Does An Increase in Supply Lead to Higher Prices

Last week, I received an e-mail from the son of a friend of mine. The son is a student at a school in the Northeast. Here's the relevant part of the e-mail:

I took a globalization class this past semester and didn't agree with my teacher all the time. The semester's over, but there's a question over which we've been emailing back and forth. If you don't mind, I would like to hear your answer.

"Why is it profitable for Saudi Arabia that Canada extracts oil from its tar sands?"

I've been arguing that it's not. Here's why: Canada's production will raise global supply. Since supply is independent of demand, with demand unchanged and supply increased the world price should decrease. Therefore Saudi Arabian oil production would be less profitable.

My teacher, however, believes that because Canadian production is more expensive, the world price will increase. I don't think this is true, because Canada will only produce if their cost is below the world price. Just because they produce oil doesn't mean that anyone has to buy it.

Here was my answer:

You nailed it. Your teacher got it wrong. He/she is confused. I'll call your teacher "he" or "him" from now on. He starts by looking at the fact that Canadian production is more expensive than Saudi production. That's true. My guess is that he then forgets the context and is implicitly thinking that Canadian production was cheaper and now has become more expensive. If that were right, his bottom line would be correct because the now-more-expensive Canadian oil means that the supply curve of Canadian oil has shifted to the left and, therefore, the world supply curve has shifted to the left, raising the world price and benefitting the Saudis.

But that's not at all what happened. Instead, new technology INCREASED the supply of oil from Canada, increasing the world supply and driving down the world price, if only slightly.

I then asked my young friend whether the teacher was an economist and whether I could post about it. His answer:

Because this is a basic example of supply and demand, I'm sure glad I wasn't missing something. And yes, you may blog about it.

I just looked up my teacher's background. Her Ph.D. is in computer science. I think it may be a good idea if I research more about teachers before I take their classes. But it does raise the question, why is she an economics and not computer science professor?

By the way, I've used your encyclopedia quite frequently. Its articles are terrific. It's certainly one of my most-read books.

Comments and Sharing

Not sure if this was what the teacher was thinking, but it's really a combination of a shift in supply due to changes in extraction technology as well as a shift in demand (i.e., a shift along the supply curve) that absolutely benefits the Saudis. In that case, of course, it's not really the Canadian production that's benefiting the Saudis. But perhaps that's what the professor is intending.

The higher cost of Canadian oil is indeed going to make a given level of Saudi production more profitable, but the only reason why we're extracting costlier oil is that demand has been increasing, not for the hell of it!

I must have picked a bad day to read Econlog. Daniel Kuehn's argument makes no sense to me whatsoever. Given any level of demand the Saudis are better off if there is less Canadian oil for sale.

Dangerous to speculate in the absence of evidence but I would bet that her thinking is totemic: the oil sands are evil so must actually do more harm than good. Benefitting the Saudis is just the particular way this cosmic principle works in this case. Just one cyncial observers's guess.

Ken B -
No, that's right. If they can actually enjoy monopoly power that's obviously better. I'm not claiming competing with the Canadians is better than avoiding competition with the Canadians.

I'm saying that if the Saudis are relatively to the left on the supply curve and Canadians are relatively to the right, then a shift along the supply curve is going to be good news for the Saudis and coincident with increased Canadian extraction - which may be what the teacher had in mind.

Certainly if the Saudis could some how enjoy the increased demand with the Canadians out of the picture they'd like that even more!

I just think if the teacher is harping on high prices being better for the Saudis it seems like she has something about demand and a movement along the supply curve in mind. That doesn't mean it was clearly communicated in the question, of course.

Writing test questions from scratch is surprisingly tough. Things you think are the intuitive interpretation often aren't what other people get out of it. The macro prof I TAed for would write a lot of her own test questions, and she would have all five of the TAs working with her (it was a big lecture class) sit around a table and argue about each question before it made it on the exam. It was interesting to see other TAs come up with perfectly reasonable alternative interpretations that had never occurred to me (or apparently the professor) that someone in the class was bound to come up with as well.

Just to be clear, although I think this may be what the teacher had in mind, I agree completely with David that as written that's not what comes out of this question. It could have benefited from some review and clarification.

Since supply is independent of demand, with demand unchanged and supply increased the world price should decrease. Therefore Saudi Arabian oil production would be less profitable.

My teacher, however, believes that because Canadian production is more expensive, the world price will increase.

DK is suggesting that the student is mistaken about what the teacher believes. Instead, he's taking the fact that Canadians have begun to produce expensive oil as evidence that demand HAS changed, upwards. This increase in demand would be to the benefit of the Saudis, regardless of changes to Canadian production.

