Monday, May 01, 2006

A Simple question for a Psuedo economist to answer.

The graph above is what I will use to help answer and analyze the question below from title link.
Why should profits on gas be higher during a period of shortage? If the cost is composed of the raw material, labor, marketing, overhead, etc., then profit comes on top of all that. I cna understand where the raw material costs, transport, etc are higher now, but why a larger portion of the cost going to profit? Something doesn't seem right about that.

And response by Dr. Haney:
You're right. It's wrong. It should be illegal (maybe it already is). Certainly it's at least immoral. I suspect it comes from simple greed, but they may be able to rationalize it some other way.

Without going into the derivation of supply and demand curves, I drew a supply and two demand curves that are inelastic above. Price elasticity of demand and Price elasticity of supply refers to a percentage change in quantity over a percentage change in price. Inelastic curves refer to when prices change as a percentage changes more than a percentage change in quantities.
When the price elasticity of demand for a good is elastic (Ed > 1), the percentage change in quantity is greater than that in price. Hence, when the price is raised, the total revenue of producers falls, and vice versa.

When the price elasticity of demand for a good is inelastic (Ed < 1), the percentage change in quantity is smaller than that in price. Hence, when the price is raised, the total revenue of producers rises, and vice versa.

Now what does this all mean to the question at hand? During the peak summer driving season the demand for gas shifts to the right from D1 to D2. I drew the Supply curve as being inelastic, but in reality for the short term the supply curve would be nearly vertical (perfectly inelastic) because of the long lead time from production and refinement to the local market.

And now we can see that while the equilibrium quantity has risen from Q1 to Q2, the price has risen more as a percentage from P1 to P2. So for the market to clear at the new equilibrium the prices went up more than the quantity. Since the new price is not constrained by a set profit level then firms that are able to deliver products are able to achieve above economic profits. If economic profits continue, then new companies get into the business or existing businesses will increase supply or alternatives will enter the market and thus reduce the equilibrium price.

When consumers or producers face inelastic curves, then this can be both a blessing and a curse. Farmers have the problem that when supply increases as in a good crop season, this drops the price drastically and thus will actually reduce income as percentage drop in prices is greater than the increase in quantity (as shown below). The demand curve is inelastic because as prices change consumers tend to purchase the same basket of products and will not change their spending habits at least over the short term.


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