Sep 30 2010

From disequilibrium to equilibrium – how prices allocate resources in a free market

Published by at 8:00 am under Product markets,Supply/Demand

Energy 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:

  1. 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?
  2. How have firms responded to soft prices? Does the reaction of the gas companies support the law of supply? Explain
  3. In the next month, what will happen to supply of natural gas?
  4. What may happen in the natural gas marketĀ  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

10 responses so far

10 Responses to “From disequilibrium to equilibrium – how prices allocate resources in a free market”

  1. Joannie Mcdewitton 30 Nov 1999 at 1:00 am

    I loved as much as you will receive carried out right here. The sketch is attractive, your authored material stylish. nonetheless, you command get bought an shakiness over that you wish be delivering the following. unwell unquestionably come further formerly again as exactly the same nearly a lot often inside case you shield this hike.

  2. Benji Rosenon 01 Oct 2008 at 10:28 pm

    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.

  3. Bastien Vogton 03 Oct 2008 at 7:22 pm

    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.

  4. Rocio Perezon 17 Oct 2008 at 9:16 pm

    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.

  5. Alex Hanon 31 Oct 2008 at 6:35 am

    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?

  6. Janne J.on 24 Sep 2010 at 5:35 pm

    There is a surplus of natural gas in this scenario as the company cannot sell all of its product. This means there is a higher supply of natural gas than there is demand for it. The soft prices are a result of the surplus, as the company tries to reach an equalibrium it must drop the price of the natural gas to get rid of the surplus. If the capital stock is decreased then the growth of the natural gas industry will slow down. In the next month the supply will drasticly drop as the price is low firms will not want to produce natural gas as the rewards are low.

  7. Sam Baronon 04 Oct 2010 at 2:47 am

    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?

    A soft price is a price that is steadily falling, I would assume that goods with prices that are falling are named "soft" because of their inability to hold a steady price. In the natural gas market this soft price theory is true because as the quotation explains the prices are dropping. If supply stayed the same then demand must have dropped and created a surplus, forcing companies to lower their prices.

    How have firms responded to soft prices? Does the reaction of the gas companies support the law of supply? Explain

    The firms that supply natural gas have reacted to the softening of prices by cutting their supply, meaning they will begin to work at a lower rate of efficiency in order to create an equilibrium in the market as it would benefit all parties involved. This reaction does support the law of supply which states that producers are willing to sell more at high prices and less at low prices and so by cutting their supply they are making less available at the low prices that are occuring.

    In the next month, what will happen to supply of natural gas?

    What happens in the coming month will be determined by what has happened in september as the quotation says that the changes took place during september. If the cut in supply was sufficient and created equilibrium then the companies will not change supply but if the changes were too great or too little then the companies will either reduce supply further (if changes were too little) or increase supply slightly (if changes were too great)

    What may happen in the natural gas market if firms reduce capital spending in the next two years?

    If firms continue to reduce capital spending then the whole market will slow its growth and perhaps fail completely, in which case these energy firms will allocate their resources towards more popular means of energy production

  8. Ivan Vercoutereon 22 Oct 2010 at 3:17 am

    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?

    Soft prices is one thing that companies dread because it means that they have supplied more than what is demanded therefore they are obliged to lower the price of the product in this case natural gas. If one were to ask him self the question as to why the prices were lowered the answer would most probably be that there was not much demand.

    How have firms responded to soft prices? Does the reaction of the gas companies support the law of supply? Explain.

    Firms have decided to lower there amount of supply by 6% to compensate with the amount of demand to get closer to an equilibrium so that they are not supplying a lot more than what is demanded. So yes this does support the law of supply.

    In the next month, what will happen to supply of natural gas?

    As Sam mentioned the coming month will definitely be the determinant as to what the next steps are. Perhaps they have lowered the amount they are supplying enough to reach an equilibrium.

    What may happen in the natural gas market if firms reduce capital spending in the next two years?

    This would be harmful to the natural gas market because they wont be able to progress.

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