Oil and the Macroeconomy since the 1970s - Example

Microeconomic Analysis Introduction The world has reduced into a village. According to Brown and Yucel (2002), the effect of changes in prices of oil can be transmitted to various economic activities. For instance, change in price of crude oil alters the price of gasoline (Alquist & Kilian, 2009). Gasoline is one of the products of crude oil. Companies mark prices of gasoline depending on the total cost of refining. This implies that fluctuation in crude oil’s price results into drastic alterations of the value of gasoline at sale pumps. Since gas and fuel are secondary basic commodity behaviors, many families have to buy them. Changes in the prices alter the consumer and buyer behaviors e.g. when families go in for alternative sources of energy such as domestic biogas (Hubbard & Obrien, 2013). The fluctuations in prices of gasoline elaborate the reasons as to why there have been economic downturns in various nations once the prices of gasoline increase. The matter worsens because all nations consume oil products at the expense of the only twelve nations producing crude oil. Political instabilities and other forms of unrest in these nations tally into the rise in prices of oil. Economic analysts in the study of gasoline consumer behavior have used the United States of America. Many researchers have done much on the relationship between fluctuation in prices and economic stability especially after the 1973 embargo. This paper tries to cover the fears for economic recovery at times a gallon of gas is going for more than $ 3.5. Yearly, the price of gasoline fluctuates in the USA. Therefore, the sellers and distributors alter their prices in case of changes. For example, in 2012, the price of oil sold for $4 a gallon by April. Thus, suppliers were forced to raise their fees a little bit to cover for the increased price. This led to complaints by motorists and domestic users and a decline in economic (Ghosh & Kanjilal, 2009). The rule of demand and supply should prevail before any economic agent comes up with a decision to invest in such an industry because it is all about market share, characterized by the magnitude of return on investment. For the case of Cousin Edgar, Putting up two gas stations is not a simple task. It will be important for him to consider the prevailing prices, competitors, demand for gasoline, supply, and all other necessary economic determinants or principles that govern the market in the country (Hubbard & Obrien, 2013, p. 34). Therefore, the behavior of customers and the fueling trends in the country will be vital ingredient worth considering in making a rational decision. Besides, the government regulations and tax multiplier should be considered because the US does not produce its own oil (Kilian, 2010). Relevant Economic Principles The first term to take note of is the mixed economy. This refers to a form of primary economy where most of the decisions are based on the behavior of buyers and sellers with relaxed government intervention (Hubbard & Obrien, 2013, p. 11). In this case, the government may enact special tax multipliers in order to strengthen its economy. This typical system prevails in the US. It was introduced in the year 1932, when the state government introduced the Social Security System that was meant to neutralize the negative effects of the great depression. The depression was characterized by intensive unemployment and unskilled labor force. Other nations emulated the United States of America after a promising performance. This type of economy still exists in the USA (Barsky & Kilian, 2004, p. 119). Therefore, to cope up with the business, Uncle Edgar has to realize the demand trends from both the customers and government. Kilian (2010) elaborates much on the behavior of gasoline consumers in the United States of America. In his famous journal article, Erickson (2011) offers a range of substitutes of gasoline that people use in times of depression. The foregone alternatives in microeconomic study are referred to as opportunity cost. Before one makes a decision on the business to establish, it is vital for the proprietor to establish all the alternatives and complements that customers go for during hard times. Further, the threat for the market share of gas in the US is the existence of Renewable Fuel Standard body that governs use of fuels to avoid depletion. The body allows the use of corn ethanol, Cellulose Ethyl Acetate, sugarcane diesel; cellulose ethanol, animal fats biodiesel, biodiesel, and renewable gasoline form the chief alternatives for the product (Erickson, 2011). Each market has its own law of demand and supply. The law states that, for a given demand of a specific good or service, there is always a supply for the particular product or service. This is referred to as the model of a competitive market: a market that has many buyers and sellers for a certain product of the same kind. The model holds true for curves and equilibrium prices. At the equilibrium price, the quantity of either a product or service demanded reflects the same amount of quantity supplied within a perfect competitive market (Whelan & Msefer, 2005, p. 35). This is well illustrated in figure 2. From the graph, one is able to realize that the equilibrium price lies at the point where the demand curve meets the supply curve. Shifts in demand curve rely on the determinants of the demand, which include tastes and preferences of the customers, change income, amount of population, future general expectations, and prices of the goods and services. On the other hand, supply is controlled by input alterations, future expectations of