In 1973, the OPEC countries sharply reduced the supply of oil in the world market — raising the price of oil and thus the marginal cost of producing gasoline in domestic refineries. In 2008, uncertainties over the stability of oil supplies and increasing demand from developing countries (as well as from oil speculators) also caused sharp increases in the price of oil — again dramatically increasing the marginal cost of producing gasoline in domestic refineries. While the causes of higher oil prices differed, the impact on domestic gasoline refineries was similar. Yet in 1973, vast gasoline shortages emerged, leading cars to line up for miles at gasoline stations and causing governments to ration gasoline —but in 2008 no such shortages emerged. In this exercise, we explore the difference between these experiences.
A. The difference is attributable to the following policy intervention used in 1973: In 1973, the government imposed price controls—i.e. price ceilings—in order to combat inflationary pressures, but in 2008 the government did no such thing.
(a) Consider first the experience of 1973. Begin by drawing the equilibrium in the gasoline market prior to the oil shock.
(b) Now illustrate the impact of the OPEC countries’ actions on the domestic gasoline market.
(c) As gasoline prices began to rise, the government put in place a price ceiling between the pre-crisis price and the price that would have emerged had the government not interfered. Illustrate this price ceiling in your graph.
(d) If we take into account the cost of time spent in gasoline lines, what was the effective price of gasoline that consumers faced?
(e) Now consider 2008 when the government did not impose a price ceiling as gasoline prices nearly quadrupled over a short period. Illustrate the change in equilibrium—and the reason no shortage emerged.
(f) Suppose that the 1973 and 2008 shocks to the marginal costs of refineries were identical as were initial supply and demand curves. If we take into account the cost of waiting in lines for gasoline in 1973, in which year did the real price of gasoline faced by consumers rise more?
(g) When the government compiles statistics on inflation, in which year would it have shown a larger jump in inflation due to the increase in the price of gasoline?
B. Suppose that the demand curve for gasoline in both years is given by p= A−αx while the pre-crisis supply curve is given by p = B +βx.
(a) Derive the pre-crisis equilibrium price p∗.
(b) Suppose the crises in both years cause the supply curve to change to p =C +βx where C > B. Derive the new equilibrium price p′ that emerged in 2008.
(c) Now consider 1973when the government imposed a price ceiling p̅ between p∗ and p′. Derive the real price p′′ paid by consumers (taking into account the effort cost of waiting in line).
(d) Can you show that p′′ > p′?