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H2 Explain the likely demand and supply factors affecting the oil (petroleum) market. [10]

Note: An "A" level Economics standard type of examination question.

This paper explains the likely demand and supply factors affecting the oil market. Demand refers to the willingness and ability to purchase a good, while supply refers to the willingness and ability to provide the good. The market price of a good is determined by the intersection of the demand and supply curves. The equilibrium output occurs when the quantity demanded is equal to the quantity supplied. 

There are various factors affecting the demand and supply of the oil market. 

First, let me deal with the demand side. For the demand aspect, the factors affecting it include derived demand, availability of substitutes and complements, population changes, expectations and increasing incomes. 

Derived demand refers to demand for goods which are not demanded for its own sake but it is used to facilitate the consumption/production of another. In the oil market, oil is demanded to facilitate the production processes in factories and for transportation. That is, the demand for oil is derived from the demand for transport as well as for production and manufacturing processes to spur the economy of a country. 

Substitutes are goods which are considered to be alternatives to each other while complements are goods that when consumed together, gives rise to a higher combined utility than if goods were consumed individually. There are no substitutes for oil as it is a necessity for the operations of machinery in production processes and for transportation. As a result, the demand for oil is very price inelastic due to lack of availability of other related goods to substitute oil. 

The rising incomes among the population affect the demand for oil too. With increasing household income, the purchasing power among consumers increases. They have the financial capability to buy private cars which offer more comfort than taking public transport. Rising income will see a rise in private car ownership as well. This will drive up the demand for oil in the private car market.

Expectations will affect the demand for oil. If the price of oil is expected to rise, buyers may want to purchase more of the oil now before the price rises, thus raising current demand. In this case, producers may intensify their production processes to take advantage of the cheaper oil price now. Conversely, if the price of oil is expected to fall, buyers may want to hold back their purchases thus reducing current demand. For instance, private car owners may switch to take public transport temporarily to save on costs. 

On the other hand, there are also various factors affecting the supply aspect in the oil market. 

This paper now deals with the supply side factors. These factors include costs of production, expectations on the part of producers, number of firms and government policies on the part of the OPEC producers. 

The entry of new firms into the oil market will shift the market supply curve rightwards. An increase in the size of existing firms raises the total capacity of the industry, thus shifting the market supply curve rightwards. In the oil market, the discoveries of new oil reserves will increase the number of producers, leading to the expansion of firms, thus, shifting the supply curve rightwards. On the other hand, when the oil reserves are used up and oil wells run dry, supply could shift to the left, reducing supply. 

Government policies on the part of OPEC influence the supply of oil too. Indirect subsidies will shift the supply curve downwards while indirect taxes shift the supply curve upwards. Increased taxes on oil will raise the cost of production of the oil barrels which reduces the supply. Alternatively, decreases in OPEC’s production will also shift supply to the left. 

Economics Diagram: Supply & Demand Interaction

[Tutor's note: This section here describes the diagram and explains the movements of the curves.] The initial equilibrium price and output is at P1 and Q1 respectively, as determined by the intersection of the S1 and D1 curves. Supply curve shifts from S1 to S2 while demand curve shift simultaneously from D1 to D2. The new equilibrium price and output is P2 and Q2, as determined by the intersection of the S2 and Q2 curves. 

In conclusion, the factors affecting demand and supply of oil will shift the curves respectively. When considering which factor is more responsible for the shifting of the curve, it is important to consider it on a case-by-case basis. 

JC Economics Essays: Economics Tutor's Comments - Demand and supply analysis is totally fundamental to "A" level Economics (for practically all the A level Economics papers, and is also important for first year introductory undergraduate Economics), and can be applied to many markets, ranging from the oil market to the car market, or from commodities to even the market for labour and other factors of production. Hence, knowing the Economics of demand and supply is crucial to scoring well at the examinations. This Economics paper is rather well written, simple, clear, and to the point. Once again, special thanks to S YQ who contributed this well written economics essay. The usual question applies: how can you make the essay better? It goes without saying that the diagram should be drawn accurately and well labelled. Other than that, what else could you do or would you have done? Note that for advanced A level students or even H2, H3 students taking the examinations, this paper could possibly have included oligopoly and perhaps even discussed elasticities, adding on to the analysis. Thanks for reading, and cheers. 

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