Microeconomics_4__Besanko

Microeconomics_4__Besanko


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Gasoline prices tend to be highly volatile. Figure 2.23
illustrates this by plotting the average retail gasoline
price in the United States in 2005.21 Large swings in
price in short periods of time are common, as are
seasonal fluctuations. The seasonal changes are
largely attributable to shifts in demand. Gasoline
A P P L I C A T I O N 2.7
What Hurricane Katrina Tells Us
about the Price Elasticity of Demand
for Gasoline
21These data are from the Energy Information Administration of the U.S. government.
c02demandandsupplyanalysis.qxd 6/14/10 1:39 PM Page 62
2.5 BACK-OF-THE-ENVELOPE CALCULATIONS 63
days. Pipeline capacities fell as well. Many refineries
were damaged or cut off from power and staff, 
and were taken offline. Refining capacity fell by 
approximately 2 million barrels per day. According to
government figures, supply fell by approximately 
8.3 percent in August 2005.
From August 29 to September 5, retail gasoline
prices rose 17.5 percent. That increase was on top of
an additional price increase in late August in antici-
pation of Katrina\u2019s being a major hurricane. In total,
gasoline prices were about 33.5 percent higher than
they had been a month before. Prices soon began to
decline again as supply increased to more normal
levels. This increase in supply partly reflected grad-
ual repairing of the oil and gasoline supply chain,
and partly temporary government policies to in-
crease short-term supply. LOOP and the pipelines re-
turned to nearly full capacity quickly. On August 31,
consumption. If a refinery or pipeline goes offline,
gasoline prices can spike quickly.
This was especially evident in the aftermath of
Hurricane Katrina, which hit Louisiana and the Gulf
Coast on August 29, 2005.22 This region plays a large
role in the U.S. oil and gasoline industries in several
ways. Oil rigs in the gulf produce roughly 25 percent
of total U.S. crude oil. The Louisiana Offshore Oil Port
(LOOP) receives delivery from oil tankers bringing ad-
ditional supply to the United States. Many oil refiner-
ies operate in Louisiana, Mississippi, or Texas. Finally,
pipelines run from this region to the East Coast and
Midwest of the country.
Damage to an oil rig, refinery, pipeline, or LOOP
could cause a spike in oil prices, but Katrina affected
all of them simultaneously. Immediately after the
storm, nearly all petroleum production in the Gulf of
Mexico halted temporarily. LOOP closed for several
Date during 2005
Dec 27Nov 27Oct 28Sep 28Aug 29Jul 30Jun 30May 31May 01Apr 01Mar 02Jan 31Jan 01
Pr
ic
e 
of
 g
as
ol
in
e 
(pe
r g
all
on
)
$3.15
$2.25
$2.55
$2.85
$3.00
$2.40
$2.70
$2.10
$1.95
$1.80
FIGURE 2.23 U.S. Price of Gasoline, 2005
During 2005, the price of gasoline in the United States fluctuated greatly, reaching a high 
of over $3 per gallon in early September 2005.
22\u201cOil and Gas: Supply Issues after Katrina,\u201d Congressional Research Service, Library of Congress,
September 2005.
c02demandandsupplyanalysis.qxd 6/14/10 1:39 PM Page 63
64 CHAPTER 2 DEMAND AND SUPPLY ANALYSIS
supply shift, as Figure 2.24 shows. We can conclude
the following:
\u2022 Percent change in equilibrium price of gasoline
(%\ufffdP) \ufffd 17.5% to 33.5%, depending on
whether we include the price rise in anticipation
of Katrina.
\u2022 Percent change in equilibrium quantity of gaso-
line demanded (%\ufffdQ) is between 0% and
\ufffd8.3%.
Taken together, these numbers imply that the price
elasticity of demand for gasoline (%\ufffdQ) (%\ufffdP) is 
between 0 and (\ufffd8.3) 17.5 \ufffd \ufffd0.47. If we include 
the anticipatory price increase, the price elasticity is
between 0 and (\ufffd8.3) 33.5 \ufffd \ufffd0.24. This tells us that
short-term demand for gasoline is inelastic. This con-
clusion makes sense. In the short run it is difficult for
consumers to change commuting methods or cancel
summer vacations, so that consumption does not
change much when the price of gasoline goes up.
/
/
/
the U.S. government authorized loans of crude oil
from the Strategic Petroleum Reserve totaling about
12.5 million barrels. The International Energy
Agency coordinated a similar global response. The
Environmental Protection Agency temporarily
waived some gasoline and diesel fuel standards that
applied to some regions, allowing the industry to 
better balance supply and demand across the country.
By mid-November 2005, gasoline prices returned to
pre-Katrina levels.
Why do changes in supply have such a large 
impact on the price of gasoline? The logic of the pre-
ceding section tells us that the demand for gasoline is
probably quite inelastic. In fact, we can use data on
gasoline supply and prices to determine approxi-
mately how inelastic short-run demand for gasoline is.
Figure 2.24 shows how.
The decrease in supply of gasoline following
Katrina is depicted as a leftward shift in the supply
curve, from S0 to S1. If the supply curve shifts leftward
by 8.3 percent, the equilibrium quantity demanded
must decrease, but by less than the amount of the
8.3%
decrease
in supply
Decrease in
equilibrium
quantity < 8.3%
Increase in
price = 17.5%
to 33.5%
S1
S0
DP
Q
FIGURE 2.24 The Gasoline Market after Hurricane Katrina
Immediately after Hurricane Katrina in 2005, gasoline supply fell by approximately 8.3 percent.
This is reflected by the leftward shift in supply from S0 to S1. Assuming that demand remains
fixed, this supply shift translates into a decreased equilibrium quantity of less than 8.3 percent.
Retail gasoline prices rose 17.5 percent in the week after Katrina, and 33.5 percent including
the price rise in anticipation right before Katrina. This implies a price elasticity of demand 
between 0 and \ufffd0.47.
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2.5 BACK-OF-THE-ENVELOPE CALCULATIONS 65
distribute the power to retail customers, including
residential and business customers.
In the early 1990s the California electric power in-
dustry was heavily regulated. The California Public
Utilities Commission (PUC) set electricity prices after
reviewing production costs. Because production costs
and prices were among the highest in the country, the
PUC began a major review of the industry in 1993.
After four years of highly politicized debate, a new
set of complex rules emerged for California\u2019s electric-
ity market. Wholesale prices were deregulated, but
the PUC continued to set retail prices, holding them
essentially fixed. Before the reform, investor-owned
electric utilities produced electricity from generating
plants they owned. Following the restructuring, the
utilities were required to sell most of their generating
plants and then obliged to buy power at the unregu-
lated wholesale prices.
The reforms seemed to be working well until sev-
eral events simultaneously shocked the electricity
market between 1999 and early 2001. The supply of
electricity in wholesale markets shifted to the left as
the amount of power from hydroelectric generators
fell by 50 percent, the price of natural gas rose six-
fold, and power outages removed some generators
The California energy crisis of 2000 and 2001 attracted
attention from around the world. During the first four
months of 2001, the average wholesale price of elec-
tricity was about 10 times the price in 1998 and 1999.
Even at these high prices, many customers were forced
to cut back on their consumption of electricity because
of supply shortages. California\u2019s two largest electric
utilities, Pacific Gas & Electric and Southern California
Edison, were buying electricity at wholesale prices that
were higher than the retail prices they were allowed to
charge. The electric utility industry was threatened
with bankruptcy. How did the crisis arise?
Figure 2.25 provides a simplified illustration of the
structure of the electric power industry. Electricity is
typically generated