Econ 435 Spring 04
Assignment 2 due Weds 28 Jan
Name:
Suggested Answers
Resource Supply and Demand
The royalties which North Slope oil producers pay to the State of Alaska depend upon
the "wellhead price" of the oil. The "wellhead price" is the price that companies would
receive if the oil were sold as the oil leaves the well on the North Slope and enters the
above-ground piping system. It is calculated as the value of crude oil delivered to a
refinery (in, for example, Texas) minus the costs of shipping it through the Trans Alaska
Pipeline and then by tanker to the refinery.
problems 1-5 (1 pts each). Use supply and demand analysis to describe the likely
effects of each of the factors listed below on North Slope oil production and the
wellhead price of North Slope crude oil. Assume, for the purposes of this question (it is
not true in reality!) that oil companies are not vertically integrated, so that purchasers of
wellhead oil have to pay for the cost of pipeline and tanker transportation to markets.
Also assume that the supply is not completely fixed, meaning the S curve is not just a
vertical line.
For each answer, draw supply and demand curves for North Slope oil, and use a
dashed line to show how one of the curves shifts. If neither curve shifts, write "no shift
in either curve." Write three brief phrases to explain which curve shifts, how North
Slope production is affected, and how the wellhead price is affected.
Remember that the questions relate to the wellhead price of North Slope oil, not the
price delivered to market. Think about this: make sure you are shifting the correct
curve.
The following is an example of how to answer these questions.
Strong American economy causes people to drive more.
P
S0
D0
D1
Q
D curve shifts out, wellhead P up, Qty supplied up
1. Increased tanker costs due to new safety regulations.
P
Demand curve shifts in (because buyers will
demand less at any given wellhead price because
their costs of getting the oil from the wellhead to
market are greater).
Wellhead price decreases
Production decreases
S
D
Q
2. Discovery and development of new oil reserves in Venezuela.
P
Demand curve shifts in (because with more oil
coming from Venezuela there is a lower price of
substitutes for Alaska oil and less demand for
Alaska oil).
Wellhead price decreases
Production decreases
S
D
Q
3. A war increases the cost of producing Saudi Arabian oil.
P
Demand curve shifts out (because with higher
costs of Saudi Arabian oil there is more demand
for Alaska oil).
Wellhead price increases
Production increases
S
D
Q
4. Invention of cheap solar-powered automobiles.
P
Demand curve shifts in (because there is less
demand for oil).
Wellhead price decreases
Production decreases
S
D
Q
5. Higher federal taxes on revenues received by oil companies from crude oil.
P
Supply curve shifts in (because companies want a
higher price for any given volume of crude oil
because of the fact that they are paying higher
taxes).
Wellhead price increases (or no change)
Production increases (or no change)
S
D
Q
Problems 6-7 (2 pts each). For each of the following two resources, answer questions
a-g below. The two resources are:
problem 7. Alaska wild salmon (salmon which return from the open ocean to spawn in
Alaska streams).
problem 8. Pine trees grown on plantations in the Southeastern U.S. and used for
making pulp which is used for making paper.
a. Characterize the elasticity of short-run demand, and give a short explanation, as in
the example below. Your answer should characterize elasticity using one of the
following phrases:
Highly inelastic
Moderately inelastic
Moderately elastic
Highly elastic.
Use your best judgment: there is no absolute correct answer. I am looking for a
reasonable answer with a reasonable short explanation. Remember that elasticity
refers to how much quantity supplied or demanded would change in response to a
change in price.
b. Characterize the elasticity of long-run demand and give a short explanation.
c. Characterize the elasticity of short-run supply and give a short explanation.
d. Characterize the elasticity of long-run supply and give a short explanation.
e. Give an example of something which might cause the demand curve to shift
permanently. Note that this means that for any given price, the quantity demanded
would be either permanently higher or permanently lower.
f. Draw a supply and demand diagram with one demand curve and two supply curves:
a "short-run supply curve" and a "long-run supply curve." Label both supply curves.
The elasticity of the supply curves should reflect your answers to questions c and d.
Remember that the more inelastic the supply curve, the steeper it is. Both supply
curves should intersect with the demand curve at the same point.
