Archive | December 2015

Oil price fall illustrates several micro concepts

The drop in oil prices (to a level below that of 2004) has been reflected in gasoline prices, which you may have observed at your local gas stand. The demand for oil is partly derived from the demand for gasoline. It is also derived from the demand for electricity and many other items.

Notice how the price movement ties in with economic principles:

  1. The fall can be explained with simple demand and supply analysis. While demand has  been shifting left (for various reasons, such as the increased availablity of substitutes) and will continue to do so (if the COP 21 promises are upheld), supply has been shifting right, due to fracking and shale oil etc.

2) But the price drop is particularly large due to the inelastic demand for oil. Draw such a curve and then shift supply right on it. Notice the large drop in price.

3) In addition, supply has continued to shift right even though it is against the collective interest of cartels, such as OPEC.  Game Theory can be used to demonstrate that each “player ” (in this case, each oil-producing country) encounters the dominant strategy which leads it to increase supply and thus reduce  prices. All the players try to maximise their own self-interest but end up in an equilibrium in which they are all worse off.

4) The important issue of market failure due to negative externalities of consumption and production also plays a large part in explaining the movements in demand.

Good news for 2016 and beyond?

The conclusion of the COP21 climate change talks in Paris, with an unprecedented deal agreed to by 196 countries, has provided some optimism that measures will be taken to reverse global warming.

In brief, both developed and developing countries are required to limit their carbon emissions to relatively safe levels, so that warming will not exceed 2C above pre-industrial levels. Finance will be provided to poor nations to help them cut emissions and cope with the effects of extreme weather. Countries affected by climate-related disasters, which are mostly among the ELDCs, will gain urgent aid.

The actions that will be taken over the next 20 years to reduce emissions range from planting tens of millions of trees and developing solar power, to reducing emissions from coal and cutting subsidies for fossil fuels. All the big development banks, including the World Bank,  have pledged to greatly increase lending for low-carbon projects such as those involving solar, wind and other renewable technologies.

There is criticism that the caps on emissions are still too loose and are likely to lead to warming of 2.7 to 3C , breaching the 2C threshold that scientists say is the limit of safety, beyond which the effects – droughts, floods, heatwaves and sea level rises – are likely to become catastrophic and irreversible.

The COP deal has implications for the study of both microeconomics (externalities and market failure), which the G11 students will start in January, and development economics, which the G12 students are already studying. It also has implications for your future and the future of the world!

Different monetary policy directions

As expected, the Federal Reserve (the US central bank) raised interest rates last week—a tightening of monetary policy. A couple of days later, and rather unexpectedly, the Bank of Japan announced steps to bolster its quantitative easing program. You don’t need to know the details, but you should know that it implies further monetary expansion. It seems that Japan is concerned that growth is still rather weak and needs boosting. It is still nowhere near its 2% inflation target.

Consider the implications–not only for real investment by firms but also for financial flows (portfolio “investment”) between the USA and Japan (in the Balance of Payments). It does seem nowadays that the effect on financial flows is much stronger than the effect on real investment. Japanese firms are still too reluctant to invest despite the “easy” money. On the other hand, the rise in US interest rates could dampen investment and growth in the US. Contraction through monetary policy seems easier to achieve than expansion. Perhaps the latter is like “pushing on a string”.

In other news…the holiday has started. Have a good rest, so that you are really ready for the next semester.