Question:
According to the Energy Information Administration, crude oil supplies gasoline, heating oil, jet fuel, lubricating oil, asphalt and many other products. Suppose that the widespread adoption of electric vehicles (EVs) reduces the demand for gasoline but does not affect the demand for other products that share fuel. How will the widespread adoption of EVs affect the value of these other products?
Answer:
The idea for this question was inspired by Deirdre McCloskey’s horror pricing theory text, The Applied Theory of Price. I like this question because it highlights the connection between markets and how powerful the supply and demand framework can be.
Let’s review two important ideas before getting to the answer.
The first idea is that we can read the demand curve as a schedule that shows the maximum amount that consumers are willing to buy at a certain price, or we can read the demand curve as a schedule that shows the maximum amount that consumers are willing to pay for something. value, which shows the marginal values of different values. For example, if the price of oil is $50 per barrel and the quantity of oil demanded at this price is 100 barrels, the marginal cost of the 100th barrel is $50.
The second idea is that when a good jointly supplies many products, as oil does, the demand curve for that good reflects the exact sum of the demand curves for those products. For example, suppose oil jointly supplies gasoline and jet fuel in fixed proportions. Suppose the marginal cost of fuel produced by a 100 barrel of oil is $30 and the marginal cost of jet fuel produced by that same barrel is $20. In this case, the maximum amount people would be willing to pay for a 100 barrel would be $30+$20=$50.
With these two ideas in mind, let’s turn to answering the question. To be clear, my answer assumes that both sides of the oil market—suppliers and demanders—are price takers, and that the oil supply curve is upward sloping. We can look at alternatives to this basic assumption, but for our purposes, this assumption will do.
A decrease in the demand for gasoline reduces both the price of oil and the amount of oil supplied to the market. Because of this, the supply of other distillates produced by oil must also decrease as suppliers produce fewer barrels of oil. Therefore, the prices of these distillates must rise to ensure that the prices of these distillates demanded are equal to the current low price supplied.
Figure 1 shows this situation graphically. For simplicity, this figure only includes the demand for two commodities—namely, gasoline and jet fuel. The demand curve D_Oil shows the total demand for oil, that is, it includes the demand for oil as fuel and the demand for oil as jet fuel. The demand curve d_JF shows the demand for oil as jet fuel. The direct 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 fuel.
Initially, there are Q*_1 barrels of oil available. At this price, the price of oil as jet fuel is P*_JF. A lower demand for gasoline reduces the total demand for oil, shown 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 in the College of Business at Florida Atlantic University and a Phil Smith Fellow at the Phil Smith Center for Free Enterprise. He is also a member of the Sound Money Project at the American Institute for Economic Research, and a member of the editorial board of Public Choice magazine.
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