The Demand and Supply is one of fundamental concepts of economics that will help us understand about oil price in a free market environment.
In order to give you a simple concept of demand and supply, please look at the fresh market image below (Figure 1).
Figure 1 – Fresh Market
What do you think about the price of fresh food in the morning and in the evening?
In the morning, the vegetables and fruits can be sold at a very good price. People want fresh product and sellers have a power to maintain good prices. However, in the evening the freshness is gone and the condition of the fresh products declines. The price goes down because sellers want to sell them but buyers don’t want to buy them so the sellers must reduce the price otherwise they can lose profit. This simple concept is a basic of the demand and supply in free market.
In the seller viewpoint, the sellers want to sell their products at the highest price as much as they can. If price of goods goes up, the sellers are persuaded to make more products (Figure 2).
Figure 2 – Seller Viewpoint
Buyers’ viewpoint is opposite to the sellers’ viewpoint. When price of goods is high, fewer buyers can effort to purchase the goods so low quantity of products will be sold (low demand). If the price drops down, there will be more buyers can buy the goods. It demonstrates that the lower price relates to increase in demand (high demand).
Figure 3 – Buyers’ Viewpoint
In a free market condition, equilibrium point reaches where the demand and supply curve are intercepted (Figure 4). According to the Figure 4, an equilibrium price is $60 and an equilibrium quantity bought and sold is 30.
Figure 4 – Equilibrium Point
What Will Happen if Price Above Equilibrium Point?
We will take a look when price is above an aquarium point. If the price of good is 70$, the demand will drop to 25 units but the supply will rise to 35 units (Figure 5). High price situation will increase the supply but the demand will be depressed. At 70$ at unit, sellers have 10 extra units of goods. If they don’t try to sell the extra unit on hands, they will be stuck with loss due to stock in hands. Sellers will lower their price to be able to sell their products so the price comes back to the equilibrium point of 60$
Figure 5 – Price Above Equilibrium Point
What Will Happen if Price Below Equilibrium Point?
This is the opposite case when the price is below an aquarium point. If the price of good is 50$, the demand will go up to 35 units but the supply will drop to 25 units (Figure 6). At low price of 50$ at unit, the demand increases but it will not convince sellers to produce more products so there is 10 units in demand. Sellers increase the prices to compensate more demand. This will result in more sellers produce more goods to sell into the market. Eventually, the price comes back to the equilibrium point of 60$
Figure 6 – Price Below Equilibrium Point
Thomas Sowell (2007) Basic economics: A Common Sense Guide to the Economy, New York, New York, USA: Basic Books.