The Theory of Demand and Supply - Essay Example

Article analysis Contents Article 3 Introduction 3 Economic Theory 3 Conclusion 6 Article 2 7 Introduction 7 Economic Theory 7 Conclusion 10 10 Reference List 11 Article 1 Introduction The theory of demand and supply is one of the most conventional theories in the discipline of microeconomics that has been the reference point of many to determine equilibrium price. The intersection between the points of demand and supply forms the basis of determination of the equilibrium price. The recent trend of global oil prices and the reaction of the U.A.E. government in recent times are however not following the conventional equilibrium theory of demand and supply. In a recent article that has been published in Gulf News states that the global price of oil is likely to fall in the forthcoming period. The oil producers in the U.A.E. are expected to increase production of oil as a response to this fall (Cornwell, 2014). This reaction of the government is contrary to the conventional economic theory which states that if the price falls then the suppliers should reduce the level of their production. But this is not happening in case of the U.A.E. Economic Theory The economic theory of demand and supply fundamentally states that as price of a product increases less and less quantity of the product is demanded and as the price of a product rises then its supply increases. The equilibrium market price is determined by the point where the quantity demanded by the consumers equals to the quantity supplied by the producers (Frank, 2008). The following diagram shows the same. Figure 1: Equilibrium price and quantity (Source: Author’s creation) The initial equilibrium point is marked by E1 and the initial equilibrium price is P1 and the quantity demanded is Q1. A fall in the market demand due to exogenous market conditions like recessions or weak demand of the products causes the price to fall and the demand curve shifts to DD2 where the new quantity is Q2 and the price falls to P2 (Frank, 2008). Following this theory it should be expected that a global fall in prices would discourage the suppliers and they should reduce their production. However, according to the news article this is unlikely to happen. U.A.E. is expected to produce 3 million barrels of oil by the end of the current financial year. According to experts factors like weaker growth of China, rise in shale production in the U.S.A. and oversupply of oil are the main factors that are responsible for the global fall in oil process. A fall in the global oil prices could be represented by a downward shift in the demand curve from point DD1 to DD2 where quantity demanded equals quantity supplied. The new equilibrium point is reached at E2. However, the determination of oil production in the global economy does not follow the cardinal rule of demand and supply. In a research that was conducted by MacAvoy (1982 cited in Alhajji and Huettner, 2000) it has been shown that the theory of demand and supply can be used to determine the point of production of oil as opposed by some researchers who had pointed out that production of oil is likely to be determined by cartel. A significant attempt can also be observed in the study that was made by Griffin (1985) who had pointed out that there can be four types of production behaviour in face of changing oil prices which are competitive model, property rights models, cartel model and target revenue model. Griffin’s methodology suffered from a problem that it was calculated in times of persistent oil price increase. Recently an attempt has been made by Ramcharran (2002) had extended the model that was originally proposed by Griffin (1985) to incorporate the effect of fall in oil prices. The last decade has often been characterized by fall in oil prices on account of number of factors like increase in supply of oil from non-OPEC countries, new exploration and production of oil, increasing volatility of demand in the oil importing countries due to external shocks like recession and improvements in the oil exploration techniques which has sufficiently brought down the production cost of oil. The research conducted by Ramcharran (2002) had shown that there is a marked difference in the production behaviour of OPEC and non-OPEC countries on account of reduction in prices of oil. The results from the research had clearly shown that the oil production behaviour of the OPEC countries is not directed by changes in demand and supply. In other words, this implies that the production behaviour is not competitive. The oil production of the non-OPEC countries are however competitive in nature and they tend to change their production behaviour immediately according to market forces. One of the reasons that had been pointed by the researcher regarding the non-competitive behaviour of OPEC countries is that they had a negative price elasticity of supply. According to theory of microeconomics it has been stated that a negative price elasticity of supply indicates that though the price of the goods changes due to changes in the market forces but this is not accompanied by a change in the quantity supplied. In case of the OPEC countries a negative price elastic of supply implies that the production objective is either to stabilize or acquire oil revenues. The present situation of the U.A.E. which is essentially an OPEC country shows that the production behaviour is not competitive. This validates the research finding of Ramcharran (2002). This is because though the prices are falling, U.A.E. is optimistic about the future growth of its oil exports. The government of the country is quite optimistic that the oil prices are likely to stabilize in the near future and it is essential to continue to increase production meet the target set for 2017. The finding from the research of Ramcharran (2002) does is not consistent with the behaviour that is exhibited by Saudi Arabia which happens to be another OPEC country which has cut its production by 330,000 a day as a response to the fall in the