Explain how the development of renewable sources of energy is likely to affect the market for oil.
AQA AS-Level Economics Paper 1 June 2023
Extract C (lines 13–14) states: ‘Concerns about the impact of oil on the environment have led to the encouragement of renewable energy, such as solar, wind and tidal power’. Explain how the development of renewable sources of energy is likely to affect the market for oil.
A market is a place where buyers and sellers meet to exchange goods and services. The markets for oil and renewable energy can be considered related as they are in competitive demand.
Oil and renewable energy are substitute goods. This means that they have a positive cross elasticity of demand (XED) with each other. Line 14 mentions that renewable energy is being subsidised. A subsidy is a payment given by the government to firms causing their costs of production to fall. This, alongside technical progress, causes the supply of renewable energy to increase, as shown below. Supply is the quantity of goods and services that firms are willing and able to produce at any given price. As supply increases, there is initially excess supply if prices remain the same. Therefore, the price falls due to the rationing function of the price mechanism. This causes an expansion along the demand curve, and the equilibrium price of renewable energy falls from p1 to p2.
In the market for oil, demand falls because renewable energy is now a cheaper and more available alternative. This initially causes excess supply in the market. Therefore, prices fall due to the rationing function. In this case, there is a contraction along the supply curve, as firms are less motivated to produce oil due to a fall in the possible profits. Overall, there is a fall in the equilibrium quantity and price in the market for oil.
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