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f07 ec51 ps4 answers

f07 ec51 ps4 answers - Economics 51D Due 1 October 2007...

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Economics 51D Due 1 October 2007 Problem Set 4 Answers 1. Spinning Wheel Although Lowenstein is a little off in the terminology, the idea implied by his article is that in the long run, price is determined by the conditions of production and in particular, price falls to the minimum of Long Run Average Total Cost. The LR Supply curve is flat—that is what Lowenstein’s repeated mention of “surplus” means, since a flat supply curve implies that you can buy as much as you want at the long-run equilibrium price. He even gives the price: $15.30 per barrel. Holy Cow! That’s a lot lower than the $80 that oil currently costs. So the question is, will we actually go from here ($80) in the short run to there ($16, say) in the long run? The first diagram simply shows the contrast between short run actual and Lowenstein’s vision of the long-run equilibrium. It’s possible to argue the matter both ways. Perhaps it’s easier to argue the No side of the argument first (no, price won’t fall to $16 per barrel), and then see whether it holds up. Basically, the same two forces making oil prices rise now are the same ones that made it rise in the past: increasing demand, primarily derived from economic growth; and restricted supply 1
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because of OPEC, a cartel (which is a group of producers who act together in order to maximize profits, usually by acting as a monopoly does: restrict supply in order to increase price). The next diagram shows this: OPEC’s influence basically fixes the quantity of oil at a low level, such that the market equilibrium is at a high price of $80 per barrel. Given that OPEC is the main restriction on supply, how likely is it that this supply restriction can persist into the future? As Lowenstein argues, OPEC had a very tight hold on the world oil supply in the late 1970s, but by the mid 1980s, there was widespread overproduction of oil and in particular, cheating by OPEC members. Some OPEC members needed the extra money to fight wars with each other, while other members needed the money to fund their governments. There always seems to be some good reason to cheat on the cartel, which is why most cartels don’t last forever. A large political or financial crisis in one or more of the OPEC countries, for example, could easily give their government a big incentive to overproduce and cheat. Once one country starts to cheat in a significant way, the cartel agreement unravels fairly quickly and the producers often start to undercut each other. 2
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Another possibility is that we really are going to run out of oil, or rather of new oil discoveries. Oil may be cheap to produce now, but demand is rising so quickly that before the forces of competition force the price down to minimum LRATC, we will hit the limit of oil production.
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