oil prices due to volatile conditions in the world economy (Cornwell, 2014). At present, U.A.E. and other OPEC countries are unable to forecast the exact demand in the future and are either being optimistic or pessimistic. Fall in oil prices definitely have a deeper implication for the oil-exporting countries as this forms the backbone of their economic growth. If the oil prices continue to fall on account of the weak global demand and volatility in the markets then this will force the government to step in to stabilize the situation. The prices have to be regulated accordingly. The Ministry of economy is however quite confident that a fall in the price of oil will not impact the GDP growth of the country on account of the diversified economic portfolio of U.A.E. at present. Presently oil exports accounts for 30% of the GDP (Reuters, 2014). Economists agree if the oil prices does not decline further and show no signs of volatility then it is unlikely to affect the economy. Conclusion The volatility of the oil prices and the recessionary conditions in the past has affected the global oil prices and they continue to fall. A strategic response would be an equivalent reduction in the supply due to the fall in global demand. However, the oil companies in the U.A.E. are confident that the fall in the price will stabilize soon. They are strongly driven by strong demand of oil exports to countries of Asia. These conditions are stalling a cut in production and they continue to increase production on account of optimism. As the economy is presently diversified so it is unlikely that this fall in oil price will hurt the robust economic growth of the Gulf countries including U.A.E provided that prices do not fall any further. Article 2 Introduction Market type and market competition are core agendas of microeconomics theory. The second article which is chosen relates to the concept of market competition in the U.A.E. The telecommunications industry in the U.A.E. represents a duopoly and is primarily dominated by two giants namely Etisalat and Du. The condition of duopoly is however not going to last long as the government is taking measures to open the market of telecommunication to market forces. In the current scenario it has been reported that the scope of competition in the telecommunication sector is quite low as the regulators of the industry which are mainly government institutions greatly impedes competition (Raveendran, 2014). It has been reported that the Etisalat have the major market share in almost all sectors like cable connections, internet connections and fixed line services. Du has primarily been a player in providing services from the mobile phone. Consumer welfare has been largely affected by the lack of competition. However, recently, GSMA, an association of mobile operators is working to reduce roaming charges for customers which are expected to improve welfare of consumers (Raveendran, 2014). Economic Theory The following two diagrams show the equilibrium price and quantity that is produced under conditions of perfect condition and monopoly. Figure 2a represents perfect competition and 2b represents monopoly. The equilibrium market price and quantity are in Figure 2a is represented by the point of intersection of demand and supply. In case of figure 2b the monopoly firm faces the demand curve of the market. The equilibrium condition for a monopolist firm is determined by the point where the marginal revenue curve cuts the marginal cost curve. In the figure the marginal revenue curve is determined by DL and the marginal cost curve is represented by JK. At this point the quantity produced is Qm (smaller than the amount under perfect competition) and price charged is Pm (greater than the perfect competition) (Boyes and Melvin, 2012). Figure 2: Comparison of price, output and deadweight loss in perfect competition and monopoly (Source: Author’s creation) The implication of this can be explained in terms of deadweight loss. In figure 2a the consumer surplus is indicated by ABPc and the producer surplus is presented by DBPc. In case of figure 2b the consumer surplus is triangle DEPm and the producer surplus is the rectangle PmEHPc. A part of the consumer surplus is passed on the producers and it becomes the producer surplus in case of monopoly. The deadweight loss to the society is represented by the triangle EFG which does not go to the producers as well as the consumers. The fall in the quantity produced and the greater price charged for this product accounts for the welfare loss to the society. The condition of U.A.E. telecommunications sector is almost like the condition presented by figure 2b. This is because Etisalat has acquired the entire market in most aspects like internet, fixed-line communications and internet service. The entry of Du in the market in 2006 has officially ended the tenure of Etisalat as a monopoly. However, Du cannot be considered as a true competitor of Etisalat because it operates only as mobile service provider having no share in the other segments. The U.A.E. telecommunications industry is regulated by Telecommunications Regulatory Authority who is responsible for taking all the strategic decisions for the industry. According to the government the regulatory environment fosters competition between telecom operators and effective pricing of products (Al Mal Capital, 2009). The existence of monopoly in the telecommunication sector is not a new process and most of the developing countries operate under the regulatory framework. Works of researchers like Griffiths and Wall (2000 cited in Smith-Hillman and Brathwaite, 2004) had shown that the rationale of economic regulation is derived from the objective of enhancing the short-term focus and promoting efficiency gains. Majority of the works that has been conducted by researchers have shown that most of the policies that aim to promote national competition operate through two main approaches namely anti-competitive conduct and anti-competitive agreements. The former deals with the objective of prevention of