China Has Gas!! (my friend wrote this one)

China rations diesel as record oil hits supplies | Markets | Reuters
In the fall of 2007 I spent  time in Shanghai, China. At the time, oil prices were hitting record levels world wide, leading to rising petrol prices for drivers in most places.  However, at the time,  I began witnesing an unusual site on my taxi rides into the city of Shanghai: as our taxi passed petrol station after petrol station, I observed dozens of blue trucks (the ubiquitous medium of transporting good from Shanghai’s factories to her ports) spilling out of gas station parking lots into the road, apparently queued, waiting for a spot at the pump. I had never seen such long lines at any of the petrol stations around Shanghai before, and I began to wonder as to the reasons for these crazy long lines!
Well, an article at the time helped solve the riddle of the long lines. As it turns out, there was a simple explanation rooted in the principles of supply and demand that any first semester AP or IB economics student would understand! The Chinese government had been forced to ration petrol (limiting the amount that a driver can buy at one go) due to the shortages resulting from the government’s price controls in the petrol market.

Truck drivers reported long queues at petrol stations along a national highway linking Fujian and Zhejiang provinces, with each truck getting 100 yuan ($13) worth of diesel, or around 20 litres, per visit at a state-run station and 40 litres at a private kiosk…
“What’s wrong with the oil market? Our drivers had to queue the whole night for only a small amount of fill, slowing the traffic by almost one day,” said Gao Meili, who manages a logistics company.

China is a major importer of oil. With an economy growing around 12% in 2007, much of the country’s growth depended on the availability of crude oil at reasonable prices, which China’s oil refining firms turn into diesel and petrol, needed to get Chinese manufactured products from factory to port and from port to overseas consumers.
The problem with the oil market in China, however, was that as “Chinese refiners cannot pass the souring crude costs on to consumers.” Oil is an input needed to make a finished product, diesel. As the price of oil rose in 2007 (it reached a record of $92 per barrel in October of that year), the resource costs to petrol and diesel producers also rose, shifting the supply of petrol and diesel to the left, putting upward pressure on the equilibrium price.   As a first semester AP or IB student knows, resource costs are a determinant of supply, and as oil (the main resource in the production of petrol and diesel) increased in price, the supply of these important commodities invariably decreased.
In a free market, a decrease in supply leads to an increase in price. Herein lies the answer to the riddle of the long lies at petrol stations in Shanghai: the Chinese petrol and diesel market is not a free market. The government plays an active role in controlling prices paid by consumers for the finished product refiners are producing, petrol fuel:

Beijing fears stoking already high inflation and rigidly caps pump fuel rates to shield users from a 50 percent rally in global oil so far this year.

As the costs to petrol and diesel producers rose in 2007, the government in Beijing took the side of consumers and forbade fuel producers from raising the price they charge consumers.  The Chinese government essentially imposed a price ceiling in the market for petrol. A price ceiling is a maximum price set by a government aimed at helping consumers by keeping essential commodities like fuel affordable. As we have learned this week in AP and IB Economics, price controls such as this end up hurting BOTH producers AND consumers, since they only lead to a dis-equilibrium in the market in which the quantity demanded for a product rises while the quantity supplied by firms falls. The shortage of petrol and diesel resulting from the government’s price control are the perfect explanation for the long lines of blue trucks and motor scooters at all the gas stations in Shanghai during October of 2007.
So why, exactly, does the government’s enforcement of a lower than equilibrium price result in such severe shortages that truck drivers are only allowed to pump 20 litres of petrol per visit and made to wait hours each time they need to refill? Below is a supply and demand diagram that illustrates the situation in the Chinese fuel market in 2007:

In the graph above, the supply of petrol has decreased due to the increasing cost of the main resource that goes into petrol, oil. This decrease in supply means petrol has become more scarce, and correspondingly the equilibrium price should rise. However, due to the government’s intervention in the petrol and diesel markets, the price was not allowed to rise and instead remained at the maximum price of Pc.
At the government-mandated maximum price of Pc, the quantity of fuel demanded by drivers far exceeds the quantity supplied by China’s petrol producers. The result is a shortage of petrol equal to Qd-Qs.
The government’s intention for keeping petrol prices low is clear: to make consumers happy and keep the costs of transportation among China’s manufacturers low so as to not risk a slow-down in economic growth in China. However, the net effect of the price controls is a loss of total welfare in the petrol market. Notice the colored areas in the graph above. These represent the effect on welfare (consumer and producer surplus) of the price control.

