Tag: average cost

The recent low price of oil has been partly the result of faltering global demand but mainly the result of increased supply from shale oil deposits. The increased supply of shale oil has not been offset by a reduction in OPEC production. Quite the opposite: OPEC has declared that it will not cut back production even if the price of oil were to fall to $30 per barrel.

We looked at the implications for the global economy in the post, A crude indicator of the economy (Part 2). We also looked at the likely effect on oil prices over the longer term and considered what the long-run supply curve might look like. Here we examine the long-run effect on prices in more detail. In particular, we look at the arguments of two well-known commentators, Jim O’Neill and Anatole Kaletsky, both of whom have articles on the Project Syndicate site. They disagree about what will happen to oil prices and to energy markets more generally in 2015 and beyond.

Jim O’Neill argues that with shale oil production becoming unprofitable at the low prices of late 2014/early 2015, the oil price will rise. He argues that a good indicator of the long-term equilibrium price of oil is the five-year forward price, which is much less subject to speculation and is more reflective of the fundamentals of demand and supply. The five-year forward price is around $80 per barrel – a level to which O’Neill thinks oil prices are heading.

Anatole Kaletsky disagrees. He sees $50 per barrel as a more likely long-term equilibrium price. He argues that new sources of oil have made the oil market much more competitive. The OPEC cartel no longer has the market power it had from the mid 1970s to the mid 1980s and from the mid 2000s, when surging Chinese demand temporarily created a global oil shortage and strengthened OPEC’s control of prices. Instead, the current situation is more like the period from 1986 to 2004 when North Sea and Alaskan oil development undermined OPEC’s power and made the oil market much more competitive.

Kaletsky argues that in a competitive market, price will equal the marginal cost of the highest cost producer necessary to balance demand and supply. The highest cost producers in this case are the shale oil producers in the USA. As he says:

Under this competitive logic, the marginal cost of US shale oil would become a ceiling for global oil prices, whereas the costs of relatively remote and marginal conventional oilfields in OPEC and Russia would set a floor. As it happens, estimates of shale-oil production costs are mostly around $50, while marginal conventional oilfields generally break even at around $20. Thus, the trading range in the brave new world of competitive oil should be roughly $20 to $50.

So who is right? Well, we will know in twelve months or more! But, in the meantime, try to use economic analysis to judge the arguments by answering the questions below.

The Price of Oil in 2015 Project Syndicate, Jim O’Neill (7/1/15)
A New Ceiling for Oil Prices Project Syndicate, Anatole Kaletsky (14/1/15)

Questions

  1. For what reasons might the five-year forward price of oil be (a) a good indicator and (b) a poor indicator of the long-term price of oil?
  2. Under O’Neill’s analysis, what would the long-term supply curve of oil look like?
  3. Are shale oil producers price takers? Explain.
  4. Draw a diagram showing the marginal and average cost curves of a swing shale oil producer. Put values on the vertical axis to demonstrate Kaletsky’s arguments. Also put average and marginal revenue on the diagram and show the amount of profit at the maximum-profit point.
  5. Why are shale oil producers likely to have much higher long-run average costs than short-run variable costs? How does this affect Kaletsky’s arguments?
  6. Under Kaletsky’s analysis, what would the long-term supply curve of oil look like?
  7. Criticise Kaletsky’s arguments from O’Neill’s point of view.
  8. Criticise O’Neill’s arguments from Kaletsky’s point of view.
  9. Will OPEC’s policy of not cutting back production help to restore its position of market power?
  10. Why might the fall in the oil price below $50 in early 2015 represent ‘overshooting’? Why does overshooting often occur in volatile markets?

Profits are maximised where marginal cost equals marginal revenue. And in a perfectly competitive market, where price equals marginal revenue, profits are maximised where marginal cost equals price. But what if marginal cost equals zero? Should the competitive profit-maximising firm give the product away? Or is there simply no opportunity for making a profit when there is a high degree of competition?

This is the dilemma considered in the articles linked below. According to Jeremy Rifkin, what we are seeing is the development of technologies that have indeed pushed marginal cost to zero, or close to it, in a large number of sectors of the economy. For example, information can be distributed over the Internet at little or no cost, other than the time of the distributor who is often willing to do this freely in a spirit of sharing. What many people are becoming, says Rifkin, are ‘prosumers’: producing, sharing and consuming.

Over the past decade millions of consumers have become prosumers, producing and sharing music, videos, news, and knowledge at near-zero marginal cost and nearly for free, shrinking revenues in the music, newspaper and book-publishing industries.

What was once confined to a limited number of industries – music, photography, news, publishing and entertainment – is now spreading.

A new economic paradigm – the collaborative commons – has leaped onto the world stage as a powerful challenger to the capitalist market.

A growing legion of prosumers is producing and sharing information, not only knowledge, news and entertainment, but also renewable energy, 3D printed products and online college courses at near-zero marginal cost on the collaborative commons. They are even sharing cars, homes, clothes and tools, entirely bypassing the conventional capitalist market.

So is a collaborative commons a new paradigm that can replace capitalism in a large number of sectors? Are we gradually becoming sharers? And elsewhere, are we becoming swappers?

Articles

Capitalism is making way for the age of free The Guardian, Jeremy Rifkin (31/3/14)
The End of the Capitalist Era, and What Comes Next Huffington Post, Jeremy Rifkin (1/4/14)
Has the Post-Capitalist Economy Finally Arrived? Working Knowledge, James Heskett (2/4/14)

Questions

  1. In what aspects of your life are you a prosumer? Is this type of behaviour typical of what has always gone on in families and society?
  2. If marginal cost is zero, why may average cost be well above zero? Illustrate with a diagram.
  3. Could a monopolist make a profit if marginal cost was zero? Again, illustrate with a diagram.
  4. Is it desirable for there to be temporary monopoly profits for inventors of new products and services?
  5. What is meant by a ‘collaborative commons’? Do you participate in such a commons and, if so, how and why?
  6. Should tweets and Facebook posts be regarded as output?
  7. What is meant by an internet-of-things infrastructure?
  8. What are the incentives for authors to contribute to Wikipedia?
  9. Could marginal cost ever be zero for new physical products?
  10. Think about the things you buy in the supermarket. Could any of these be produced at zero marginal cost?
  11. How can capitalists make profits as ‘aggregators of network services and solutions’?
  12. Provide a critique of Rifkin’s arguments.