Supply and Demand – More Critical Thinking

SupplyAndDemandI did economics at A-Level and always enjoyed it. You could sit and think scenarios through in your head. I found it a nice mix between the rigour of mathematics and an art. It seems to almost be viewed now as a science but it is not. Also the basic concepts are not difficult so don’t get pushed aside from thinking about it because you’re not an ‘expert’ or you’ve not been ‘ trained’. These two things are your biggest assets right now since at the moment the only thing you hear from economists and politicians is the same old thinking. They are locked in one paradigm.

Lets look at a most basic economic concept which anyone can understand. Supply and Demand. This is the relationship between the price of a product and its supply and the demand for that product. The picture above illustrates it. You see that supply increases as price increases and demand decreases as price increases. Note the following

  1. It assumes demand will continue to decrease to zero as prices go up
  2. It assumes demand will keep increasing as price comes down
  3. It assumes that supply can continue increasing

Demand may decrease to zero as price goes up but certain products will be quite stubborn – eg food. The shape of the curve can reflect this. Demand continues to increase as price goes down but again there may be some limit which can be reflected in the curve.

The supply side is more interesting. It assumes that if prices keep increasing that more will be supplied. The argument being that as prices increase more people will enter the market to make the product and resources will be moved from elsewhere to increase the supply.

All sounds good and logical so far. What about a non renewable resource. This is not something that is made it’s something thats extracted in one way or another. The total amount available has a limit. OK, increases in technology can allow more extraction (so say with oil you go from getting 50% from a well to 60%) but these increases in efficiency have a limit which is at 100% efficiency. It will likely be lower than that since costs of increasing efficiency may become prohibitively expensive. In the case of oil once it takes more oil to extract than what you get then it will stop. This is the nail in the coffin of plant based ethanol (more on that in a later post).

SupplyAndDemand1

Lets look at oil. This diagram shows a theoretical supply and demand curve. The blue is supply which plateaus out at maximum extraction rate. It shows that if the demand curve moves up from Dt1 through Dt2 to Dt3, say reflecting increase world demand, the price will move from P1 to P2 and finally P3.

However, historically the oil price has been fairly stable by the OPEC countries (mainly Saudi Arabia) increasing supply as required to keep prices stable. So instead of P2 being a price increase the supply curve is moved to the right (ie increasing supply) in such a manner to maintain a stable price. In effect OPEC turned on the taps to meet the increased demand.

SupplyAndDemand2This is all well and good as long as you have surplus capacity. With a finite resource there must come a point where this is not possible. I would expect this to be self evident but it clearly is not. Many people don’t believe this at all. I won’t go in to the details here but if you’re interested just google “Peak Oil” or wait till I blog on it.

Through the late 80s and 90s we saw relatively stable oil prices (with an increase during the first Iraq war) as it was possible to increase supply to meet increasing demand. We also experienced a period of enormous growth. People my age have only ever experienced this so the belief of endless growth is backed by experience, we belief our pension funds will be valuable, our houses will increase in price, we’ll get pay rises. However, during this period also:

  1. The world population has increased due to ever cheaper food produced using oil
  2. Most nations in the world pursue western growth and western lifestyles – the promise of cars and massive consumption.

Both these have meant that oil demand kept shifting to the right – more demand at every price level.

At the same time oil has got more expensive to extract. This should be self evident as we see ever more deep water extraction, tar sands and endless talk of getting the stuff from the Arctic. It’s also completely sensible that the easiest and cheapest oil will be extracted first. Thus the Supply curves are moving leftwards – ie less supply at each price point since these more expensive supplies become uneconomical as prices drop so that supply is removed.

As we decline down Hubberts Peak the maximum rate of oil extraction will come down. This will be exacerbated by domestic demand in oil exporting nations resulting in even less available for importers. Most oil producers heavily subsidise petrol to their populations. For example here are some recent  prices of petrol at the pumps:

  • $3.99 per gallon – USA
  • $8.54 per gallon – UK
  • $0.85 per gallon – Saudi Arabia
  • and per Wikipedia Venezuala has been at $0.02 per litre for a long long time.

With subsidised prices these markets are operating under completely different supply curves to us. All this only accelerates the decline in peak production capacity available for importing nations.

SupplyAndDemand3The diagram illustrates this. You can argue about at what point the limits I’ve put on supply will apply but apply they will at some point. The trends are correct. Demand for oil is ever increasing (just think of the talk of the billion Chinese all wanting cars when there’s estimated to be only 700 million cars in the world now).

The recent price rises have shown that no longer can Saudi Arabia just turn on the taps to keep the oil price stable. Prices have rocketed. If you see in my diagram – demand from Dt1 to Dt2 and supply from St1 to St2. We see that the price increases along with the supply.

However what happens when demand starts to exceed the maximum supply (which some commentators say it already has) ? Hopefully it’s obvious – prices go through the roof. When that happens there will not enough oil whatever the price. In my diagram it shows how when we’re at Dt3 and St3 the price has gone up to P3 but the supply at that price is less than at previous times. At that point it’s not just that everything that requires oil (eg food, transport) goes up in price but some needs for oil won’t be met.

At that point you’ve gotta hope that either you have a convenient replacement in place for those needs or they’re not essential.

So start buying local

Start buying organic

By supporting your local producers now you start to improve on your food security in the future. These non oil based local suppliers will be where you get your food from in years to come so please use them now to ensure they’re still around.

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