the suppliers, technology, and number of the suppliers (Meave, 2013). Another factor to put in mind while making investment decisions is the price elasticity of both demand and supply. Price elasticity of demand is the measure of the degree to which the amount demanded of a product shifts at the time its price changes. The results of price elasticity influence both substitution and income effects (Abbala, 2009). It is calculated as: Price elasticity of demand ] ×100 Change in quantity = Current- initial Example Suppose the price of gasoline changes to $10.4 per 2 gallons from the initial $6.8 per 3 gallons, determine the price elasticity of demand. Solution ] ×100 =] ×100 = 52.9% Change in quantity =current qnty-initial qnty = 2-3 = -1 PED = -1/52.9 = -0.02% This implies that the demand of gasoline at this particular time is inelastic since it has a value less than 1. Figure 3 elaborates other meanings for any value within the given ranges and their corresponding graphs for each element. Price elasticity of supply is the measure of responsiveness of quantity that is supplied to the change in price (Abbala, 2009). It is given as follows: ES  The result may give the impression of the market in terms of perfectly price inelastic when the outcome is zero (0) either in the long run or short run. It mainly influences possibilities in both production and storage (Abbala, 2009). Recommendations and economic justification Cost of production dictates the price of commodities in a perfectly competitive market. Each market has its own demand and supply. It is very important for one when establishing any business to consider the nature of the market forces. All the implications of price elasticity should be brought out in order to determine the way forward for the business. Besides, one has to consider all the determinants of demand, supply, and the price elasticity of both demand and supply (Abbala, 2009). This will enable a firm or an individual to make sound economic decisions. Business is all about decisions. Proper decision-making leads to an increase in the total market share. This culminates into more returns on investment than the reverse. In fact, profit maximization is a core objective of any organization regardless of scale of production (Monayo, 2012). In the case of Uncle Edgar, it will be necessary for him to look at the market in all the above-mentioned dimensions. To achieve this, he has to consider all the relevant information on sales of gasoline. For instance, trends within the market, price elasticity of gasoline, current demand and supply, competition, customers’ preferences and tastes, governmental regulations and sources of the product. Besides, Edgar should take note of the emerging issues that may include the use of other alternatives as the opportunity cost. More so, the location of the two pumps may influence much in terms of attracting customers. There, he should locate the stations at strategic points in the market considering the target market. Appendix Figure 1 a) Demand curve b) Supply curve Figure 2 A graph showing the relationship between supply, demand and the equilibrium price Price of market balance: P – price Q – quantity demanded and supplied S – supply curve D – demand curve P0 – equilibrium price A – an excess demand – when PP0 Figure 3 Description measure Perfectly inelastic Quantity in demand does not change due to change in price 0 Inelastic Q changes by a smaller magnitude than the price does 0-1 Unitary elasticity Q changes by exact magnitude as P does 1 Elastic Q changes by a bigger amount of % than P does 1-infinity Perfectly elastic Buyers are ready to purchase all they are able to obtain at a given price but not at higher prices infinity a) Perfectly inelastic b) perfectly elastic c)Unitary elastic P D E=O p p E=∞ D D Q q q References Abbala, J. (2009). The concept of elasticity of supply and demand. Microeconomic theory, 20-35. Alquist, R., & Kilian, L. (2009). What do we Learn from the Price of Crude Oil Futures Forthcoming? Journal of Applied Econometrics. Barsky, R., & Kilian, L. (2004). Oil and the Macroeconomy Since the 1970s. Journal of Economic Perspective, 115-134. Brown, S., & Yucel, M. (2002). Energy prices and aggregate economic activity: an interpretive survey. Quarterly Review of Economics and Finance(42), 193-208. Darby, M. (1982). The price of oil and world inflation and recession: American Economic Review, 738-751. Erickson, B. (2011). Oversight hearing on domestic renewable fuels: from ethanol to advanced biofuels. Energy journal, 1-28. Fletcher, M., & Mui, Y. (2011). $4-a-gallon gas fueling fears for recovery. The Washington post, 9-11. Ghosh, S., & Kanjilal, K. (2009). Impact of Oil Price Shocks on Macro-economy: Evidence from an Oil Importing Developing Country. New Delhi: Imi Publishers. Hubbard, G., & Obrien, A. (2013). Microeconomis (4 ed.). San Francisco: Pearson Education. Kilian, L. (2010). Explaining Fluctuations in Gasoline Prices: A joint ModeL of the Global Crude Oil Market and the US Retail Gasoline Market. The Energy Journal, 31(2), 103-159. Meave, M. (2013). The laws of demand and supply. New York: Longhorn Publishers. Monayo, K. (2012). Decision making in microeconomic field. NJ: Macmillan Publishers. Richard, N. (2013). Demand, supply, and their interaction on markets, as seen from the perspective of evolutionary economic theory: Journal of evolutionary economics, 23(1), 17-38. Simon, B., Cameron, A., & Gilbert, R. (1997). Do Gasoline Prices Respond Asymmetrically to Crude Oil Price Changes? Quarterly Journal of Economics, 305-339. Whelan, J., & Msefer, K. (2005). Economic supply and demand. Economic journal, 34-40. Read More