Tag: variable costs

The demand for oil is growing and yet the price of oil, at around $46 per barrel over the past few weeks, remains at less than half that of the period from 2011 to mid 2014. The reason is that supply has been much larger than demand. The result has been a large production surplus and a growth in oil stocks. Supply did fall somewhat in October, which reduced the surplus in 2015 Q3 below than of the record level in Q2 – but the surplus was still the second highest on record.

What is more, the modest growth in demand is forecast to slow in 2016. Supply, however, is expected to decrease through the first three quarters of 2016, before rising again at the end of 2016. The result will be a modest rise in price into 2016, to around $56 per barrel, compared with an average of just over $54 per barrel so far for 2015 (click here for a PowerPoint of the chart below).

But why does supply remain so high, given such low prices? As we saw in the post The oil industry and low oil prices, it is partly the result of increases in supply from large-scale investment in new sources of oil over the past few years, such as the fracking of shale deposits, and partly the increased output by OPEC designed to keep prices low and make new investment in shale oil unprofitable.

So why then doesn’t supply drop off rapidly? As we saw in the post, A crude indicator of the economy (Part 2), even though shale oil producers in the USA need a price of around $70 or more to make investment in new sources profitable, the marginal cost of extracting oil from existing sources is only around $10 to £20 per barrel. This means that shale oil production will continue until the end of the life of the wells. Given that wells typically have a life of at least three years, it could take some time for the low prices to have a significant effect on supply. According to the US Energy Information Administration’s forecasts, US crude oil production will drop next year by only just over 5%, from an average of 9.3 million barrels per day in 2015 to 8.8 million barrels per day in 2016.

In the meantime, we can expect low oil prices to continue for some time. Whilst this is bad news for oil exporters, it is good news for oil importing countries, as the lower costs will help aid recovery.

Webcasts

IEA says oil glut could worsen through 2016 Euronews (13/11/15)
IEA Says Record 3 Billion-Barrel Oil Stocks May Deepen Rout BloombergBusiness, Grant Smith (13/11/15)

Articles

IEA Offers No Hope For An Oil-Price Recovery Forbes, Art Berman (13/11/15)
Oil glut to swamp demand until 2020 Financial Times, Anjli Raval (10/11/15)
Record oil glut stands at 3bn barrels BBC News (13/11/15)
Global oil glut highest in a decade as inventories soar The Telegraph, Mehreen Khan (12/11/15)
The Oil Glut Was Created In Q1 2015; Q3 OECD Inventory Movements Are Actually Quite Normal Seeking Alpha (13/11/15)
Record oil glut stands at 3 billion barrels Arab News (14/11/15)
OPEC Update 2015: No End To Oil Glut, Low Prices, As Members Prepare For Tense Meeting International Business Times, Jess McHugh (12/11/15)
Surviving The Oil Glut Investing.com, Phil Flynn (11/11/15)

Reports and data

Oil Market Report International Energy Agency (IEA) (13/11/15)
Short-term Energy Outlook US Energy Information Administration (EIA) (10/11/15)
Brent Crude Prices US Energy Information Administration (EIA)

Questions

  1. Using demand and supply diagrams, demonstrate (a) what has been happening to oil prices in 2015 and (b) what is likely to happen to them in 2016.
  2. How are the price elasticities of demand and supply relevant in explaining the magnitude of oil price movements?
  3. What are oil prices likely to be in five years’ time?
  4. Using aggregate demand and supply analysis, demonstrate the effect of lower oil prices on a national economy.
  5. Why might the downward effect on inflation from lower oil prices act as a stimulus to the economy? Is this consistent with deflation being seen as requiring a stimulus from central banks, such as lower interest rates or quantitative easing?
  6. Do you agree with the statement that “Saudi Arabia is acting directly against the interests of half the cartel and is running OPEC over a cliff”?
  7. If the oil price is around $70 per barrel in a couple of years’ time, would it be worth oil companies investing in shale oil wells at that point? Explain why or why not.
  8. Distinguish between short-run and long-run shut down points. Why is the short-run shut down price likely to be lower than the long-run one?

‘Farm-gate’ milk prices (the price paid to farmers) have been rising in the UK. In July they reached a record high of 31.4p per litre (ppl). This was 5.1ppl higher than in July 2012. There were further price rises this month (October). Sainsbury’s increased the price it pays farmers by nearly 2ppl to 34.15ppl and Arla Foods by 1.5ppl to 33.13ppl. Muller Wiseman is set to raise the price it pays to 32.5p per litre.

And yet many farmers are struggling to make a profit from milk production, claiming that their costs have risen faster than the prices they receive. Feed costs, for example, have risen by 2.12ppl. On average, farmers would need over 38p per litre just to cover their average variable costs. What is more, exceptional weather has reduced yields per cow by some 7%.

Meanwhile, in the USA, supply has risen by some 1.3% compared with a year ago. But despite this, the prices of dairy products are rising, thanks to strong demand. Cheese and butter prices, in particular, are rising rapidly, partly because of high demand from overseas. Demand for imported dairy products is particularly high in China, where supply has fallen by some 6% in the past couple of months.

