november 2013 Professor yeung

Course Project Part 1

Business Economics

David Gui

11/12/2013

This is part 1 of the course project in fulfillment of ECON 545. This paper analyzes the microeconomic issue “Everyone’s Gasoline Problem”, and Question 14 from Chapter 3 and Question 18 from Chapter 5.

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Exercise 1: Everyone’s Gasoline Problem

Chart 1 (GasBuddy, 2013)

When look at the average regular gasoline prices in the past 12 months in Seattle, we can

see that the prices have been fluctuating in between the one-year period, where regular gas prices

average was $3.585 exactly a year ago, and today (November 12)’s prices average is the lowest

in 12 months at $3.267. Moreover, in the one-year period, the highest prices average was $4.04,

which happened in May 2013.

Fluctuations on prices of gasoline are attributed to fluctuations on prices of crude oil. In

United States, crude oil prices make up 72% of the prices of gasoline, the rest of what consumers

pay at the pump depends on refinery and distribution costs, corporate profits, and federal taxes.

Usually, these costs remain stable, so that the daily change in the price of gasoline accurately

reflects oil price fluctuations. (Amadeo, 2013) Oil prices are a little more volatile than gas prices.

This means oil prices might rise higher, and fall farther, than gas prices. (Amadeo, 2013)

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Government regulations, shortage of supply, and Middle East tensions all have an influence on

prices of oil. For example, in 2012, when Iran threatened to close the Straits of Hormuz, oil

prices rose to their peak at $128.14 a barrel on March 13, and gas prices reached $3.997 on April

9. Both returned to normal until August, when commodities traders began bidding up oil prices

to $117.48 on September 14. They were hedging against the Federal Reserve’s QE3 program,

which they thought would lower the value of the dollar, which would force oil (which is priced

in dollars) to be higher. Then, Hurricane Isaac closed refineries, causing gas prices rise to $3.939

by September 17. And due to the local distribution shortages, gas prices rose to $4.50 in

California. (Amadeo, 2013)

The above examples show that prices of gasoline that consumers pay at the pump are

driven by demand and supply. When demand remains unchanged but there is a decrease in

supply, prices will rise. When supply increases, prices will fall. If demand rises and supply falls,

prices will increase, and just the opposite when demand decreases and supply increases, prices

will go down. When both demand and supply increase, what will happen to prices is uncertain. If

demand grows relatively more than supply, prices will rise, but if supply grows relatively more

than demand, prices will fall. When both demand and supply decrease, what will happen to

prices is also uncertain. If demand falls relatively more than supply, prices will fall; if supply

falls relatively more than demand, prices will rise. (Stone, 2008, pp. 69-72) Being a non-

renewable resource, there are few substitutes to oil, which in turn makes gasoline an inelastic

product, meaning the quantity demanded for it is not very sensitive to price changes. Therefore,

the price fluctuations do not have much effect on quantity demanded for gasoline. In the US,

21% of world’s oil is used here, and two-thirds of it is gasoline used for transportation. (Amadeo,

2013) Since people rely heavily on gasoline, demand for it has never changed much. Given the

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current domestic and global economic conditions, such as rising employments and increasing oil

demand by developing countries like China and India, demand for gasoline will remain steadily

rising, and prices of it can be expected to continue to fluctuate. Alternative ways to save on

gasoline such as hybrid and electric vehicles and more public transportations are available now;

nevertheless, gasoline remains irreplaceable.

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Exercise 2 and 3

Exercise 2: Chapter 3 Question 14

When demand or supply changes, the demand curve or supply curve shifts, equilibrium

also shifts, resulting in a new equilibrium price and/or output. Therefore, even if there is only

demand or only supply change, we can predict the change in equilibrium price and equilibrium

output. (Stone, 2008, p. 68) When Starbucks introduces the premium blends to the market and

demand for it rises substantially, demand curve shifts to the right, and equilibrium price will also

rise and equilibrium output will grow. This may also bring a negative effect to the overall

market, as it may cause the demand for regular coffee to decrease, which in turn makes the

equilibrium price and output of regular coffee decrease.