• The total areas of the green, orange and grey shapes represent the total amount of consumer and producer surplus in the petrol market assuming there were NO price controls. At a price of Pe, the quantity demanded and the quantity supplied are equal (at Qe) and the consumer surplus and producer surplus are maximized. The market is efficient at a price of Pe. Neither shortages nor surpluses of petrol exist.
• However, at a price of Pc (the maximum price set by the government), the amount of petrol actually produced and consumed in the market is only Qs. Clearly, those who are able to buy petrol are better off, because they paid a lower price than they would have to without the price ceiling. But notice that there is a huge shortage of fuel now; many people who are willing and able to buy petrol at Pc simply cannot get the quantity they demand, because firms are simply not producing enough!
• The total consumer surplus changes to the area below the demand curve and above Pc, but only out to Qs. The green area represents the consumer surplus after the price control. It is not at all obvious whether or not consumers are actually better off with the price ceiling.
• The total producer surplus clearly shrinks to the orange triangle below Pc and above the supply curve. Petrol producers are definitely worse off due to the government’s action.
• So how is the market as a whole affected? The black triangle represents the net welfare loss of the government’s price control. Notice that with a price of Pe, the black triangle would be added to consumer and producer surplus, but with a disequilibrium in the market at Pc, the black triangle is welfare lost to society.

Price controls by government’s clearly have an intended purpose of helping either consumers (in the case of a maximum price or price ceiling) or producers (in the case of a minimum price or price floor).  But the effect is always predictable from an economist’s perspective. A price set by a government above or below the equilibrium price will always lead to either a shortage or a surplus of the product in question. In addition, there will always be a loss of total welfare resulting from price controls, meaning that society as a whole is worse off than it would be without government intervention.
Discussion Questions:

1. Why has the supply of petrol decreased?
2. With a fall in supply of a commodity like petrol, does the demand change, or the quantity demanded? What is the difference?
3. Define “consumer surplus” and “producer surplus”. Why does a government’s control of prices reduce the total welfare of consumers and producers in a market like petrol?
4. How would a government subsidy to petrol producers provide a more desirable solution to the high oil prices than the maximum price described in this post? In your notes, sketch a new market diagram for petrol and show the effects on supply, demand, price and quantity of a government subsidy to petrol producers. Does a subsidy create a loss of welfare? Why or why not?

Have Your Pasta and Eat It Too!!

Have a look at this article before reading the blog post below: Pasta prices rise after North Dakota loses million acres of wheat to heavy rain, flooding – Associated Press
Prices are determined by the relative scarcity of a good, service or productive resource. This fundamental lesson is one of the first things we learn in a high school economics class. Why are diamonds, which nobody really needs, so much more expensive than water, which everyone needs? The answer lies not in the relative demands for the two goods (clearly, water is far more demanded than diamonds), but rather the relationship between the relative demand and the supply. Between the two, diamonds are far more limited in supply than water, thus they are scarcer and accordingly more expensive.
This lesson applies not only to water and diamonds, but indeed to any product for which there is a market in which buyers and sellers engage in exchanges with one another. Commodities are goods for which there is a demand,  but for which the supply is standardized across all markets. For instance, bicycles are not a commodity, because there are hundreds of different types of bicycles, meaning it is not a standardized product. But steel, which is used to make bicycles, is a commodity since steel is fairly standard regardless of its ultimate use by manufacturers. Cookies are not a commodity, but wheat is, since wheat is a highly standardized ingredient used in the production of cookies.
Commodity prices, like the prices of anything, are determined in markets. Buyers are usually the manufactures of secondary products for which the commodities are an input. Since commodities are traded all over the world, there tends to be a common market price determined by the national or international supply and demand for the commodity. In recent weeks, one very important commodity has increased in scarcity, leading to an increase in the price for the finished product the commodity is used to produce.

