Consider the graph of crude oil prices in Figure 14.1. a) Explain how a decrease in price could

step 1 This problem covers the concepts in supply and demand. The problem asks us to use a supply and d

Consider the graph of crude oil prices in Figure 14.1. a)...

Key Concepts

Hotelling's Rule

Hotelling’s rule is a fundamental concept in the economics of non?renewable resource extraction that states the net price (market price minus extraction cost) of a resource should rise at the rate of interest over time. This rule reflects the idea that resource owners are balancing the immediate profit from extraction against the future value of their remaining reserves, taking into account the opportunity cost of depleting the resource today rather than earning interest on the capital.

Discounting and Opportunity Cost

The concept of discounting is central to Hotelling’s rule, as it involves comparing the benefits of extracting a resource today versus in the future. Even if the rule predicts an upward trend in prices to match the interest rate, temporary price decreases can occur if market conditions or other factors cause short?term deviations, because owners may postpone extraction due to expected changes in future profitability, reflecting the opportunity cost of immediate extraction.

Assumptions Underlying the Model

Hotelling’s rule is built on several simplifying assumptions such as constant extraction costs, perfect competition, no technological change, and a certainty of future demand. In real-world situations, particularly in resource markets like oil, these assumptions often fail to hold. For instance, extraction costs can vary due to changes in technology or scale economies, and markets might be influenced by geopolitical factors or cartel behavior, leading to observed price patterns that deviate from the theoretical prediction.

Transcript

00:01 This problem covers the concepts in supply and demand.

00:04 The problem asks us to use a supply and demand diagram to represent each of the following scenarios.

00:10 Let's begin.

00:12 For part a, let's begin by drawing a supply and demand diagram.

00:17 I'll put q on the x -axis representing quantity and p on the y representing price.

00:24 S -line represents the positive relationship between price and quantity, while the d -line represent the negative relationship between price and quantity.

00:32 The equilibrium price is the intersection is resulted from the intersection between line s and d we'll call it p1 and the equilibrium quantity of q1.

00:46 So the scenario in a says the improvement in transportation costs lower transportation lowers the cost of importing oil into the united states in the 60s.

00:55 What's this scenario going to do to this graph? now since the transportation cost of oil is lowered, there will be a lot of people trying to get the oil at a lower price.

01:07 And once there's many, many people getting to know the news, there will be a higher demand for oil at such a low price.

01:14 And as there are higher demand for oil, this will drive the demand curve from d1 to d2.

01:24 So the demand curve will shift up, resulting in an equilibrium price, a p2, which is higher than p1, and a equivalent of quantity of q2 which is either than q1.

01:43 Okay, let's do the same thing in b.

01:52 So the scenario in part b suggests that after the war, after a 73 war, oil producers cuts oil production sharply.

02:04 So what's going to happen to this supply and demand graph? now, once the oil supply supply is cut substantially by the oil producers, the supply of oil would intuitively drop.

02:20 So to represent this drop, line s1 will shift downwards to line s2, forming a lower equilibrium price by the higher equilibrium quantity.

02:34 Okay.

02:41 For part c, let's draw this again.

02:45 Supply and demand, equilibrium price p1, quantity price quantity q1, sorry.

02:56 And for scenario c, it says after the 80s, 1980, smaller automobiles get more miles per gallon.

03:09 So as smaller automobiles get more miles per gallon, this means that it's more efficient for smaller automobiles to use the oil.

03:20 That means the efficiency of having per gallon oil increases.

03:24 This will shift the whole demand curve up because people knows that just a gallon of oil will now result in a more efficient travel time of smaller vehicles.

03:38 And those owning smaller vehicles would demand more oil at this point, driving the oil demand up from d1 to d.

03:50 And this graph looks similar to part a, resulting in the price of p2, higher than p.

03:58 Q2, higher than q1.

04:03 So for the fourth scenario, it says that a record -breaking cold winter in 95 to 96 i expectedly raised the demand for heating oil.

04:18 Now this one is pretty straightforward because it's just as the cold winter kind of causes people to want more heat and need more heat, therefore leading to a higher demand in oil to power those heat...

Please give Ace some feedback