Tag: price elasticity of supply

Oil prices have been rising in recent weeks. With Brent crude currently at around $85 per barrel, some commentators are predicting the price could reach $100. At the beginning of the year, the price was $67 per barrel; in June last year it was $44. In January 2016, it reached a low of $26. But what has caused the price to increase?

On the demand side, the world economy has been growing relatively strongly. Over the past three years, global growth has averaged 3.5%. This has helped to offset the effects of more energy efficient technologies and the gradual shift away from oil to alternative sources of energy.

On the supply side, there have been growing constraints.

The predicted resurgence of shale oil production, after falls in both output and investment when oil prices were low in 2016, has failed to materialise as much as expected. The reason is that pipeline capacity is limited and there is very little scope for transporting more oil from the major US producing area – the Permian basin in West Texas and SE New Mexico. There are similar pipeline capacity constraints from Canadian shale fields. The problem is compounded by shortages of labour and various inputs.

But perhaps the most serious supply-side issue is the renewed sanctions on Iranian oil exports imposed by the Trump administration, due to come into force on 4 November. The USA is also putting pressure on other countries not to buy Iranian oil. Iran is the world’s third largest oil exporter.

Also, there has been continuing turmoil in the Venezuelan economy, where inflation is currently around 500 000 per cent and is expected to reach 1 million per cent by the end of the year. Consequently, the country’s oil output is down. Production has fallen by more than a third since 2016. Venezuela was the world’s third largest oil producer.

Winners and losers from high oil prices

The main gainers from high oil prices are the oil producing countries, such as Russia and Saudi Arabia. It will also encourage investment in oil exploration and new oil wells, and could help countries, such as Colombia, with potential that is considered underexploited. However, given that the main problem is a lack of supply, rather than a surge in demand, the gains will be more limited for those countries, such as the USA and Canada, suffering from supply constraints. Clearly there will be no gain for Iran.

In terms of losers, higher oil prices are likely to dampen global growth. If the oil price reaches $100 per barrel, global growth could be around 0.2 percentage points lower than had previously been forecast. In its latest World Economic Outlook, published on 8 October, the IMF has already downgraded its forecast growth for 2018 and 2019 to 3.7% from the 3.9% it forecast six months ago – and this forecast is based on the assumption that oil prices will be $69.38 a barrel in 2018 and $68.76 a barrel in 2019.

Clearly, the negative effect will be greater, the larger a country’s imports are as a percentage of its GDP. Countries that are particularly vulnerable to higher oil prices are the eurozone, Japan, China, India and most other Asian economies. Lower growth in these countries could have significant knock-on effects on other countries.

Consumers in advanced oil-importing countries would face higher fuel costs, accounting for an additional 0.3 per cent of household spending. Inflation could rise by as much as 1 percentage point.

The size of the effects depends on just how much oil prices rise and for how long. This depends on various demand- and supply-side factors, not least of which in the short term is speculation. Crucially, global political events, and especially US policies, will be the major driving factor in what happens.

Articles

Data

Questions

  1. Draw a supply and demand diagram to illustrate what has been happening to oil prices in the past few weeks and what is likely to happen in the coming weeks.
  2. What is the significance of the price elasticity of demand and supply in determining the size of oil price increase?
  3. What determines (a) the price elasticity of demand for oil; (b) the income elasticity of demand for oil; (c) the price elasticity of supply of oil?
  4. Why might oil prices overshoot the equilibrium price that reflects changed demand and supply conditions?
  5. Use demand and supply diagrams to illustrate (a) the destabilising effects that speculation could have on oil prices; (b) a stabilising effect.
  6. What industries might gain from higher oil prices and why?
  7. What would OPEC’s best policy be in the current circumstances? Explain.

Food prices often rise or fall with good or bad harvests or because of a change in demand. A recent example is the price of brazil nuts, which by May this year had risen over 60% on European markets.

Part of the reason for the price rise has been on the demand side. Consumption of brazil nuts has increased as more people switch to healthier diets. This includes the purchase of the nuts themselves and as part of healthier snack foods. With supply being relatively inelastic, any rise in demand tends to have a relatively large effect on price.