Consumers are paying more for pasta after heavy spring rain and record flooding prevented planting on more than 1 million acres in one of the nation’s best durum wheat-growing areas.
North Dakota typically grows nearly three-fourths the nation’s durum, and its crop is prized for its golden color and high protein. Pasta makers say the semolina flour made from North Dakota durum produces noodles that are among the world’s best.
This year’s crop, however, is expected to be only about 24.6 million bushels, or about two-fifths of last year’s. Total U.S. production is pegged at 59 million bushels, a little more than half of last year’s and the least since 2006, according to the U.S. Department of Agriculture.
The cost of pasta jumped about 20 cents in the past few months to an average of about $1.48 a pound nationwide…
…North Dakota durum fetched about $15 a bushel this spring but has dropped to about $11, due to the lack of buying and selling.
Still, that’s about twice what it sold for at this time last year, she said…
“This is one of the few crops we have that can have such an immediate impact on the consumer,” Goehring said. “This year, they will experience higher pasta prices.”

The story above is one played out in countless markets for commodities (such as wheat) and the goods they are used to produce (pasta, in this case) all the time. Due to poor weather and a particularly wet spring, farmers were unable to plant as many of their fields with wheat as they have in the past. Therefore, the 2011 wheat harvest is less than it usually is, meaning the supply of wheat has decreased. However, since there has been no fundamental change to the demand for wheat (we still eat pasta!) the relative scarcity of wheat is greater than in the past. Demand remained constant, while supply fell, therefore the relative scarcity increased.
The value of anything is based on its relative scarcity. In product markets, like that for wheat, value is conveyed by the commodity’s price. As the article says, the price of wheat is currently selling at “about twice what it sold for at this time last year”. At the current price of $11 per bushel, we can assume that the price last year was $5.50. However, the price reached as high as $15 earlier in the summer, indicating that the reduced supply of 59 milliion bushels, which is “a little more than half of last years” (which we’ll assume was around 100 million bushels), caused the price to peak at $15 this year. All this is a complicated way of saying that as the output of wheat fell, wheat prices rose because demand remained constant.
Additionally, the price of the product for which wheat in an input also rose. Pasta prices have jumped “20 cents in the past few months” to $1.48. Since the price of wheat is a resource cost for pasta producers, higher wheat prices lead to a fall in the supply of pasta, making pasta more scarce and driving the price up for pasta consumers.
All this can be demonstrated graphically using simple supply and demand analysis.

Based on the figures in the graphs above, the responsiveness of wheat consumer (which are mostly pasta producers) to the rising price of wheat can be easily calculated. Price elasticity of demand (PED) is the measure of consumers’ sensitivity to price changes. It is measured by calculating the percentage change in quantity following a price change divided by the percentage change in price. The quantity demanded of wheat fell by 41%, while the price rose by 272%, meaning that the PED for wheat is 41/272, or 0.15. This is considered relatively inelastic since such a large price increase led to a relatively small fall in the quantity of wheat demanded.
It is likely that if wheat prices remain elevated throughout 2011, next spring farmers across the American Midwest will have a strong incentive to plant more acres of wheat than they have in years past. Assuming the weather conditions improve and the fields are dry enough to grow wheat, it would be expected that a year from now wheat prices will be much lower than they are today, as supply returns to or exceeds historical levels next year. High prices for wheat today have harmed pasta consumers, but in the long run everyone, both pasta producers and pasta consumers, will likely enjoy lower prices thanks to the high prices of today.
This is how the market system works. When resources are under-allocated towards a particular good, as they have been towards wheat in 2011, price rises in response to the good’s increased scarcity. But the higher prices incentivize producers to allocate more resources towards those goods’ production, and over time the supply increases once more, reducing its scarcity and bringing the price back down.
Discussion Questions:

1. Why did wheat become more scarce in 2011, even though the demand for wheat did not change?
2. Interpret the claim that “wheat consumers are relatively unresponsive to higher wheat prices”. Can you think of a reason why this is the case? Can you think of an example of a product for which consumers would likely be much more responsive to a change in the price?
3. How does the high price of wheat and pasta in 2011 likely assure that a year from now, prices will be much lower than they are today, assuming there are not further problems with flooding in wheat growing areas?
4. How do prices “allocate resources” in a market economy? What do you think would have happened to the number of acres farmers would plant in wheat next year if instead of the price doubling this summer, it had been half of what it was in previous years?

