Evangel's IB Economics Blog

Less oil, more battery (Photo by Automotive Today)

Demand is the willingness and ability to purchase a quantity of a good or service at a certain price over a given time period. Supply is the quantity of goods and services that producers are willing and able to produce at a certain price. Equilibrium price is the market clearing price. Price control is controls that governments or other authorities put in place to try to influence the outcome of a market. Price floor is a limit beyond which a cost will not be allowed to fall.

One of the most important resources of the world today is oil. Oil does more than just fuel automobiles and keep the heater going. It is the base upon which our entire modern society is built. However, the price of oil is skyrocketing, rising 10% within a month. According to the article, “How High Gas Prices Can Save the Car Industry” in The New York Times, increasing the gas prices and setting a price floor can help the hybrid car industries that are currently suffering. If the oil price is high, quantity demanded for the conventional gasoline car will decrease because oil is a complementary good of normal automobiles. This means that the alternative choice, the hybrid cars, will experience increase in demand. Therefore, the United States government is planning to set price floor of oil to $3.50 per gallon. This price control by the government will prevent the price of oil from dropping less than $3.50 per gallon; the price of oil is set higher than the equilibrium price in order to protect certain industries.

The diagram below (Figure 3) clearly portrays the situation of United States.

(Figure 3) The illustration of government intervention in price of gasoline

Consider the point E as the equilibrium point where for quantity demanded for gasoline and quantity supplied of gasoline equals each other. At this point, Q amount of gasoline is in the market at the price of P. However, the government intervenes in this situation and sets a price floor, a high, minimum price of PF per gallon. Now, QS amount of gasoline is supplied when only QD amount of gasoline is demanded; this is a surplus. By setting price floor, the government wishes to save the hybrid car companies, but the consequence of this can be surplus in oil.

However, oil is a basic necessity in lives of individuals. Therefore, it goes against the law of demand, which states as the price of a good rises, the quantity demanded decreases, ceteris paribus. In other words, people will have to demand oil even though the price of oil rises.