A more acute reason is on the supply side. There has been a very poor harvest of brazil nuts. The nuts are grown largely in the Amazon basin which has been hit by drought linked to the El Niño effect. This, however, is only a temporary effect and future harvests should increase again as rainfall returns to normal. However, in the longer term, rainfall patterns may change with the effects of global warming.

The price rise in the UK has also be aggravated by the depreciation of the pound since the Brexit vote, which has fallen some 13% against the dollar since June 2016. A rise in the dollar price of brazil nuts has thus led to an even bigger rise in their sterling price.

Articles

Brazil nuts are rocketing in price – here’s why The Conversation, Iain Fraser (24/10/17)
Brazil nut prices soaring due to reduced harvests after droughts Independent, Zlata Rodianova (16/5/17)

Data

Index Mundi commodities Linked from Economics Network site
Commodity Markets World Bank (see Excel file of monthly prices)

Questions

  1. Explain the specific supply conditions that have affected the price of brazil nuts in 2017.
  2. Why did prices rise ahead of the change in supply?
  3. How has the size of the price rise been affected by the price elasticity of demand for brazil nuts?
  4. What determines the price elasticity of demand for brazil nuts?
  5. Find out what other food prices have risen or fallen a lot in recent months and explain why.
  6. How do real food prices (i.e. prices after correcting for inflation) compare today with 10 and 20 years ago? Explain why.

OPEC members agreed on 30 November 2016 to reduce their total oil output by 1.2m barrels per day (b/d) from January 2017 – the first OPEC cut since 2008. The biggest cut (0.49m b/d) is to be made by Saudi Arabia.

Russia has indicated that it too might cut output – by 0.3m b/d. If it carries through with this, it will be the first deal for 15 years to include Russia. OPEC members hope that non-OPEC countries will also cut output by 0.3m b/d. There will be a meeting between OPEC and non-OPEC members on 9 December in Doha to hammer out a deal. If all this goes ahead, the total cut would represent nearly 2% of world output.

The OPEC agreement took many commentators by surprise, who had expected that Iran’s unwillingness to cut its output would prevent any deal being reached. As it turned out, Iran agreed to freeze its output at current levels.

Although some doubted that the overall deal would stick, there was general confidence that it would do so. Markets responded with a huge surge in oil prices. The price of Brent crude rose from $46.48 per barrel on 29 November to $54.25 on 2 December, a rise of nearly 17% (click here for a PowerPoint of the chart)..

The deal represented a U-turn by Saudi Arabia, which had previously pursued the policy of not cutting output, so as to keep oil prices down and drive many shale oil producers out of business (see the blog, Will there be an oil price rebound?)

But if oil prices persist above $54 for some time, many shale oil fields in the USA will become profitable again and some offshore oil fields too. At prices above $50, the supply of oil becomes relatively elastic, preventing prices from rising significantly. As The Observer article states:

It is more likely that a $60 cap will emerge as the Americans, who stand outside the 13-member OPEC grouping, unplug the spigots that have kept their shale oil fields from producing in the last year or two.

… The return to action of once-idle derricks on the Texas and Dakota plains is the result of efficiency savings that have seen large jobs losses and a more streamlined approach to drilling from the US industry, after the post-2014 price tumble rendered many operators unprofitable. Only a few years ago, many firms struggled to make a profit at $70 a barrel. Now they can be competitive at much lower prices, with many expecting $50 for West Texas Intermediate – a lighter crude that typically earns $5 a barrel less than Brent.

OPEC as a cartel is much weaker than it used to be. It produces only around 40% of global oil output. Cheating from its members and increased production from non-OPEC countries, let alone huge oil stocks after two years when production has massively exceeded consumption, are likely to combine to keep prices below $60 for the foreseeable future.

