Running Head: Price Elasticity of Demand and Supply 1

 Impact of Price Elasticity of Supply and Demand

BUS 505a Managerial Economics

Alexander Shrestha

Professor Omar Amareen

Westcliff University

25/05/2020
Running Head: Price Elasticity of Demand and Supply

1. Introduction

The changes in global demand, disruptions in supply, and precautionary motives and variety of
other forces has attributed on the swings in the prices of oil and have been widely accepted by
academics, practitioners, and policy maker[ CITATION Cal19 \l 1033 ]. Oil has been the crown
jewel of commodities that is being consumed and used in multiple ways in our lives, from fuel to
plastics to asphalt and thus the changes in prices on oil have sent shockwaves throughout the
world economy. The factors behind this drastic fall in prices have been accounted to the millions
of barrels of oil produced in the US called shale oil and in this paper we will be looking at the
supply and demand for this commodity and analyze its price action.

Demand and supply for any commodity affects its price in the long-term or in the short-term, and
in the case of oil the rapid production of shale oil meant the surplus of supply on the market.
There were two factors that contributed towards the boom for the U.S. shale oil. Firstly, the oil
prices in the spam of three years, from 2011 to 2014 averaged above $90 per barrel and thus,
helping the shale oil production and exploration to be profitable. Secondly, low-interest rate
played a huge role in this as they gave private investors and banks strong incentives to loan shale
oil companies[ CITATION Mcf20 \l 1033 ]. The production of shale oil revolutionized the oil
market as before oil prices used to have predictable seasonal swings but now due to this
production the market has undergone a significant transformation resulting into 60% price drop
as mentioned in the discussion and have taken the market by surprise[ CITATION Măn15 \l
1033 ].

2. Demand and Supply

The law of supply and demand states that if the price of a commodity goes down it is due to
supplies of the commodities are being met or excess supply has been done, and if the price for a
commodity goes up it is due to the rising demand for that commodity or due to shortage of that
commodity in the market[ CITATION Gue12 \l 1033 ]. Although, prices play a big role when it
comes to the demand and supply for a commodity, economist argue other factors also affect it
such as changes in the state of economy, changes in taste and long-term changes in the
production capacity[ CITATION Whe96 \l 1033 ]. In this case we look into the demand and
supply of shale oil and how it has been affecting its price.
Running Head: Price Elasticity of Demand and Supply

Demand is the rate set by the consumers that want to buy the product and usually consist of two
factors; Taste, which determines their willingness to buy that given good at a specific price and
their desire towards that good. Their ability to buy that given good at that specified price, and
must possess sufficient income or wealth[ CITATION Whe96 \l 1033 ]. These both factors
depend on the market price ultimately and we can come to a certain understanding that when a
price is low, demand is high and when the price for the good is high, the demand is low. We can
look into a figure below to understand the relationship between the price of a good and the
quantity which the consumers are willing to purchase at a given period, which can simply be
known as Demand Curve.

Figure 1: Demand Curve[ CITATION Whe96 \l 1033 ]

This demand curve simply states that the price is only factor affecting demand, but naturally
this is not the case as we recall all the other factors that influence the changes in demand but in
the long time frame. Over a time period, these factors are assumed to be constant and thus price
causes stabilizing supply and demand.

Supply can be determined as the willingness and ability to provide needed good as determined
by the seller, the higher the price for that given commodity the more available it is for the buyers.
Running Head: Price Elasticity of Demand and Supply

This usually happens because suppliers are able to maintain a profit despite the higher cost of
production that may result from short-term expansion of their capacity[ CITATION Whe96 \l
1033 ]. In a real market, manufacturers tend to raise both the price and supply of their product
whenever there are fewer inventories for their desired inventory. The short-term increase in
supply causes manufacturing costs to rise, therefore leading the price to further increase. The
price change in turn will raise the desired rate of production and a similar effect occurs if
inventory is too high. We can look into the figure 2 which explains the Supply curve in which it
is assumed that it slopes upward due to the fact that each additional unit is assumed to be more
expensive or difficult to create than the previous one, and therefore required higher price to
justify its production.

