Example 27 The World Qil Market On The Back Of An Envelope

Since 1974, the world oil market has been dominated by the OPEC cartel. By collectively restraining output, OPEC succeeded in pushing world oil prices well above what they would have been in a competitive market. OPEC producers could do this because they accounted for a large fraction of world oil production (about two-thirds in 1974).

We discuss OPEC's pricing strategy in more detail in Chapter 12 as part of our analysis of cartels and the behavior of cartelized markets. But for now, let's see how simple linear supply and demand curves (and the back of a small envelope) can be used to predict what should happen, in the short and longer run, following a cutback in production by OPEC.

This example is set in 1973-1974, so all prices are measured in 1974 dollars (which, because of inflation, were worth much more than today's dollars). Here are some rough figures: 1973 world price = $4 per barrel, world demand and total supply = 18 billion barrels per year (bb/yr), 1973 OPEC supply = 12 bb/yr and competitive (non-OPEC) supply = 6 bb/yr. And here are price elasticity estimates consistent with linear supply and demand curves:11

You should verify that these numbers imply the following for demand and competitive supply in the short run:

Short-run Competitive Supply: Sc = 5.4 + 0.15P

Of course, total supply is competitive supply plus OPEC supply, which we take as constant at 12 bb/yr. Adding this 12 bb/yr to the competitive supply curve above, we obtain the following for total short-run supply:

Short-run Total Supply: St= 17.4 + 0.15P

You should check that demand and total supply are equal at a price of $4 per barrel.

You should also verify that the corresponding demand and supply curves for the long run are

Long-run Competitive Supply: Sc = 3.6 + 0.6P

Again, you can check that supply and demand equate at a price of $4.

Now let's calculate what should happen if OPEC cuts production by one-fourth, or 3 bb/yr. For the short-run, just subtract 3 from total supply:

By equating this total supply with demand, we can see that in the short run, the price should rise to $12 per barrel, which in fact it did. Figure 2.19 illustrates the shift in supply and its effect on price. The initial equilibrium is at

1 'These elasticities are larger when price is higher. For the sources of these numbers and a more detailed discussion of OPEC oil pricing, see Robert S. Pindyck, "Gains to Producers from the Carteliza-

tion of Exhaustible Resources," Review of Economics and Statistics 60 (May 1978): 238-251, and James M. Griffin and David J. Teece, OPEC Behavior and World Oil Prices (London: Allen & Unwin, 1982).

Quantity (billion barrels/yr)

figure '2.19 ' OPEC Production Cut. Total supply is the sum of competitive (non-OPEC) supply and the 12 billion barrels per year of OPEC supply. These are short-ran. supply and demand curves. If OPEC reduces its production, the supply curve will shift to the left. In the short run, price will increase sharply. 1

the intersection of Stotai and D. After the drop in OPEC production, the equilibrium occurs where Stotai and D cross.

In the long run, however, things will be different. Because both demand and competitive supply are more elastic in the long run, a one-fourth cut in production by OPEC will no longer support a $12 price. By subtracting 3 from the long-run total supply function and equating with long-run demand, we can see that the price will be only $5.25. This is $1.25 above the old $4 price but much lower than $12.

We would therefore expect to see a sharp increase in price, followed by a gradual decline,as demand falls and competitive supply rises in response to price. And this is what did occur, at least until 1979. But during 1979-1980 the price of oil again rose dramatically. What happened? The Iranian Revolution and the outbreak of the Iran-Iraq war. By cutting about 15 bb/yr from Iranian production and nearly 1 bb/yr from Iraqi production, the revolution and war allowed oil prices to continue to increase, and consequently they were a blessing for the other members of OPEC.

Yet even though the Iran-Iraq war dragged on, by 1986 oil prices had fallen much closer to competitive levels. This was largely due to the long-run response of demand and competitive supply. As demand fell and competitive supply expanded, OPEC's share of the world market fell to about one-third, as compared with almost two-thirds in 1973.

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