Welcome all new Econ students! Time to start thinking like economists

One of the questions I like to ask my student during the first week of class every year is “What is Economics?” The answers are always interesting to read, because unlike many other high school classes, Econ is one of those subjects students sometimes have no idea what it’s all about when they sign up for the class. Below are some of the definitions of “Economics” students shared in their first day survey this week:

• “Economics is the study of money flow between either countries or individual companies.”
• “My definition of Economics is the control of money by a person, organization or nation.”
• “Economics is a complex system that determines and justifies global prices, currency values, and ultimately the success of a nation.”
• “I’d say Economics is the study of how humans use resources including income, investments, taxes and the economy.”
• “I think economics is the study of investments and money. Especially income and outcome, and taxes in the government.”
• “The study of the distribution of wealth and how human beings tend to handle wealth.”
• “A bunch of old men moaning about all of the potentially free lunch oppurtunities they had missed in their youth, passed off as the behaviour of markets.”

As you can see, most students do not yet have a clear definition of the subject in their heads when they start the course, which is perfectly understandable! So I thought I’d start the year off by sharing my definition of economics. Please read the following introduction to Economics then answer the discussion question that follows.
So what IS Economics, anyway? Well, look around you. What do you see? From within the Mainland Regional district, I see a massive bridge project in Somers Point. I can count eight yellow cranes swinging their arms hauling construction materials around their respective sites. I see farm markets, flower shops, farms, and gardens. I see a church steeples and businesses all around our school. I can just see the tops of cars racing along the Parkway to and from towns and cities all along south and north Jersey.
Now ask yourself, how did things get to be this way? Why are new bridges going up in the midst of America’s deepest recession in decades? Why are farmers and gardeners able to continue on when condos and single family houses are selling for half a million dollars just beyond their fields? Why are the Pinelands and parks still standing even as development has encroached into most of the region’s  forests and natural ecosystems? How do normal people make enough money to live comfortably in this expensive country? Where do the things we buy come from? Who built this computer I’m typing on and what will I be doing for a living in twenty years?
One of my favorite quotes that to me sums up what economics is all about comes not from an economist, but from the civil rights leader Martin Luther King. In 1967 King wrote:

Did you ever stop to think that you can’t leave for your job in the morning without being dependent on most of the world? You get up in the morning and go to the bathroom and reach over for the sponge, and that’s handed to you by a Pacific islander. You reach for a bar of soap, and that’s given to you at the hands of a Frenchman. And then you go into the kitchen to drink your coffee for the morning, and that’s poured into your cup by a South American. And maybe you want tea: that’s poured into your cup by a Chinese. Or maybe you’re desirous of having cocoa for breakfast, and that’s poured into your cup by a West African. And then you reach over for your toast, and that’s given to you at the hands of an English-speaking farmer, not to mention the baker. And before you finish eating breakfast in the morning, you’ve depended on more than half the world. This is the way our universe is structured, this is its interrelated quality.

Economics is about all the questions I posed above and it’s about all the interactions King describes. Economics is about solving one major problem faced by all human societies going back thousands of years. Economics is about the problem of scarcity. Scarcity is the natural phenomenon arising from the fact that all the world’s resources are physically limited in quantity.
Limited resources alone would not pose a problem if it were not for one characteristics of human beings that makes us truly unique in the animal kingdom. The fact that we have desires and wants beyond our basic physical needs. In the face of humans’ practically unlimited desires and wants, the limited nature of the earth’s limited natural resources gives rise to conflicts regarding the allocation of those resources. Economics is the social science that deals with the allocation of earth’s scarce resources among the competing wants and needs of society. Economists provides society with various tools and techniques for efficiently allocating our scarce resources.
Discussion question:

1. Scarcity of resources has given rise to countless conflicts among and between societies throughout history. Identify one conflict from the past or present that you think the problem of scarcity gave rise to.
2. Some say that many of the environmental problems our world faces to day can be solved by economics. If that’s the case, then they must have to do with scarcity. Identify one environmental problem and explain how it relates to scarcity.
3. Time is one of the scarcest resources. Explain how the decisions you make regarding your limited time in and out of school can be considered economic decisions.