[Editor’s note: Welcome to the second of our new series on Price Theory problems with Professor Bryan Cutsinger. We reprint this month’s question below; you can also view the original post from earlier this month here. You can also see the solution to last month’s problem here.]
Ask:
According to the Energy Information Administration, crude oil collectively supplies gasoline, heating oil, jet fuel, lubricating oil, asphalt and many other products. Suppose that widespread adoption of electric vehicles (EVs) reduces demand for gasoline but does not affect demand for the other products collectively supplied by oil. How will widespread adoption of electric vehicles affect the price of these other products?
Answer:
The idea for this question was inspired by Deirdre McCloskey’s great price theory text, The applied price theory. I like this question because it highlights the interconnectedness of markets and how powerful the supply and demand framework can be.
Let’s look at two important ideas before we get to the answer.
The first idea is that we can read a demand curve as a schedule showing the maximum quantity consumers are willing to buy at a given price, or we can read a demand curve as a schedule showing the highest price consumers are willing to pay for a certain price. quantity, which reflects the marginal values of different quantities. For example, if the price of oil is $50 per barrel and the quantity of oil demanded at this price is 100 barrels, then the marginal value of the 100th barrel is $50.
The second idea is that when a good collectively supplies multiple products, as oil does, the demand curve for that good reflects the vertical sum of the demand curves for those products. For example, suppose that oil together only supplies gasoline and jet fuel in fixed proportions. Let’s say the marginal value of gasoline produced by the 100th barrel of oil is $30 and the marginal value of jet fuel produced by that same barrel is $20. In this case, the maximum price people would be willing to pay for the 100th barrel would be $30+$20=$50.
With these two ideas in mind, let’s look at answering the question. To be clear, my answer assumes that both sides of the oil market – the suppliers and the demanders – are price takers, and that the oil supply curve slopes upward. We could consider other alternatives to these basic assumptions, but for our purposes these assumptions are sufficient.
A decline in gasoline demand reduces both the price of oil and the quantity of oil supplied to the market. As a result, supply of the remaining oil-produced distillates should also decrease as suppliers produce fewer barrels of oil. The prices of these distillates must therefore rise to ensure that the quantities demanded of these distillates are equal to the now lower quantity supplied.
Figure 1 illustrates this scenario graphically. For simplicity, the figure only includes demand for two distillates, namely gasoline and jet fuel. The demand curve D_Oil reflects the total demand for oil, that is, it consists of the demand for oil as gasoline plus the demand for oil as jet fuel. The demand curve d_JF reflects the demand for oil as aviation fuel. The vertical distance between the demand for oil as jet fuel, d_JF, and the total demand for oil, D_Oil, represents the demand for oil as gasoline.
Initially there are Q*_1 barrels of oil available. At this quantity, the price of oil as aviation fuel is P*_JF. Lower demand for gasoline reduces total demand for oil, as illustrated in Figure 1 by the demand curve D’_Oil. At the new price, suppliers are only willing to supply Q*_2 barrels of oil, so the price of jet fuel must rise to P’_JF.
Bryan Cutsinger is an assistant professor of economics at Florida Atlantic University’s College of Business and a Phil Smith Fellow at the Phil Smith Center for Free Enterprise. He is also a fellow at the American Institute for Economic Research’s Sound Money Project and a member of the editorial board of Public Choice magazine.