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I am teaching myself basic economics and I'm trying to understand supply and demand. Recently, in my country, there was news of a strike by the petroleum suppliers. Expectations of an impending fuel shortage increased demand. (as evidenced by the long queues at petrol stations).

Now,by plotting the supply and demand curves, it seems apparent that an increase in demand would lead to an increase in equilibrium price and equilibrium quantity. However, in reality, during this time, none of the petrol stations increased the price of petrol. Is this because of government regulation of prices or due to some other factor? Thanks

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Such a situation can be explained in the following ways:

  1. If supply is perfectly elastic (horizontal supply curve), then an increase in demand does not increase the price. It's highly unlikely that supply of petrol here is perfectly elastic. This could be the case under perfect competition with constant marginal costs of petrol. However, typically petrol has increasing marginal costs. Alternatively, it could be the case with constant marginal costs and Bertrand competition (price competition, with few firms) meaning they also set prices equal to marginal costs as in perfect competition.

  2. There may be costs to increasing the price. So-called menu costs make prices sticky and therefore changes are not as often as we expect. E.g. if you're a restaurant and want to increase prices, you have to reprint all menus, which may not be worth it for a temporary demand increase. However, this is probably not tbe case in your example.

  3. When setting the price before the shortage was announced, the increase in demand was expected and the price already set accordingly high. Was there an increase in the price (shortly) before the announcement? If not then the next explanation is the only possibility.

  4. Government regulation of the price.

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  • $\begingroup$ Also, fear of consumer backlash. And it may be that the OP misinterpreted the signs and there really is no significant disruption in supply. (In the US Midwest there is regularly a "refinery fire" around June, at the start of the summer travel season, threatening supplies and therefore justifying a price jump. Folks have come to expect it, however and do not panic nearly as much as the oil companies would like.) $\endgroup$ – Hot Licks May 3 '17 at 11:29
  • $\begingroup$ Hot Licks.. there was no large disruption in supply..but there definitely was increased demand. 1 and 3 did not occur.. 2 is unrealistic. So it must be 4 $\endgroup$ – mahela007 May 4 '17 at 9:32
  • $\begingroup$ I suppose if there is a realistic fear of consumer backlash, that could be a reason. That is if firms expect demand in the future (and therefore their profits) to significantly decrease due to a price increase now. However, such organized boycotts due to price increases are rare, as it requires great coordination on the side of consumers, who do not necessarily all know each other. Furthermore, for a good like petrol, for which demand is very inelastic, it is unlikely that consumers would forgo petrol to get back at firms. I have also now expanded on reason 1). $\endgroup$ – BB King May 4 '17 at 9:49
  • $\begingroup$ I do not think that Bertrand competition can be used to explain this situation as I am fairly positive it does not exist in the petroleum industry. OPEC was literally created to control supply of oil and this heavily influences the price setting. $\endgroup$ – MH.Q May 4 '17 at 10:08
  • $\begingroup$ Even if international oil is controlled by OPEC, local gas stations can still be under Bertrand competition. In fact gas stations are a famous example of Bertrand competition. In that case the gas stations buy their oil from OPEC.The price OPEC sets is then simply the marginal cost for the gas stations. $\endgroup$ – BB King May 5 '17 at 16:19
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I just want to add on to Hot Licks's point in the comments section.

Supply of oil provided by the petrol stations are not real-time. In a way, you could say that they probably have enough to cover for the oil demand for the month. Now assuming there is this increased demand that you observed. The consumers are buying the oil ahead of their needs, probably up to the month's needs, for fear of future price hikes.

Now why does this not cause an increase in price? The demand of oil simply had not exceeded the supply enough to cause a price hike. This is where there is a disconnect between theories and practical. You are assuming the petrol stations match their supply to the equilibrium demand at any given point in time, such that the increase in demand as you observed, would create demand in excess of the current supply, resulting in increased prices. Which is not the case in reality since they likely still have the supply to cover the increased demand.

Also, how do you define increased demand as an individual entity? the only group able to do that should be a legitimate statistical body or the producer themselves. As such, we as individuals are unable to determine if the increased demand are really large increases or just a small insignificant spike.

As this is a supply shock, the increased demand resulting is a one-off type of thing and it does not affect the longer term equilibrium. It would be seem excessive for firms to increase prices based on that. If they did, once the issue is resolved, the price hikes could quickly backfire and cause lower demand. Note that in this case we are talking about oil, the demand would not necessarily go lower, but imagine the backlash from the consumers.

But in all, I do agree that government regulation of the oil prices have a hand in this because well, oil is a "sensitive" commodity.

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  • $\begingroup$ Doesn't the presence of massive queues at stations where there are normally no more than 2 or 3 cars at a time indicate increased demand? $\endgroup$ – mahela007 May 5 '17 at 12:36

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