market, which results in shortages and surpluses.

If the government feels that the price of a good or service is too low, it can

enact a price floor. A price floor is a minimum price that must be paid for a

good or service. When it comes to the labor market, many government

officials believe it is beneficial for workers to receive a wage that allows them

to have their basic needs met. The minimum wage is one example of a price

floor, since that is the minimum price that firms are allowed to pay laborers.

Conversely, if the government feels that the price of a good or service is too

high, it can enact a price ceiling. A price ceiling is a maximum price that

sellers can charge for a good or service. One example of a price ceiling is a

price-gouging law. During natural disasters, the demand for essential goods

can skyrocket. Many states and local governments enact price-gouging laws

that prevent firms or individuals from making exorbitant profits at the

consumers' expense on items such as water, ice and other vital necessities

that are needed after a natural disaster.

While price ceilings and price floors are created in order to solve a problem,

there is also an unintended side effect. Let us take a look at the graph below,

which illustrates a price floor, such as minimum wage.

Let us assume that the equilibrium price for unskilled labor is $5, with an

equilibrium quantity of 20 million. However, the government creates a

minimum wage of $7.25. This higher price will result in 22 million jobs being

supplied by unskilled laborers, with only 18 million being demanded by firms.

This creates a surplus of 4 million unskilled workers who are looking for jobs,

but cannot find them. Most of the time, the market will autocorrect to eliminate

this surplus, but the price floor prevents the market from reaching its

equilibrium price and quantity, so the surplus persists in the long-run.

Next, let us take a look at what happens when a price ceiling is enacted. The

graph below depicts a price ceiling of $3 for a bottle of water after a natural

disaster. Because demand can skyrocket after an earthquake, hurricane, or

when supplies are limited, the equilibrium price for water may be as high as

$8 a bottle. Because the government may deem this item necessary for

survival, they could choose to cap the price at $3. While 130,000 bottles of

water would be supplied and demanded under normal circumstances, the

price ceiling causes 100,000 to be supplied, with 160,000 being demanded.

This results in a shortage of 60,000 bottles of water. Again, the market would

normally autocorrect, but will not in this instance so long as the price-gouging

law is in place.