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(solution) The price of oil has fallen over the last year or so, from highs


The price of oil has fallen over the last year or so, from highs around $110 per barrel to current levels around $40 per barrel (with Goldman Sachs predicting the price could fall as low as $20 per barrel).  

Consider the market for crude oil.  There are suppliers of crude (who own and extract oil) and demanders of crude (including both consumers who use oil products to drive and warm their homes and firms that use oil products as inputs to produce the goods they sell).  One belief is that the price of oil has fallen because of two market forces: (1) the demand for oil has fallen because some countries are not growing as fast as they were and, as a result, are demanding less of a constant flow of oil than they have demanded in the past and (2) producers have bolstered production over the last few years.   

Using the type of analysis developed in class that relates industry equilibrium and the behavior and profitability of individual firms, identify who wins and who losses (in terms of profits) in the short- and the long-run from a drop in oil prices.  Consider firms that are in the oil industry, including both those firms that sell oil and those that support firms that sell oil (e.g., pipelines, drilling, exploration, etc...).   Also consider firms that use oil products as a factor of production. 

One of the most important features of oil is that it is a storable commodity; if someone owns oil, their wealth can change significantly if the price of oil changes.  One of the things that can affect the position of an individual's demand curve for a particular product is that person's level of wealth (e.g., I personally demand more fine California Chardonnay wine now that I am wealthier than when I was a poor student in graduate school).  As the price of oil falls, there are a significant number of people in the world whose wealth and income will fall (e.g., people in the oil industry in countries that export oil - like Canada).  On the other hand, as the price of oil falls, many people will have higher disposable incomes since they will have to spend less on things like transportation and heating.  As oil prices fall, which types of firms are likely to be positively affected and which ones will likely be negatively affected in the short run?  Why is the net effect positive or negative?   

Given that there are winners and losers, do you think that a drop in oil prices is good or bad on net?  Why?


1. Using the type of analysis developed in class that relates industry equilibrium and the

 

behavior and profitability of individual firms, identify who wins and who losses (in

 

terms of profits) in...

 


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