The question wasn't about whether Canadian oil production is proftable for "Saudi Arabian oil producers," but whether it is profitable for Saudi Arabia. I think it's uncontroversial that it is.

The people of Saudi Arabia profit because Canadian production reduces the cost of energy. With energy cheaper (and more available) more Saudis will be able to afford air conditioning, refrigerators, computers, and all the other trappings of modern life.

@Daniel Kuehn,
I think you're stretching here, although my young friend who e-mailed me may want to come on as a commenter and clarify. It seems to me fairly obvious that the discussion was likely about Canadian tar sands, not about an increase in demand. And if I had to bet, I would bet that Ken B's cynical guess is closer to the truth.

My teacher, however, believes that because Canadian production is more expensive, the world price will increase.

Labour theory of value anyone?

My reading is that she is saying that higer production prices for tar sands oli causes higher market prices which is in turn good for the Saudis. High cost Canadian oil raises prices.

My cynical guess is that she sees this is an example of the working of the *real* invisible hand, not the one Adam Smith fantasized about but the karmic one whereby western exploitation makes everything worse. Even cookies. (Outrageous speculation on my part.)

An increase in the demand for oil is never mentioned in the question. The issue is whether Saudi Arabia is better off with Canada producing oil or not, given a certain level of demand. In that case, the answer is clearly no. The professor, I believe, makes a "field of dreams" mistake by assuming that, if the Canadians produce oil, they will sell that oil. Since they are high-cost producers, their sales will increase the world oil price, benefiting the Saudis.

However, as David explained, this violates the law of supply and demand.

@Daniel Kuehn,
Repeating your argument doesn't make it stronger. Because you said it clearly the first time, I got what you said the first time and I'm guessing most other readers of your comment did too.
@Charley Hooper,
I don't think she's making the "field of dreams" mistake. If she were, it wouldn't be a mistake. Added oil, even added high-cost oil, brings the price down, not up. To put this in perspective, when I did a tour of the tar sands in 2003, our hosts told us, IIRC, that the break-even price above which production would be profitable was about $40 a barrel. So even if it costs $60 a barrel because they were too optimistic, the result of that added oil is a lower price, not a higher one.

I did not understand your argument the first time I read it, and I'm glad you posted some clarifying follow-up comments.

Perhaps a better way to phrase the teacher's question would have been, "Twenty years ago, someone looked into a crystal ball and was able to predict that Canada would be producing oil from tar sands in 2012. Would Saudi Arabia consider this good news or bad news?"

The answer is, in this case, "Good news," because it implies that the equilibrium price of oil is high, even though the increase in supply is itself bad for Saudi Arabia.

Of course it must be said that if this is the point the teacher was going for, the question as written completely fails to bring it out.

William -
re: "Of course it must be said that if this is the point the teacher was going for, the question as written completely fails to bring it out."

Yes, that must be said which is why I also said it and agreed with David saying it!

Given the options of someone being entrusted with teaching economics and not being able to understand supply and demand vs. someone being entrusted to teach economics and not being able to carefully word questions about movements along vs. movements of a supply curve, I like to think the latter is more likely, but I could be wrong.

I know you do, Daniel. You always assume the best about people, and don't get offended too much by rudeness or respond in kind. That's why I sort of like you, even though I almost always disagree with your comments.

But you are being overly charitable here; the available evidence strongly suggests that the teacher is just wrong and doesn't understand the basic economics of supply and demand, however a priori unlikely that might have seemed.

I'm pretty sure this is not what the teacher was thinking and I'm just trying to rationalize the other side as a kind of mental exercise but here goes:

The oil market contains information asymmetries. Particularly among oil producers, who have private information about future production schedules and remaining reserves. Many of the firms investing in Canadian tar sand extraction are vast mega-companies with tons of operations spanning the globe. The fact that a firm like BP has secondary market trading desks that can and do make high risk-adjusted profits indicates that BP has a strong information advantage over most market participants.

The investment in Canadian tar sands is only profitable if oil prices average over a certain threshold price. So the investment of a firm like BP in Canadian tar sands indicates a strong confidence by them that oil prices will remain above tar sand profitability thresholds.

This possibly reveals private information that those firms have high expectations for future prices. The oil market will incorporate this once private information into current market prices. It's quite possible that the revelation of the private information will have a greater effect than the new increase in supply.

As an analogy imagine there's a corporate executive whose given two options by the board. Either he can receive stock options worth a million shares with a strike at the current stock price, or he can receive three million shares with a strike at a 50% premium to the current stock price.