Illustrate the shift in demand you described in answering (e) by drawing a new demand
curve represented by a dashed line.
g. Use your supply and diagram to show whether the effect on the price would be
“large,” “moderate,” or “small” in the short-run and whether the effect on the price would
be "large," "moderate," or "small" in the long-run.
In answering these questions, use the following format as an example:
Sample answer: WATER IN ARIZONA
a. Short run demand is moderately inelastic, because people can cut back on lawn
watering, car washing, etc. if the price of water rises
b. Long run demand is moderately elastic, because over time people can substantially
change their lifestyles to use less water (for example, installing toilets that use less
water to flush) and are likely to do so if the price of water rises.
c. Short run supply is highly inelastic, because there are no short-run sources of new
supply, even if the price rises a lot.
d. Long run supply is moderately inelastic, because over time new pipelines can be
built to bring water from distant sources if the price rises enough.
e. A permanent increase in demand might be caused by increased popularity of
swimming pools due to studies showing that swimming is good for your health.
f. see diagram:
P
Ssr
Slr
P1
P2
P0
D1
D0
Q
g. The effect is large in the short run.
The effect is moderate in the long run.
Alaska Wild Salmon
(your stories may differ)
a. Short run demand is moderately elastic, because there are several substitutes for AK
wild salmon. (your story may differ)
b. Long run demand is moderately-highly elastic, because over time people can switch
to other fish and other sources of protein.
c. Short run supply is highly inelastic, because there are no short-run sources of new
supply, even if the price rises a lot.
d. Long run supply is moderately inelastic, because over time managers can reallocate
from sport to commercial and perhaps invest more rescources in fine-tuning the
escapement measurements so that allowable catch can be increased. But for this
particular product even LR supply cannot be very price responsive if prices rise.
e. A permanent increase in demand might be caused by new scientific evidence
showing that eating salmon is good for your health.
f.
SR supply (highly
inelastic)
SR new price
LR supply
(moderately
inelastic)
LR new price
Old price
The effect on price is large in the short run.
The effect on price is moderate in the long run.
Pine Trees Grown in Southeastern US for pulp for paper
(your stories may differ)
a. Short run demand is moderately inelastic, because there are probably some
substitutes for this particular source of pulp but it’s also hard to rearrange contractual
obligations
b. Long run demand is moderately-highly elastic, because over time paper makers can
find new sources of pulpwood (other countries) and consumers will switch away from
paper if paper price also goes up and stays up.
c. Short run supply is moderately inelastic, because the trees are physically fixed.
Cutting rates could be increased, but this is difficult beyond certain limits (how many
feller machines do you have etc., how much labor force, how much processing
capacity).
d. Long run supply is moderately elastic, because over time suppliers can plant more
trees, buy more land for tree production etc.
e. A permanent increase in demand might be caused by increasing enforcement of
environmental laws in Asian countries, reducing the supply of trees from these places.
f.
SR supply (moderately
inelastic)
SR new price
LR supply
(moderately
elastic)
LR new
price
Old price
The effect on price is large in the short run.
The effect on price is moderate in the long run.
Problem 8. Netback Pricing (1 pt) In a sort of recent article about coffee prices (David
Dishneau, "Coffee price plunge hasn't filtered down." Anchorage Times, Thursday May
14, 1992) the reporter claims that "Raw coffee bean prices are at a 20-year low, but the
decrease has not fully filtered down to coffee drinkers." He cites the following data:
Raw coffee prices dropped from $1.04/lb to $0.58/lb while retail prices dropped from
$3.07 to $2.63. Use the data to evaluate whether the concept of netback pricing applies
to this market, and state whether or not you agree with the reporter’s statement, and
why or why not.
Netback pricing seems to apply almost perfectly here – the retail price dropped 44 cents
while the raw coffee price dropped 46 cents. The 2 cents difference is not worth
worrying about. There is no reason at all why the percentage change in the two prices
should be the same. There is also no indication from these data which caused which –
did supply conditions cause the raw coffee price to go down as the article implies, which
then were passed along to the retail price due to competition, or did the retail price drop
due to, say, demand shift and then it was passed backward to the raw coffee price. Also
note that coffee, unlike oil, is not likely to generate economic rents for producers at least
not in the long run, because more growers can enter the business. I just used this
resource because it was a real-world example of netback pricing.