PJC H2 ECONS P2 Q1

Pioneer Junior College (Economics Department) 1 PJC 2017 H2 Prelim Exam Paper 2 Q1 Question: Oil prices have fallen after the OPEC group of oil producing nations said global crude stocks had risen coupled with Saudi Arabia's production increasing to 10.011 mill ion barrels per day from 9.748 million barrels per day. In addition, a weaker economic outlook means demand for oil in 2017 is likely to grow at a slower rate. Discuss how the above events are likely to impact the market for oil and its related markets. [25] The market for oil works through the forces of dema nd and supply. Demand refers to the willingness and ability to pay at each and every price while supply refers to the willingness and ability to produce a good at each and every price level. Hence, if there are any changes to demand and/or su pply for oil, the market will be affected and the equilibrium quantity and price will change dependin g on the extent and direction of the changes in demand and supply. In addition, the price elasticity of demand and supply can also impact the extent of price changes when demand and supply change. Being an essential factor input that is involved in almost the production of all other goods and services, the change in the price of oil would defi nitely have an impact on many other markets such as air travel, energy and manufactured goods. With reference to the preamble, the rise production of oil by Saudi Arabia and slower growth will impact the supply and demand for oil respectively. With a rise in supply of oil due to the higher prod uction by Saudi Arabia, this will result in a right ward shift of the supply curve. A surplus will occur at the original price, causing downward pressure on price and a subsequent fall in oil prices and an in crease in equilibrium quantity. As demand for oil i s price inelastic due to the fact that it is an essen tial factor input used for producing almost all goo ds and services and a basic commodity, a rise in suppl y against a price inelastic demand curve will result in a huge fall in its price. The preamble also mentioned that growth rate is exp ected to slow down amidst the weaker economic outlook. With slower growth, income levels will rise but at a much slower rate. Demand for goods and services will still increase and this rai ses the demand for oil as oil is a necessary factor input used in essential areas such as transport and energy. The rise in demand for oil will result in a

Pioneer Junior College (Economics Department) 2 shortage at the original price, with upward pressur e on price and ultimately causing the equilibrium price and quantity to increase. With supply of oil being price inelastic as it takes a long time to ca rry out exploration and extraction, the rise in demand against a price inelastic supply will cause the price of oil to rise significantly. Overall, it is likely that the rise in supply of oil will outweigh the rise in demand as economic outlook is still bleak and many economies’ growth rates are on ly starting to pick up. Hence, taking into account the change in demand and supply factors, the price of oil should fall in conjunction with a rise in equilibrium quantity. Evaluation: The extent to which price of oil may fall might be limited as Saudi Arabia would attempt limit its production in view of the rapidly falling prices. This is because the fall in oil prices will have an adverse impact of the country’s economy since oil is one of their main sources of export revenue and it is likely the Saudi Arabian government will inte rvene accordingly to boost oil prices to minimize t he negative consequences of falling oil prices.

Pioneer Junior College (Economics Department) 3 One of the markets that would be heavily affected by changes in the oil market would be air travel. Oil is an essential factor input used in the produc tion of fuel and petrol. As oil prices fall, the co st of production for airline will fall as fuel costs take up a huge percentage of their total costs of production. This will result in a significant rise in supply of air travel services, resulting in a fall in equili brium quantity and a fall in the equilibrium price. In ad dition, demand for air travel should also rise significantly due to the fact that income levels ar e actually still increasing and air travel to most consumers are luxurious goods. Thus the overall imp act on price depends on the extent of the shifts in demand and supply while equilibrium quantity has increased. Evaluation: The extent to which the price of air travel will be affected by the fall in oil prices might be mitigated by rising costs of labour and other expen ses which airlines might incur such as airport taxes. With many developed countries such as Singap ore, Japan and UK facing demographic challenges such as an ageing population, labour cos ts will rise significant and this may have a greater impact on airlines’ operating costs. Thus, the net rise in supply for air travel could be limi ted with opposing factors working against each other. With falling oil prices resulting in lower fuel costs for airlines, the airlines may see this as an excellent opportunity to expand their operations due to the e xistence of higher potential profits and offer more routes and choices for consumers. For instance, Sco ot has embarked on providing flights to places such as Athens, Honolulu and Osaka. With more marke ting and options for consumes, the demand for air travel will increase, leading to a rise in equilibrium price and quantity. The overall impact on the air travel industry will depend on the extent of the shifts of the demand and supply curves. In the short term, the rise in supply of air travel is likely to outweigh the demand for air travel as expansion plans always take time to materialize and the fall in oil prices seemed substantial and is likely to persist in the midst of weak economic outlook. Another related market that is affected by falling oil prices would be the energy market. As oil is an essential factor input used in the pro duction of many forms of energy and fuel such as electricity and petrol, the fall in oil prices woul d imply a fall in cost of production for energy. Th is would lead to a rise in supply of energy in the ene rgy market, causing energy prices to fall and the equilibrium quantity to fall. The fall in energy pr ices could even reduce cost pressures greatly, increasing the short run aggregate supply curve for economies and lead to a fall in cost push inflation. The impact on the traditional energy market may imp act the market for alternative sources of energy such as natural gas. As traditional sources of ener gy is now cheaper, the substitution effect will reduce the demand for these alternative sources of energy, leading to a lower price and quantity traded in the market. Evaluation: The impact of falling oil prices on the alternativ e energy market is uncertain. This is because many governments in the world are heavily s ubsidizing and supportive of the use of such energy sources to combat climate change. The market price of such energy sources may be driven to very low levels through government intervention and despite the fall in traditional sources of energy derived from oil, the demand for alternative sources of energy such as natural gas may not be affected to a large extent.

Pioneer Junior College (Economics Department) 4 Falling oil prices will have an impact on the market for manufactured goods and services. As oil has a direct impact on energy prices and energy is required to produce all kinds of goods and services, the cost of production for all types of goods and services will rise. A fall in cost of production wil