The problem for dairy farmers in the UK is partly one of the power balance in the industry. Farmers have little or no market power. Supermarkets, however, have considerable market power. As large oligopsonistic buyers, they can put downward pressure on the prices paid to their suppliers. These are mainly large processing firms, such as Robert Wiseman Dairies, Arla Foods and Dairy Crest. They, in turn, can use their market power to keep down the price they pay to farmers.

Articles

Dairy farmers renew protests over milk prices Farmers Weekly, Philip Case (5/9/13)
Dairy farmers ‘lost more than 1p/litre last year’ Farmers Weekly, Philip Case (2/10/13)
South West farming businesses and producers still making a loss on milk South West Business (3/10/13)
Q&A: Milk prices row and how the system works BBC News (23/7/12) (note date of this)
Positive Dairy Trend: Rising Milk Production and Strong Demand The Farmer’s Exchange, Lee Mielke (27/9/13)
Chinese supply crisis to delay dairy price adjustment Rabobank (25/9/13)
China milk ‘crisis’ fuels world dairy price rise Agrimoney (1/10/13)

Data

UK milk prices and composition of milk ONS
Combined IFCN world milk price indicator IFCN

Questions

  1. Give some examples of (a) variable costs and (b) fixed costs in milk production.
  2. Why may farmers continue in dairy production, at least for a time, even if they are not covering their average variable costs?
  3. What factors determine (a) the price of milk paid to farmers; (b) the retail price in supermarkets?
  4. Explain how dairy futures markets work.
  5. Could the milk processors use their market power in the interests of farmers? Is it in the interests of milk processors to do so?
  6. Why is there a Chinese “dairy supply crisis”? What is its impact on the rest of the world? What is the relevance of the price elasticity of demand for dairy products in China to this impact?

The pricing model for low-cost airline seats seems simple. As the seats get booked, so the price rises. Thus the later you leave it to book, the more expensive it will be. But, in fact, it’s not as simple as this. Seat prices sometimes come down as the take-off date approaches. So what is the pricing model?

The general principle of raising prices as the plane fills up still applies. This enables the airline to discriminate between passengers. Holidaymakers and those with flexibility about when, and possibly where, to travel tend to have a relatively high price elasticity of demand. People who wish to travel at the last minute, such as businesspeople and those facing a family emergency, tend to have a much lower price elasticity of demand and would be prepared to pay a higher, possibly much higher, price.

With relatively high fixed costs for each flight, low-cost airlines need to fill, or virtually fill, their planes if they are to make a profit. And it’s not just about the direct revenue from ticket sales. Low-cost carriers also rely on the revenue from selling extras, such as on-board refreshments, hold luggage, hotels, car hire and travel insurance. With variable costs being tiny, the pricing model is about maximising revenue for each flight. So the fuller the plane, the better it is for the airline.

The airlines are very experienced in estimating demand over the period from a flight coming on sale and the departure date. If they get it right, then prices will indeed rise as take-off approaches. But sometimes they get it wrong. If, as time passes, a given flight is filling up too slowly, then it makes sense to be more flexible on prices, cutting them if necessary. Pricing may be easy in principle; but not always easy in practice!

Article

Low-cost air fares: How ticket prices fall and rise BBC News, Erica Gornall (21/6/13)

Papers
Pricing strategies of low cost airlines Air Transport Group, Cranfield University, Keith J Mason (2002)
Pricing strategies of low-cost airlines: The Ryanair case study Journal of Air Transport Management, 15, Paolo Malighetti, Stefano Paleari and Renato Redondi (2009)

Questions

  1. Does a low-cost airline always charge lower prices than a traditional scheduled airline? If not, why not?
  2. Identify the various reasons why holidaymakers may have a relatively elastic demand for a particular flight?
  3. Explain the system of ‘buckets’ of seats?
  4. Are low-cost airlines engaging in price discrimination and, if so, which type?
  5. Are there any variable costs of operating a particular flight (assuming that the flight does actually take place)?
  6. If demand for a flight becomes less elastic as the date of departure gets nearer, why might a budget airline choose to lower the price, at least for a few days?
  7. Why can Ryanair operate with lower costs than easyJet?
  8. Would it be in low-cost airlines’ interests to charge more (a) to overweight people; (b) for using the toilet?

Market trading has existed for centuries and in many respects it hasn’t changed very much. One thing that has developed is the means of exchange. Goods used to be traded for other goods – for example 1 pig for 4 chickens! But then money was developed as a means of exchange and then came cheques and plastic.

However, for many market traders, accepting credit and debit cards is relatively costly. It involves paying a monthly contract, which for many traders is simply not worthwhile, based on the quantity and value of the transactions. But, for many customers using debit or credit cards is the preferred method of payment and the fact that some traders only accept cash can be a deterrent to them making purchases and this therefore reduces the sales of the market traders.

