[Editor’s note: Welcome to the second of our new series on Price Theory problems with Professor Bryan Cutsinger. You can view the posts from last month’s problem here and here. Share your proposed solutions in the Comments. Professor Cutsinger will be present in the comments for the next two weeks, and we’ll again post his proposed solution shortly thereafter, May the graphs be ever in your favor, and long live price theory!]
Question:
According to the Energy Information Administration, crude oil jointly supplies gasoline, heating oil, jet fuel, lubricating oils, asphalt, and many other products. Suppose the widespread adoption of electric vehicles (EVs) reduces gasoline demand but does not affect the demand for the other products jointly supplied by oil. How will the widespread adoption of EVs affect the prices of these other products?
READER COMMENTS
David Henderson
Oct 16 2024 at 1:23pm
Great question. A related question was one of the keys in one of the mystery novels written jointly by Ken Elzinga and William Breit under the pen name Marshall Jevons. I’ve forgotten which of the 4 novels it is, though.
Bryan Cutsinger
Oct 20 2024 at 4:51pm
Thanks, David!
I had no idea a related question had come up in one of their novels!
-Bryan
john hare
Oct 16 2024 at 7:21pm
Depends on how the electric power is generated. If it’s oil fired there’s little difference.
Bryan Cutsinger
Oct 20 2024 at 4:50pm
John,
An interesting complication–I like it!
I think you’re right if the decrease in demand for oil as gasoline is offset exactly by an increase in demand for oil as energy. Suppose instead that the two effects don’t offset each other. What happens then? For example, what if the increase in demand for oil as energy does not fully offset the demand for oil as gasoline?
-Bryan
John Hall
Oct 16 2024 at 8:47pm
Links in the note are missing.
Bryan Cutsinger
Oct 20 2024 at 4:46pm
Thanks, John. I’ll make sure we get this fixed.
-Bryan
John Hall
Oct 16 2024 at 9:12pm
Eliminating the demand for gasoline reduces the derived demand for crude oil. Reduced demand for crude oil – assuming no supply response – reduces the price of crude oil (as well as quantity demanded).
Crude oil is an input into “heating oil, jet fuel, lubricating oils, asphalt, and many other products”, so a lower price has the effect of shifting the supply curve right for all these products.
Generally speaking, this lowers the price of each product and increases the quantity demand. How much it does so depends on the relative supply/demand elasticity of the products. For instance, if heating oil has more inelastic demand than asphalt, then the rightward supply curve shift will have a bigger impact on reducing the price for heating oil than asphalt.
Bryan Cutsinger
Oct 20 2024 at 5:00pm
John,
I like that you incorporated elasticity in your analysis. When I’ve posed this question to my students in the past, I haven’t asked about elasticity, but I going to do so going forward.
The price of oil will fall in this case, but so does the quantity of oil supplied, meaning there is less oil available to satisfy those other demands. How does this affect the price of oil as heating oil, asphalt, etc.?
-Bryan
Monte
Oct 17 2024 at 11:39am
I’ll take a stab.
If the widespread adoption of EVs does not affect the demand for the other jointly-supplied products, one can reasonably assume that a reduction in demand for gasoline would result in an over-supply of crude oil, causing a decrease in the price of these other products. OTOH, a widespread adoption of EVs would force suppliers to shift their operations to increasing their supply of crude oil-derived products – many of which are essential to the manufacture of EVs – thus causing an increase in the cost of operations and a consequent increase in the price of the jointly-supplied products.
A bit counter-intuitive, but such is the nature of economics.
Bryan Cutsinger
Oct 20 2024 at 5:02pm
Monte,
I like your extension of the analysis to highlight the possibility that demand for oil in these others forms may rise. Let’s set that possibility aside. While the price of oil would fall, so will the quantity of oil supplied. There will be less oil available for these other uses–how does that affect the price of oil as jet fuel, heating oil, etc.?
-Bryan
Monte
Oct 22 2024 at 5:07pm
I suppose prices for the other products would then increase in the face of a reduced supply of crude due to increased demand for its remaining uses.
Thomas L Hutcheson
Oct 17 2024 at 9:19pm
I’ll assume that the adoption of EV is the result of a specific subsidy that encourages the substitution of EV for ICE vehicles.
The first effect is to reduce the demand for gasoline and diesel, but some of the other petroleum products mentioned are by-products of gasoline and diesel so as amounts of ICE fuel demanded and supplied falls, supplies of some of the by-products will fall and prices of some of the byproducts will rise.
Bryan Cutsinger
Oct 20 2024 at 5:13pm
Thomas,
I like the added complication of including subsidies in the analysis, but let’s set that aside for now.
The demand for oil as gasoline falls, so the price of oil and the quantity of oil supplied also fall. There’s now less oil available to satisfy the demand for oil in other forms, e.g., jet fuel. What happens to the price of oil as jet fuel?
Regarding the subsidy assumption, does it matter whether we assume the government subsidizes the supply of EVs or demand for EVs? How would either affect the demand for oil as gasoline?