dominant market power by charging arbitrary prices and the later deals with the use of market sharing agreements to prevent abuse of power. The research conducted by Stern (1997) had shown that use of anti-competitive conduct acts as a catalyst to distort market competition and decrease market efficiency. The situation in the U.A.E. is similar as it has been noted that the existing player Etisalat charges internet tariff for a day that is charged by other companies for a month of subscription. This greatly reduces the welfare of the customers. The research conducted by Lehr and Glassman (2001) had shown that though telecommunication industry has long been considered as a natural monopoly, it will result in significant welfare loss if conditions of competition are not fostered. It was pointed out in the research that incumbent firms have the capacity to circumvent policies that are set by the regulatory authorities like investing in surplus capacity or over investing in capital. These policies results in higher deadweight loss. The government of the U.A.E. has somewhat realized the same and the current news article has shown that the government is trying to liberalize the telecommunication sector and this is expected to improve conditions in the forthcoming years. The liberalization of the telecommunication sector has been one of the primary agenda ever since the U.A.E. has joined the World Trade Organization. The country is trying to attain full liberalization of the telecommunication sector by 2015 and the policy taken by GSMA is expected to improve the quality of service by enhancing regional connectivity and reducing the price at which the service can be obtained. It is also expected that the choice available to consumers are also likely to improve on account of this. The liberalization of the telecommunication sector is expected to provide very high benefits to the residents of the U.A.E. primarily in terms of the reduction of the price or tariff rates of the existing operators. The consumers will also benefit from the entry of competitors in the market in terms of getting a variety of subscribers to choose from. A reduction in the price of the service can also stimulate the demand as more consumers are expected to take up internet, cable or fixed-line communications. This can also bring additional investments in the industry thereby enhancing its capacity. The existing literature suggests that there are instances of modernization of equipments and infrastructure in the telecommunication sector. It has been observed that positive effects on incentive-based regulation can be obtained from enhancement of competition in the telecommunication industry (Greenstein, McMaster and Spiller, 1995). The deadweight loss of the regulation is expected to be eliminated from liberalization thereby increasing overall welfare. Conclusion The telecommunication industry of the U.A.E. has been undergoing rapid changes since the accession of the U.A.E. into the WTO. The telecommunication industry in the U.A.E. has been marked by conditions of monopoly as a single service provider Etisalat has been the only player in the market. This has resulted in charging very high prices from consumers like provision of internet plans which definitely decreases their welfare. The recent development of the U.A.E. market in terms of entry of GSMA and Du is expected to reduce the power of Etisalat and foster greater competition in the market. The improvements in the roaming services and the greater choice offered to customers is expected to improve their welfare. The prices of the services obtained will also come down substantially after the regulation is reduced in the telecommunication industry. The article bears testimony to the fact that the government is trying to meet its goal of liberalization of telecommunication sector by opening up of the markets. Reference List Al Mal Capital, 2009. UAE telecoms sector. [pdf] Al Mal Capital. Available at: < http://content.argaam.com.s3-eu-west-1.amazonaws.com/244db147-3f5c-41d0-a3be-e7aadcb5a6f5.pdf> [Accessed 6 November 2014]. Alhajji, A. F. and Huettner, D., 2000. OPEC and world crude oil markets from 1973 to 1994: cartel, oligopoly, or competitive? The Energy Journal, pp. 31-60. Boyes, W. and Melvin, M., 2012. Fundamentals of economics. Connecticut: Cengage Learning. Cornwell, A., 2014. UAE to increase oil production as global prices fall. Gulf News, [online] 23 September. Available at: [Accessed 6 November 2014]. Frank, R., 2008. Microeconomics and behavior. New York: Granite Hill Publishers. Greenstein, S., McMaster, S. and Spiller, P. T., 1995. The effect of incentive regulation on infrastructure modernization: Local exchange companies deployment of digital technology. Journal of Economics & Management Strategy, 4(2), pp. 187-236. Griffin, J. M., 1985. OPEC behavior: a test of alternative hypotheses. The American Economic Review, pp. 954-963. Lehr, W. and Glassman, J. K., 2001. Competition in telecommunications and economic growth. [pdf] Center for e-Business at MIT. Available at: < http://ebusiness.mit.edu/research/papers/127%20Lehr,%20Competition%20in%20Telcommunications.pdf> [Accessed 6 November 2014]. Ramcharran, H., 2002. Oil production responses to price changes: an empirical application of the competitive model to OPEC and non-OPEC countries. Energy economics, 24(2), pp. 97-106. Raveendran, K., 2014. UAE inches closer to fully open telecom market. Gulf News, [online] 02 June. Available at: < http://gulfnews.com/business/opinion/uae-inches-closer-to-fully-open-telecom-market-1.1341984> [Accessed 6 November 2014]. Reuters, 2014. Falling oil prices ‘will not hurt UAE GDP. The National, [online] 14 October. Available at: [Accessed 6 November 2014]. Smith-Hillman, A. V. and Brathwaite, T. W., 2004. Learning to swim with sharks: Caribbean and African telecommunications regulatory experience under monopoly conditions (1993-2003). Info, 6(5), pp. 308-317. Stern, J., 1997. What makes an independent regulator independent? Business Strategy Review, 8(2), pp. 67-74. Read More