Webcasts

OPEC Cuts Daily Production by 1.2 Million Barrels MarketWatch, Sarah Kent (30/11/16)
How Putin, Khamenei and Saudi prince got OPEC deal done Reuters, Rania El Gamal, Parisa Hafezi and Dmitry Zhdannikov (2/12/16)
Fuel price fears as OPEC agrees to cut supply Sky News, Colin Smith (30/11/16)
OPEC Confounds Skeptics, Agrees to First Oil Cuts in 8 Years Bloomberg, Jamie Webster (30/11/16)
Game of oil: Behind the OPEC deal Aljazeera, Giacomo Luciani (3/12/16) (first 10½ minutes)
Russia won’t stick with its side of the OPEC cut bargain CNBC, Silvia Amaro (1/12/16)

Articles

Oil soars, Brent hits 16-month high after OPEC output deal Reuters, Devika Krishna Kumar (1/12/16)
OPEC reaches a deal to cut production The Economist (3/12/16)
Opec doesn’t hold all the cards, even after its oil price agreement The Observer, Phillip Inman (4/12/16)
Saudi Arabia discussed oil output cut with traders ahead of Opec Financial Times, David Sheppard and Anjli Raval (4/12/16)
The return of OPEC Reuters, Jason Bordoff (2/12/16)
‘Unfortunately, We Tend To Cheat,’ Ex-Saudi Oil Chief Says Of OPEC Forbes, Tim Daiss (4/12/16)
After OPEC – What’s Next For Oil Prices? OilPrice.com (2/12/16)
The OPEC Oil Deal Sells Fake News for Real Money Bloomberg, Leonid Bershidsky (1/12/16)

Data and information
Brent crude prices, daily US Energy Information Administration
OPEC home page Organization of the Petroleum Exporting Countries
OPEC 171st Meeting concludes OPEC Press Release (30/11/16)

Questions

  1. What determines the price elasticity of supply of oil at different prices?
  2. Why is the long-term demand for oil more elastic than the short-term demand?
  3. What determines the likelihood that the OPEC agreement will be honoured by its members?
  4. Is it in Russia’s interests to cut its production as part of the agreement?
  5. Are higher oil prices ‘good news’ for the global economy and a boost to economic growth – a claim made by Saudi Arabia?
  6. What role does oil storage play in determining the effect on the oil price of a cut in output?
  7. What are oil prices likely to be in five years’ time? Explain your reasoning.
  8. Is it in US producers’ interests to invest in new shale oil production? Explain.

Young people are increasingly finding it impossible to buy their own home. The reasons are easy to find: income rises of young people have failed to match rises in house prices, and access to loans has become more restrictive since the financial crisis. In 2002, 58.6% of 25-34 year-olds owned their own home; today, the figure is just 36.7%.

Conventional wisdom is that the source of the problem is on the supply side: a lack of house building. But according to the Redfern Review, led by the chief executive of Taylor Wimpey, Pete Redfern, the source of the problem lies mainly on the demand side. Overall demand for housing has been rapidly rising, stoked by low interest rates and the Help to Buy scheme, which is available to existing home owners as well as first-time buyers. However, purchases by first-time buyers have fallen as their incomes have declined relative to those of older people.

Of course, increasing supply, especially of cheaper starter homes, would help young people, but, according to the Redfern Review, such schemes take a long time to make much of a difference (although building modular homes could be much quicker). In the meantime, help could be provided on the demand side by making the Help to Buy scheme available only to first-time buyers and by increasing the help to them provided under the scheme, and also by encouraging lenders to make access to mortgages easier.

But a problem for most young people is high levels of debt, including student loans. Such debt and a lack of savings makes it difficult to raise a deposit, let alone afford mortgage repayments. And on the rental side, accommodation is becoming less and less affordable as rents rise faster than incomes, further exacerbating the difficulty of clawing down debt and saving for a deposit.

A long-term solution must involve increased supply – as the Redfern Review recognises. But in the short-term, providing more help to first-time buyers and those paying high rents could make a significant difference.

Webcast

Tackling UK housing crisis ‘will take generations’ ITV News, Joel Hills (16/11/16)

Articles

Review of home ownership in UK shows severe decline in young buyers PropertyWire (16/11/16)
Housing crisis: Lack of new building not to blame for soaring house prices finds Labour-commissioned report Independent, Ben Chu and Ashley Cowburn (16/11/16)
Redfern Review: Focus on First Time Buyers and Launch Housing Commission Money Expert, Danny Lord (16/11/16)
First-time buyers need more help, review finds BBC News (16/11/16)
Redfern Review echoes Homes for Scotland’s call for joined-up approach to housing Scottish Housing News, Nicola Barclay (17/11/16)
Redfern review into housing: worth building on? The Guardian, Nils Pratley (15/11/16)
UK housing review downplays developers’ role in crisis, critics say The Guardian, Graham Ruddick (16/11/16)