Figure 2: Supply Curve[ CITATION Whe96 \l 1033 ]

In the case of oil manufacturers there seems to be decrease in the price of the commodity due to
rise in production of shale oil. Where hundreds of millions of us, consume oil, individually have
limited power to influence prices, but collectively have plenty. There are other factors as well,
impacting the oil industries such as, cost of refining capability, foreign affairs and oil reserves.
We can link the fall in price of the oil industry once again here by concluding that demand was
stable in the market and the surplus of supply of the commodity was there due to the production
Running Head: Price Elasticity of Demand and Supply

of shale oil in the market. Now we look into the impact of elasticity of Demand and Supply for
this commodity in the long and short run.

3. Elasticity of Demand and Supply

The elasticity of Demand can be defined as the relationship of percentage change in the quantity
demanded of a product and percentage change in price (price elasticity of demand) or percentage
changes of income of consumers (income elasticity) and have been widely accepted in the
literature[ CITATION Vuk17 \l 1033 ] . It is a measuring tool that looks into the degree of
responsiveness of demand for a product to the change in price; a demand is said it to be inelastic
if a change in price causes a smaller change in demand where (PED<1) and a demand is said to
be elastic when a change in price causes a bigger percentage change in demand where (PED>1).

In the case of oil industry, the price has seen a drastic fall as per the statement in the question and
one of the reasons mentioned is due to the mass production of shale oil. The commodity that we
are looking at is oil and in the short run demand can be considered to be inelastic in nature
because even if there is an increase or decrease in price, people will tend to keep buying it out of
habit and as there are not so many alternatives. In the long run a product like this which is oil,
will tend to have elastic demand as an increase or decrease in price will affect its price drastically
as people will look for alternative sources and in this which is electric vehicle, natural gas, and
hydrogen or solar panels but it will take time to make the switch. Therefore, demand will be
more elastic over time. This is considered as an important economic instrument without which it
is not possible to make any significant business decision, regarding markets, market activities
and market performance[ CITATION Vuk17 \l 1033 ]. We can look at the figure below that
demonstrates the perfect example:
Running Head: Price Elasticity of Demand and Supply

Figure 3 Price Elasticity of Demand

In the short term, the demand can be seen as inelastic because the percent change in Q
1/13=7.7% the percentage change in price is 42.9% where PED= -0.17 but in the long run as per
the diagram, demand is said to be more elastic as percentage change in Q 8/13= 61.5% when the
percentage change in price is 42.9% PED=- 0.70. But in this case the price has fallen even if
there is a steady demand for the commodity which means due to the production growth of shale
oil and the constant supply for this had been met or even exceeded. The short term impact that
comes through this is that in the U.S. market as they are major importer of oil, they will
significantly reduce its energy import dependency and this would ultimately entail a reduction in
the US trade deficit and therefore the prices will fall for the commodity as seen in the case and
Running Head: Price Elasticity of Demand and Supply

when the dependency shifts in the long run it would have a positive effect on the price as well
because it will be stable. We can look into the price elasticity of supply to understand this little
better, as it measures the responsiveness in quantity supplied of a good to a change in price of
that good[ CITATION Gue12 \l 1033 ]. In this case of shale oil, we can assume that in the short
run the fall in price resulted due to the greater quantity produced/supplied of that good thus
making it more likely to be inelastic in nature (PES<1) as there has been noticeable impact on
the supply for the commodity and price doesn’t affect the quantity supplied. However, in the
long run the fall in price would drastically impact supply/production for the product as it is an
un-renewable energy with less to no alternative thus making production and supply of it harder
in future. So, small change in price leads to big change in quantity supplied/produced. Therefore,
it is more likely to be elastic in nature (PES>1).

4. Conclusion

We can come to conclusion in this paper that, as of now oil consumption can been regarded as a
necessity. In a growing market such as this, there is always fluctuation in prices and this affects
the overall supply and demand for that product. In this paper we can also see how price elasticity
helps us to calculate the responsiveness of that product in relation to the changes in price that
occurs in the market. The production of shale oil has somewhat help to fill in the gap for oil
production in present. Therefore, we can come to the conclusion that the economical impact that
this has in the long run can be seen through the changes in resources, demand and supply for that
commodity has but in the short run these changes are barely visible.

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Mcfarlane, G. (2020, 2 13). Investopedia. Retrieved 5 25, 2020, from Investopedia.com:

https://www.investopedia.com/articles/investing/100614/oil-price-analysis-impact-supply-
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