If a hard freeze eliminates Brazil’s premium coffee crop, supply of premium coffee will

fall, together with the fact of demand for it rises substantially, we can conclude that there will be

a clear increase in equilibrium price, but what will happen to equilibrium output remains

indeterminate or ambiguous; there are alternative outcomes depending on the relative

magnitudes of the changes in demand and supply. If supply declines relatively more than

demand rises, output will fall. If supply declines relatively less than demand rises, output will

rise. (Stone, 2008, p. 71) Nevertheless, price of premium coffee will rise because consumers

want more of it since it has become dearer. In addition, consumers may turn back to regular

coffee, causing the demand for it to increase, thus making the equilibrium price and output of

regular coffee to increase.

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Exercise 3: Chapter 5 Question 18

A.

The midpoint formula for computing elasticity of demand is Ed = {(Q1 – Q0) / [(Q1 + Q0) /

2]} / {(P1 – P0) / [(P1 + P0) / 2]}. (Stone, 2008, p. 117) In this case, the formula to calculate the

price elasticity of demand for Coke is:

Ed = {(992 – 1000) / [(992 + 1000) / 2]} / {(1.26 – 1.25) / [(1.26 + 1.25) / 2]}

= -0.008 / 0.008

= |-1|

= 1

Since the absolute value of the price elasticity demand for Coke is equal to 1, we can say

the demand is unit or unitary elastic; meaning the percentage change in quantity demand is

precisely equal to the percentage change in price. (Stone, 2008, p. 115)

B.

When we assume the demand for Coke is a linear line, elasticity changes at different

prices along the linear demand curve. In the case of 75 cents a can, it would make the elasticity

of demand inelastic. This is because 75 cents a can is a low price and it would make the quantity

demanded high. If we infer from A and assume that for every 1 cent change in price results in an

8-unit change in quantity demanded, sales increases to 1,400, the elasticity is then {(1400 –

1000) / [(1400 + 1000) / 2]} / {(0.75 – 1.25) / [(0.75 + 1.25) / 2]} = 0.667. This will set it to the

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lower right end of the demand curve, where price is low and quantity demanded is high, demand

is inelastic and price increase causes total revenue to increase, price decrease causes total

revenue to decrease. (Stone, 2008, pp. 120-122)

C.

When Coke is $2.00 a can and we also assume the demand is a linear line, same logic

applies. $2.00 would make the elasticity of demand for Coke elastic because such high price

would make quantity demanded low. Sales decreases to 400, elasticity is {(400 – 1000) / [(400 +

1000) / 2]} / {(2.00 – 1.25) / [(2.00 + 1.25) / 2]} = 1.857. This will set it to the upper left end of

the demand curve, where price is high and quantity demanded is low, demand is elastic and price

increase causes total revenue to decrease, price decrease causes total revenue to increase. (Stone,

2008, pp. 120-122)

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ReferencesAmadeo, K. (2013, July 20). How Crude Oil Prices Affect Gas Prices. Retrieved November 12,

2013, from About: US Economy: http://useconomy.about.com/od/supply/p/oil_gas_prices.htm

GasBuddy. (2013, November 12). Seattle 1 Year Average Retail Price Chart. Retrieved November 12, 2013, from GasBuddy: http://www.GasBuddy.com/gb_retail_price_chart.aspx?city1=Seattle&city2=&city3=&crude=y&tme=12&units=us

Stone, G. W. (2008). Chapter 3 Supply and Demand. In G. W. Stone, CoreEconomics (p. 68). New York, NY, USA: Worth Publishers. Retrieved November 12, 2013

Stone, G. W. (2008). Chapter 3 Supply and Demand. In G. W. Stone, CoreEconomics (p. 71). New York, NY, USA: Worth Publishers. Retrieved November 12, 2013

Stone, G. W. (2008). Chapter 3 Supply and Demand. In G. W. Stone, CoreEconomics (pp. 69-72). New York, NY, USA: Worth Publishers. Retrieved November 12, 2013

Stone, G. W. (2008). Chapter 5 Elasticity. In G. W. Stone, CoreEconomics (p. 117). New York, NY, USA: Worth Publishers. Retrieved November 12, 2013

Stone, G. W. (2008). Chapter 5 Elasticity. In G. W. Stone, CoreEconomics (p. 115). New York, NY, USA: Worth Publishers. Retrieved November 12, 2013

Stone, G. W. (2008). Chapter 5 Elasticity. In G. W. Stone, CoreEconomics (pp. 120-122). New York, NY, USA: Worth Publishers. Retrieved November 12, 2013