-Bryan
Ken P
Oct 22 2024 at 2:08pm
Adoption rate is likely sped up by EV subsidies but cost of maintenance, and operating is much lower for EVs and cost to produce EVs is headed much lower than ICE vehicles.
The tricky part is that if natural gas use goes up for electricity generation, does it just reduce total drop in oil use or does it squeeze supply on other components that are already hit by the lower oil demand?
Bryan Cutsinger
Oct 28 2024 at 2:13pm
Ken,
The effect on natural gas is an interesting complication I hadn’t considered.
nobody.really
Oct 18 2024 at 2:32am
Much depends on the meaning of “jointly supplied.” For example, trees jointly supply wood for desks and chairs; a fad for standing desks might reduce the demand for chairs—which would free up wood that could be used to make more tables. In contrast, cows jointly supply beef and leather—in a roughly fixed ratio; a surge of vegetarianism would reduce the demand for beef, but none of that excess beef could be converted into leather.
I could imagine that oil no longer needed to produce gasoline might be used instead for these other products. In this case, I see one aggregate demand for oil. The reduced demand for oil to be used for gasoline would simply mean reduced demand for oil in general. Assuming oil has a downward-sloping demand function and an upward-sloping supply function (that is, economies of scale do not overwhelm the diseconomies of scale), I would expect the cost of oil to fall. And if the market for the other products were competitive, I would expect producers to pass on a portion of the reduced cost of oil to their customers.
Alternatively, I could imagine that different products require different distillates of crude oil, and the process of refining (“cracking”) the oil produces distillates in a roughly fixed ratio. In this case, we would face different demand curves for each of the distillates–and the loss of demand for any one distillate would have no effect on the demand for the others. If demand for the distillate used for asphalt drove the demand for crude oil, then a drop in the demand for a separate distallate used for gasoline might have no effect on the demand for crude oil. But if the demand for the distalate used for gasoline drove the demand for crude oil, then a fall in the demand for gasoline would reduce the aggregate demand for crude oil. All else being equal (and assuming competitive markets, etc.), I would expect this to reduce the price for all crude oil products.
But would all else be equal? If a refiner incurred a lump sum cost to generate multiple distillates in fixed ratios, and the market for each of the distillates were competitive, then Frank Ramsey would argue that the refiner would seek to recover the lump sum costs from the customers with the least cross-elasticity of demand. (See Baumol & Bradford, “Optimal Departures from Marginal-Cost Pricing” (1970).) If the distillate for making gasoline had the lowest cross-elasticity of demand, then the cost of distilling crude oil would have been recovered from the customers for this distillate. If the demand for gasoline effectively disappeared, then the distillate with the next lowest cross-elasticity of demand would have to bear the lump-sum cost of refining the oil.
Thus, even if crude oil prices fell due to a drop in aggregate demand, the shift in the supply curve for one of the distillates (reflecting the need to recover the lump-sum cost of refining the crude oil) might offset the effects of the reduced demand, making the effect on the price of that distillate indeterminate.
Bryan Cutsinger
Oct 20 2024 at 5:24pm
nobody.really,
I realize there is some ambiguity in the term “jointly-supplied.” I’m using the term as Deirdre McCloskey does in her price theory textbook.
I appreciate you questioning the “all else equal assumption” here. All else may not be equal, nonetheless, I think it’s useful to consider the partial equilibrium effects before considering the general equilibrium effects.
In terms of the first part of your response, I agree that an upward sloping supply curve for oil means that a decrease in demand for oil means a lower oil price. However, it also means less oil available for the demand for oil in other forms, e.g., jet fuel. How does that affect the price of oil as jet fuel?
-Bryan
johnson85
Oct 21 2024 at 5:48pm
Unless you are wanting the people giving the answers to pick up on this possibility on its own, I think you need to provide some explanation of how oil is used to create the different products referenced. It’s going to be different for the type of oil you are getting, but I think for brent crude oil a typical breakdown would be that a little less than half of a barrel of oil is turned into gasoline and a little more than a quarter is turned into some form of diesel, and like a tenth of it can be used to make jet fuel, and then the remainder goes into asphalt, lubricants, and whatever else.
To my knowledge, you can’t just decide, well gasoline prices are dropping so we’re going to flip the percentages of diesel and gasoline to make more diesel from each barrel. You have some choices between products, but you choices are limited by the make-up of the oil in question.
Without knowing this, you are going to end up with an incorrect prediction of what happens to the price of oil.
I think the basic answer is that gasoline is going to get cheaper and every other product that comes out of a barrell of oil (assuming their demand isn’t impacted by adoption of EVs), is going to get a little more expensive. Over time you’d see more applications shift to gas engines instead of diesel engines to take advantage of this and offset the initial changes.
Bryan Cutsinger
Oct 28 2024 at 2:18pm
Hit submit too quickly…
Widespread EV adoption would increase the demand for electricity, and thus natural gas. I’m curious if there are any other products jointly supplied by natural gas as their is with oil. I don’t know enough about the production processes to say anything interesting on that point, but it’s an interesting extension to consider.
Comments are closed.