Sep 30 2008
Prices as signals from buyers to sellers - a case study
Published by Jason Welker at 12:00 pm under
Technorati
Flickr
del.icio.us
Ice Rocket
WikipediaEnergy Roundup - WSJ.com : In Today’s Journal: Easing Back on the Gas
Here’s a great example of a market in disequilibrium:
“Amid an abundance of natural-gas supplies and soft prices, gas producers are starting to pull the plug. Chesapeake Energy Corp. said it will cut 6% of its gas production in September in response to low natural-gas prices. The Oklahoma City-based company will also reduce its capital spending by 10% in 2008 and 2009. Other natural-gas producers are cutting back their output as well, analysts said.”
We learn in IB and AP Economics that markets are generally efficient thanks to the signals that prices send from consumers to producers to determine where scarce resources should be allocated. We’ve also learned how supply and demand interact in a market (such as that for natural gas) to determine equilibrium price and quantity. In the above example, there exists a disequilibrium, where either the quantity demanded exceeds the quantity supply (a shortage), or the quantity supplied exceeds the quantity demanded (a surplus).
Based on the excerpt above, discuss the causes and effects of the disequilibrium in the natural gas market. Are resources being under or over-allocated towards gas production right now? What about in a month or two? On a piece of scratch paper, sketch a supply/demand diagram and illustrate the above scenario. Describe the shifts you would draw in such a diagram.
Discussion questions:
- What is meant by “soft prices” in the natural gas market? Assuming output by gas producers remained constant, what must have changed to cause the soft prices?
- How have firms responded to soft prices? Does the reaction of the gas companies support the law of supply? Explain
- In the next month, what will happen to supply of natural gas?
- What may happen in the natural gas market if firms reduce capital spending in the next two years?
Once you’ve read this post, thought about the situation in the gas market, and commented below, read this for a clear, concise explanation of the situation from a college professor, or click here: Environmental Economics: A demand and supply example
About the author: Jason Welker is a teacher at Zurich International School in Switzerland, where he teaches Advanced Placement and International Baccalaureate Economics. Jason was an international school student in Malaysia before studying economics at Seattle University then earning his Masters in Education. He calls Seattle and Northern Idaho home. In addition to maintaining an economics wiki and this blog for economics student and educators, Jason also gives presentations on using Web 2.0 tools in education at workshops and conferences around the world. His economics wiki won the 2007 "Best Educational Wiki" award from the "EduBlog Awards". 
![Freakonomics [Revised and Expanded]: A Rogue Economist Explores the Hidden Side of Everything](http://ecx.images-amazon.com/images/I/51Z1scnqz1L._SL160_.jpg "Freakonomics [Revised and Expanded]: A Rogue Economist Explores the Hidden Side of Everything")
![The World Is Flat [Updated and Expanded]: A Brief History of the Twenty-first Century](http://ecx.images-amazon.com/images/I/410FGAGYGPL._SL160_.jpg "The World Is Flat [Updated and Expanded]: A Brief History of the Twenty-first Century by Thomas L. Friedman")
According to the quote, there is a surplus of natural gas and low (soft) prices leaving the companies in a situation where they are not maximizing their profit. The way the gas prices sofened assuming gas prices sayed the same, was because of high supply and not as much demand. In an attempt to sell their product, and reach an equilibrium companies then had to lower the prices to match the poinit on the demand curve where the quantity demanded is equal to the quantity supplied. The effect of companies lowering their prices though is that they will now lower their supply substantially, and we will see less natural gass being produced as prices stay low. The companies see it fit to invest in capitol for other areas since they become more profitable. What as a result will occour is natural gas production, as an industry, slow down in growth, and maybe even go into recession as the scarce resources are allocated into creating more supply in other areas.
There is obviously a surplus in natural gas. I agree with Benji that the demand for natural gas has decreased because of the the surplus. The only way to solve this problem was for the supply and demand to be at the same point. For this their companies had to sell cheap natural gas to get rid of the surplus. The negative effect that this surplus will have on natural gas in the next few months is that the supply will decrease because natural gas is being sold for so cheap. In the next two years companies may move towards different means of demand, and supplying other resources. This may lead to a end in the supply of natural gas because the price is so low and production is to costly.
Like Benji and Basti already mentioned, the gas companies’ reaction to soft prices is to lower their output or quantity supplied. This shows a direct relationship between price and quantity of output supplied and clearly illustrates the Law of Supply.
If I were to sketch this on a supply/demand diagram, the point that natural gas companies are right now is below the equilibrium point (illustrating a surplus of gas). The point has had to shift closer to the demand curve (by lowering the prices) to comply with customer’s demands and rid themselves of the surplus. However, with prices so low, they will only lose money and not make any worthy profits. The natural gas market would unfortunately suffer if firms reduce their capital spending in the next two years causing them to allocate their production towards something else that will not cause them to lose money. Therefore, resources are being under-allocated towards natural-gas at the moment since the quantity supply has been reduced.
First of all, Rocio I think you meant to say that the initial price is ABOVE the equilibrium price.
I agree with Rocio when she says that lowering price is unaffordable and that reducing supply is also not the best means of reaching an equilibrium. Now, those are two solutions, but there is another which is increasing the demand. It is obvious that people will not easily demand more. Therefore this is ultimately when the government kicks in and does something helpful for once by buying that surplus. SO NOW WE’VE REACHED EQUILIBRIUM. But where does the government get that money? TAX. Which means that the consumers are paying more and consumer surplus is decreasing. Nevertheless it keeps the natural gas industry going plus that surplus stored can be used for future usage in the case of a SHORTAGE because natural gas is a non-perishable product. So we’ve just talked about three potential ways of reaching equilibrium. In my opinion the government intervention solution is the most effective despite of its negative consequences…. Anyone agree or disagree?