Report

The Redfern Review into the decline of homeownership (16/11/16)

Data

Economic Data freely available online: UK house prices The Economics Network
UK House Price to income ratio and affordability Economics Help blog (21/9/15)
House Price Index Nationwide
UK House Price Index: reports ONS/Land Registry
House Price Index: Statistical Bulletin ONS (Sept. 2016)

Questions

  1. Do a data search to find out what has happened since 1990 to (a) average UK house prices; (b) average incomes; (c) the distribution of income since 1990; (d) first-time buyer affordability of houses.
  2. Use a supply and demand diagram to illustrate current average house prices compared with house prices in 2000.
  3. How does the price elasticity of supply of houses affect the impact of a rise in demand on house prices? Illustrate your answer with a diagram.
  4. What determines the price elasticity of supply of houses?
  5. What particular problems do young people face in being able to afford to buy a house or flat?
  6. How would making it easier for young people to be able to raise finance to purchase their first home affect the price of starter homes?
  7. What policies could be adopted by the government to make rents more affordable? Discuss the advantages and disadvantages of such policies.

Many countries have experienced soaring house prices in recent years. To find out why, you need to look at demand and supply.

Low mortgage interest rates and more relaxed lending rules in the last couple of years have stimulated demand. In some countries, such as the UK, demand has been further boosted by governments providing increased help to buyers. In others, various tax breaks are given to house purchasers.

Typically the rise in demand has not been matched by an equivalent rise in supply. Social house building has slowed in many countries and building for private purchase has often be hampered by difficulties in obtaining appropriate land or getting planning permission.

The articles linked below look at the situation in Australia. Here too house prices have been soaring. Over the past 30 years they have grown by 7.25% per year – way above the growth in incomes. As the second article below states:

So expensive are homes becoming that the share of median household income devoted to mortgage payments for Australians aged 35 to 44 has more than doubled in 30 years. Incredibly, it’s happened at a time when mortgage rates have slid to their lowest on record.

But why? Again, to understand this it is necessary to look at demand and supply.

Strong population growth combined with easy availability of mortgage loans, low interest rates and tax breaks for both owner occupiers and property investors have stoked demand, while new building has lagged behind. As far as investors are concerned, any shortfall of rental income over mortgage payments (known as negative gearing) can be offset against tax – and then there is still the capital gain to be made from any increase in the property’s price.

But in some Australian towns and cities, price rises have started to slow down or even fall. This may be due to a fall in demand. For example, in Perth, the ending of the commodity boom has led to a fall in demand for labour in the mining areas; mine workers often live in Perth and fly up to the mining areas for shifts of a week or more. The fall in demand for labour has led to a fall in demand for housing.

House price changes are amplified by speculation. People rush to buy houses when they think house prices will rise, further pushing up prices. Landlords do the same. This speculation fuels the price rises. Speculation also amplifies price falls, with people with houses to sell keen to sell them quickly before prices fall further. Potential purchasers, including property investors, hold back, waiting for prices to fall.

Articles

House prices are surging because of low supply – it’s Economics 101 The Guardian, Stephen Koukoulas (27/10/16)
Who’s to blame for rising house prices? We are, actually. Sydney Morning Herald, Peter Martin (27/10/16)
The Price of Australia’s Real Estate Boom The New York Times, A. Odysseus Patrick (17/10/16)
Solutions beyond supply to the housing affordability problem The Conversation, Nicole Gurran (24/10/16)

Data

Residential Property Price Indexes: Eight Capital Cities Australian Bureau of Statistics (20/9/16)

Questions

  1. Identify the specific demand factors that have driven house price rises in Australia.
  2. How are the price elasticities of demand and supply relevant to explaining house price rises? Use a diagram to illustrate your analysis.
  3. What determines the rate of increase in house prices?
  4. Explain what is meant by ‘negative gearing’. How is the tax treatment of negative gearing relevant to the property market?
  5. What are the arguments for and against giving tax breaks for house purchase?
  6. Why are rising prices seen as politically desirable by politicians?
  7. What practical steps could a government (central or local) take to increase the supply of housing? Would such steps always be desirable?
  8. Does speculation always amplify house price changes? Explain.
  9. How are house prices related to inequality?