If he chooses the latter it will probably cause a rise in the value of the company's shares. Yes future supply will most likely be higher because he will sell three times as many shares if he exercises. But that is most likely overwhelmed by the market's reaction to an insider revealing optimism about the future stock price.

RH -
There's not always space or time to do it of course, but in these sorts of situations I'd highly recommend spelling it all out. If you just put what the prof takes to be the "wrong" answer they may grade you off. If you put what you think they want you to write and then put your alternative and explain why you think your alternative is better I think it's the very rare professor that won't appreciate that.

@Daniel Kuehn,
Thanks. The cartoon is funny. I actually used it at the start of a speech, to great effect.
Re your answer to RH, I know him pretty well, and I'm guessing that his major concern was not the grade. But again he can answer for himself.

If the teacher is like many of today's "Liberals", I can see why she would say what she said (and it would not matter that she had a degree in economics, go look at how Krugman writes).

Many of the "new" technologies that are used today to extract oil and gas are not "new" - but yes, they have been refined - and so they work very well today - at prices that the market can support - Someone, some company took the risk of spending money on developing new recovery methods, technologies and oi using such technologies came to the market when the technology got better along with increase in demand and when the prices were such that they supported these "new" methods ...

If Saudi Arabia can take out even more oil than they are at far lower prices, yes, they can make it expensive for the other technologies - and yet, what will happen is spur the development of yet other methods to make it less expensive

I love the non-guild like thinking of economists. So far no one, even though virtually all agree she got a basic microecon issue wrong, have made derogatory comments about a PhD in Comp Sci teaching econ.

Okay, this is a stretch (but being economics I can make just about anything stand up at a stretch):

Since the Saudis (via OPEC) effectively fix the price of oil they will reduce their own supply when Canadian oil comes on stream. The small reduction in revenue in the short term will allow them to benefit from expected future higher prices for oil.

Seeing as SA is the swing producer, more incremental production at high prices effectively increases SA's swing capacity wherever the Canadian producers set their production costs, $70-$80. That additional capacity at $70-$80 enables SA to reduce volatility and prevent demand destruction through higher prices.

It's not as easy as "more capacity equals lower prices." There are real markets out there.

"Canadian producers set their production costs" Seriously? Why not set them at $0 then?

"prevent demand destruction through higher prices" I take you mean the Saudis benefit from everyone knowing there is more oil out there, and being able to buy it, because then they won't switch to another source. Well maybe but that seems to make a lot of assumptions and it requires a lot more oil doesn't it, oil not under Saudi control, which in fact reduces the Saudi's ability to move prices. You are basically arguing cartel busting is good for cartel members aren't you?

@Ted Levy,I love the non-guild like thinking of economists. So far no one, even though virtually all agree she got a basic microecon issue wrong, have made derogatory comments about a PhD in Comp Sci teaching econ.
Great insight! You've put your finger on something that I have long been proud of about my profession.

Canadian oil sands productions prevents oil prices from hitting $150-200 as the demand outstrips Persian Gulf production and forces a high market clearing price.

While Saudi profits in short run, a decade, soar, its margins fall as its must invest much more to maximize total yield at high production - slower production is less costly. Restricting supply to optimal rates would drive prices even higher. Remember the cost curve are U shaped - lowest marginal costs are below maximum output.

The higher the market price, the greater the incentive to substitute with high tech.

$200 oil would be $8 gas in the US ($12 in Europe) driving demand for electric vehicles which would trigger new battery generations, or fuel cells, or something else, every year and rapidly falling costs.

As demand for oil drops price, the existing investment in electric production will simply continue with lower profits, with lower costs through bankruptcy to shed debt that bought equipment, so over time experience reduces production costs. Electric always has a market (wheel chairs, golf carts, fork lifts,...) so even if driven into niche markets, electric production capacity will be used to nibble away at the gas powered market.

Maybe the substitute is algae, but once the technology for an alternative is created, the price of oil is capped and Saudi reserves lose value as an asset.

Michael Pettengill basically makes the argument that Canadian production prevents demand destruction, like I argue above. This isn't a theoretical concern, a barrel of oil reached single digits in the mid 80s, if I remember correctly. The price is set by the marginal producer, and it's a good thing for the Saudi's that the marginal producer (Canada) has high production costs. That's probably what the teacher was trying to say. Rrepeating the accounting identities of economics and bashing them over somebody else's head is not insightful.

Billyjo, you are confused . You are now saying its good for the Saudis that Canadian oil is costly. Extrapolate then. What if Canadian oil were costlier still? What if it were a thousand times the price? What if the price was infinite?

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