But, with advances in technology a new way of paying has emerged. Small card readers can now be plugged into iphones, ipads, other tablets and smartphones. By putting a customer’s card into this device customers can then pay by card and either sign for their purchase or use the phone to enter their security details. There are plan for these companies to offer chip and pin technology to further ease payment by card on market stalls. The traders pay a small commission per transaction, but aside from that, the initial start-up cost is minimal and it is likely to encourage more customers to use markets. Jim Stewart, the Director of a firm that has begun using this technology said:

I think it’s definitely going to take off, the world is going that way … The money has always appeared in my bank account, no transactions have been declined, my accountant is happy, it’s all been good.

Some customers have raised concerns about the security of these transactions, as they have to put their cards into someone else’s ipad. However, traders have said that there are no risks and that customers can be sent a receipt for their purchase. The following few articles look at this latest (and other) technological developments.

Smartphone card payment system seeks small firms BBC News, Rob Howard (19/1/13)
POS Trends: What’s new for 2013 Resource News (17/1/13)
Payments by text message service to launch in UK in Spring 2014 BBC News (15/1/13)

Questions

  1. What are fixed cost and why does having a traditional card payment machine represent a fixed cost for a firm?
  2. How might this new technology affect a firm’s sales and profits?
  3. Will there be an increase in the firm’s variable costs from adopting this technology?
  4. Using a cost and revenue diagram, put your answers to questions 1 – 3 into practice and show how it will shift them and thus how the equilibrium may change for a market trader.
  5. What are the properties of money that allow it to be a good medium of exchange?
  6. How will this increased use of debit and credit cards affect the demand for money? Use a diagram to illustrate your answer.

For those looking to buy larger electrical appliances at cheaper prices, things might be looking up, as Comet have begun heavy discounting after entering administration. Deloitte, as the administrator, will now begin the search for a buyer for this retailer, while Comet aims to raise the funds to rescue the company.

Comet was bought by OpCapita last year, but with poor performance continuing across the 200+ stores, we could be about to see the demise of this retailer. Over 6,000 jobs are now at risk, although Deloitte has maintained that stores will continue to trade and that redundancies will not be made. One of the administrators said:

‘Our immediate priorities are to stabilise the business, fully assess its financial position, and begin an urgent process to seek a suitable buyer which would also preserve jobs.’

The retail environment has inevitably suffered over the past few years, with well-known companies such as Woolworths, Optical Express and JJB Sports (to name a few) entering administration. Comet, therefore seems to be the latest in a long line of sad trading stories. So, which factors have contributed towards the collapse of this giant retailer?

Over the past few years, online retailers have gained a larger and larger market share. These internet retailers do not have the same overhead costs that Comet and other high street retailers face. To open a store in an area where customers are in high supply, premium rents must be paid and this adds to the cost of running any given store. In order to cover these higher costs, higher prices can result and this, together with consumers facing tight budgets, has led many customers to look at the cheaper alternatives online. Deloitte has also said that Comet has been suffering from a lack of credit, which has meant that it has not been able to purchase stock in the run-up to Christmas. Deloitte commented that:

‘The inability to obtain supplier credit for the peak Christmas trading period means that the company had no realistic prospect of raising further capital to build up sufficient stock to allow it to continue trading.’

Concerned customers are naturally emerging, wondering whether items they have ordered and paid for will actually turn up. However, Deloitte’s reassurance that trading will continue may go some way to relieving their concern. The following articles consider how Comet has fallen from the sky.

Comet officially enters administration, stores re-open for expected firesale The Telegraph, Graham Ruddick and Helia Ebrahimi (2/11/12)
Comet calls in Deloitte as administrators BBC News (2/11/12)
Apple sky-high as Comet falls to earth The Guardian, Zoe Wood (2/11/12)
Comet enters administration, Deloitte seeks buyer Reuters (2/11/12)
Comet electricals administrators formally begin search for saviour The Guardian, Zoe Wood (2/11/12)
Comet goes into administration Financial Times, Andrea Felsted (3/11/12)
Comet collapse: Deloitte blames internet and lack of first-time home buyers The Telegraph(2/11/12)
Collapse of Comet puts 7000 jobs in danger Independent, James Thompson (2/11/12)

Questions

  1. Why does the retail environment remain very weak?
  2. Explain why Deloitte suggest that a lack of first time home buyers has played a part in the demise of Comet.
  3. Why has a lack of credit contributed towards Comet’s downfall?
  4. Should customers be concerned about how Comet’s demise (if indeed a buyer is not found) might affect prices in other retailers such as Currys, given that they will now have a larger share of the market?
  5. Why has online trading contributed towards the harsher retail environment for the high street stores? You should think about fixed and variable costs in your answer.
  6. Why are companies such as Apple doing so well relative to other companies, such as Comet and JJB Sports? Is there a secret to their success?
  7. What impact might this collapse have on local labour markets, given Comet employs so many people? Think about the effect on wages, unemployment and on claimants of benefits.