In 2008, world oil prices rose to $150 a barrel due to renewed tension in the Middle East. At that same time, the price of corn flour tortillas sold in the streets of Mexico City also peaked. Using supply and demand graphs for each of the following markets, explain how the rise in oil prices caused the rise in the price of corn flour tortillas.
The six markets are (not necessarily in the correct order): a) corn; b) gasoline; c) oil; d) corn tortillas; e) ethanol (a substitute for gasoline made with corn); f) corn flour.
Rearrange the above markets in the right logical order and, for each market, explain, in your own words and graphically, what happens to supply or demand, as well as the equilibrium price and quantity (increases or decreases). Make sure that you graphs are properly labeled!
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As I understand it, you want these markets put in order to show the chain of causality that led from an increase in the price of oil to an increase in the price of corn tortillas in Mexico. I will base my answer on this understanding. I cannot draw graphs for all of these, but I will tell you what curves to move on your graphs.
The first link in the chain is the market for oil. Oil prices rose because demand rose as people expected that supply shocks might occur. Because they were worried about supply shocks, they bought more oil so as to have reserves. The demand curve moved right and the price rose.
The next link in the chain is gasoline. When the price of oil rose, the supply of gasoline dropped. Supply is determined in part by changes in the cost of production. When the cost of production rises, supply drops. Since gasoline is made from oil, a rise in the price of oil also causes the price of producing gas to increase. This makes supply fall (movement of the curve to the left) and prices rise.
The next link is ethanol. Ethanol is a substitute for gasoline. When the price of a product rises, demand for its substitutes rises as well. People, in this case, were buying more ethanol because gas was getting more expensive. With the demand for ethanol rising (demand curve moves right) the price of ethanol rose.
When the price of ethanol rose, the price of corn also rose. This was because there was greater demand for corn that could be made into ethanol. So demand for corn rises and the price of corn rises. When the price of corn rises, the supply of corn flour falls. This is the same process described in the paragraph about gasoline. When the supply of corn flour falls, the price of that flour rises. Finally, the same process occurs with corn tortillas. Corn flour is one of the ingredients of corn tortillas so an increase in the price of corn flour causes a decrease in the supply of corn tortillas, which causes an increase in the price of those tortillas.
Through this chain of causality, unrest in the Middle East led to an increase in the price of corn tortillas in Mexico.
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