Microeconomics Demand & Supply of Oil: Key Concepts and Elasticity

Demand Curve

Shows the quantity demanded at different prices.

Consumer Surplus

The difference between willingness to pay and actual price.

Formula for Consumer Surplus

Area of a triangle = ½ × base × height.

Shifts in Demand Curve

Increase in demand: Curve shifts outward (right/up).

Decrease in Demand

Curve shifts inward (left/down).

Income Effect on Demand

↑ Income → ↑ demand for normal goods (cars, electronics).

Population Effect on Demand

More people = more demand.

Price of Substitutes

↓ price of natural gas → ↓ demand for oil.

Price of Complements

↓ price of beef → ↑ demand for hamburger buns.

Expectations in Demand

If future supply is threatened, demand increases today.

Tastes Effect on Demand

Fads, health trends, advertising.

Supply Curve

Shows quantity supplied at different prices.

Producer Surplus

Difference between market price and minimum acceptable price (cost).

Total Gains from Trade

Consumer Surplus + Producer Surplus.

Shifts in Supply Curve

Decrease in costs → Supply increases (curve shifts right/down).

Technology / Input Prices

Better drilling tech → more supply.

Taxes & Subsidies

Tax → increases costs, shifts curve up by tax amount.

Expectations in Supply

If firms expect higher future prices, they reduce supply today.

Entry or Exit of Producers

More producers → ↑ supply (curve shifts right).

Changes in Opportunity Costs

If producing oil becomes more/less attractive compared to alternatives, supply shifts.

Key Things to Remember for Test

Demand slopes down (due to substitution & different valuations).

Supply Slopes Up

Due to rising production costs.

Equilibrium Price (P*)

The price where quantity demanded = quantity supplied.

Equilibrium Quantity (Q*)

The amount bought/sold at equilibrium.

Surplus

Occurs when price > P*, leading to excess supply.

Shortage

Occurs when price < P*, leading to excess demand.

Consumer Surplus (CS)

Difference between willingness to pay and actual price.

Producer Surplus (PS)

Difference between actual price and cost.

Total Surplus (TS)

Sum of Consumer Surplus and Producer Surplus, maximized at equilibrium.

Efficiency Conditions of a Free Market

1. Goods go to buyers with highest WTP. 2. Goods are produced by sellers with lowest cost. 3. No unexploited gains or wasted trades.

Increase in Demand

Entire demand curve shifts right.

Increase in Quantity Demanded

Movement along the curve due to lower price.

Supply Shift Up

Costs fall or technology improves, leading to lower prices and higher quantity.

Supply Shift Down

Costs rise, leading to higher prices and lower quantity.

Demand Shift Up

Leads to higher prices and higher quantity.

Demand Shift Down

Leads to lower prices and lower quantity.

Free Market

Pushes toward Q* with no wasted resources or missed gains.

Vernon Smith

Conducted 1956 lab experiments showing prices/quantities converged to predicted equilibrium.

OPEC Embargo (1973-74)

Supply cut leading to prices tripling.

Iranian Revolution (1979)

Supply shocks leading to record high prices ($180 in 2022 dollars).

2009 Recession

Demand decreased, leading to falling prices.

China & India Growth (2000s-2010s)

Increased demand leading to rising prices.

Market Forces

Sellers compete with sellers to lower prices; buyers compete with buyers to raise prices.

Price Elasticity of Demand (Eᴅ)

Responsiveness of Qᴅ to a change in P.

Price Elasticity of Demand Formula

Eᴅ = %ΔQᴅ ÷ %ΔP

Midpoint Method for %ΔQᴅ

%ΔQᴅ = (Q₂ - Q₁) ÷ [(Q₂+Q₁)/2]

Midpoint Method for %ΔP

%ΔP = (P₂ - P₁) ÷ [(P₂+P₁)/2]

Elastic Demand

Eᴅ > 1 → Q changes a lot

Inelastic Demand

Eᴅ < 1 → Q changes a little

Unit Elastic Demand

Eᴅ = 1

Perfectly Elastic Demand

Flat curve

Perfectly Inelastic Demand

Vertical curve

Determinants of Demand Elasticity

More substitutes → elastic; Longer time horizon → elastic; Luxury vs necessity → luxuries elastic; Narrow market → elastic; Larger share of budget → elastic.

Price Elasticity of Supply (Eₛ)

Responsiveness of Qₛ to a change in P.

Price Elasticity of Supply Formula

Eₛ = %ΔQₛ ÷ %ΔP

Elastic Supply

Eₛ > 1

Inelastic Supply

Eₛ < 1

Perfectly Elastic Supply

Flat curve

Perfectly Inelastic Supply

Vertical curve

Determinants of Supply Elasticity

Difficult to increase production (raw materials) vs Easy to increase production (manufactured goods); Large share of input markets vs Small share of input markets; Global supply vs Local supply; Short run vs Long run.

Income Elasticity of Demand (Eᵢ)

Eᵢ = %ΔQᴅ ÷ %ΔIncome

Normal Goods

Eᵢ > 0 (necessities small, luxuries large)

Inferior Goods

Eᵢ < 0

Cross-Price Elasticity of Demand (Eₓʏ)

Eₓʏ = %ΔQᴅ (X) ÷ %ΔP (Y)

Substitutes

Eₓʏ > 0

Complements

Eₓʏ < 0

Demand Shift Prediction Formula

%ΔP = %ΔD ÷ (|Eᴅ| + Eₛ)

Supply Shift Prediction Formula

%ΔP = -%ΔS ÷ (|Eᴅ| + Eₛ)