Question

1. Suppose there is a sudden increase in the price of crude oil. a. How will this change the equilibrium price and quantity in the market for gasoline? (2 points) b. Based on your answer in part a), will there be a change in the equilibrium price and quantity in the market for new automobiles? (2 points) c. Based on your answers above, will there be a change in the equilibrium price and quantity in the market for used automobiles? (2 points)

Answer 1

Before answering this question let us revisit the basic concept of law of supply and demand.
The law of demand states that price is inversely related to demand i.e if the price of a commodity rises then the quantity of commodity demanded will reduce and vice versa
The law supply states that price is directly related to supply i.e if the price of a commodity rises then the quantity of commodity supplied will rise and vice versa.

Now, let us first establish the relationship between crude oil and gasoline. Essentially gasoline comprises of around 71% crude oil which makes it an essential an important ingredient. Therefore if the price of crude oil were to increase then the price of gasoline would also simultaneously increase. Therefore,

a) A sudden rise in the price of crude oil will result in the rise in prices of gasoline eventually. This will lead to a decrease in demand for gasoline quantity in the market since consumers always react negatively to price rises(law of demand). But this will lead to a rise in the supply of gasoline in the market because producers are always looking to maximise profits. Over time the amount of supply will adjust itself to meet the amount of demand to attain equilibrium in the market

b) Crude oil is not a very essential part of producing and assembling of automobiles. Since it's not a very important factor of production let us assume that a rise in its price does not affect the cost of production of an automobile.
Now how can the rise in the price of automobiles be affected indirectly by the sudden rise in the price of crude oil? As established in a) the price of gasoline rises with the price of crude oil. Gasoline is essential to make an automobile function since gasoline is used to power the vehicle to move. If the price of gasoline rises the cost of maintaining an automobile will increase. The rise in the cost of maintenance works against the wishes of the consumer who always looks to minimize cost. Therefore, the demand for automobiles running on gasoline will decrease in the market, especially since there are alternatives like electric cars easily available. This reduction in demand will cause disequilibrium in the market. Therefore the supply and price of automobiles will reduce to meet the amount of reduced demand in the market caused by the rise in prices of gasoline, to restore equilibrium.

c) The answer to this question is subjective. We shall restrict our study to only used automobiles running on gasoline. Assuming that a consumer looks over other alternatives, the quantity of demand for used automobiles will rise compared to new automobiles. This is because, since the price of gasoline has increased, a consumer would look to minimise his overall expenditure since maintenance cost of the automobile will rise with the rise in the price of gasoline as proven in sub-section b). Therefore the quantity demanded for used automobiles will rise compared to the demand for new automobiles.
In this scenario, the increase in demand for used automobiles will cause disequilibrium in the market. To restore equilibrium, price and supply of used automobiles must rise.