Question

Consider the global market of oil, which has become quite competitive, so you can rely on the supply and demand graph . A group of oil producing countries (OPEC) would like to impose a price floor, to prevent the price from reaching a low equilibrium level. Show graphically the effect of a successful price floor on oil buyers, sellers, and society at large.

In recent years, the number of new oil producers has risen considerably (one reason among many is the discovery of shale oil). How is this going to affect the market under the same price ceiling? Will OPEC find it easier to maintain the ceiling? Explain.

Answer 1

Let DO be the Global Demand Curve for Oil in the graph below which we assume to be highly inelastic considering oil as an essential input and resource of economy and society in most countries of the world. There are no or limited costly substitute of oil and its demand changes very little with the change in its price.

Now, considering the global supply of oil which we assume to be highly elastic initially but highly inelastic afterword considering that oil is non-renewable resource and has limited stock in the world. Let SO1 be the initial supply curve in the oil market dominated by OPEC- group of leading oil producers in the world.

Let A (PO1, QO1) be the initial equilibrium point of global oil market. Now, assume due to entry of new oil producers, oil market becomes more competitive and hence oil supply curve keeps shifts rightward and also becomes less inelastic. Let SO2 be the new oil supply curve and B (PO2, QO2) be the new equilibrium.

Now, if the OPEC successfully decides to impose price floor at point A instead of letting the new market equilibrium shift to point B, then the oil buyers will be worse off by the reduced area of consumer surplus at point B compared to point A as oil buyers will be paying more prices (PO1 > PO2) and consuming lower quantity (QO1 < QO2).

On the other hand, OPEC suppliers are better off at point A compared to point B as they are getting higher producer surplus (area of A, PO1, PO4 > area of B, PO2, PO5) at point A compared to point B.

However, the society as a whole is worse off due to higher artificial oil price and reduced oil consumption as oil is a key input and resource of economy and society used for manufacturing and transport of most products and higher oil price will keep the prices of other products high in the society. Although oil suppliers in the oil industry benefits but their size and share is very less compared to oil users population such that even from social welfare perspective society as a whole is worse off in higher oil situation compared to lower oil situation.

Oil supply market was highly monopolistic and oligopolistic few decades ago but has become highly competitive now as the market power of OPEC has reduced considerably over time. Thus, OPEC would find difficult to hold price floor to above equilibrium due to non-cooperation from increasing share of non-OPEC suppliers in the world. Since the new suppliers are located at different geographies and have better technology, cost structures and shape of supply curves so they may be able to under-cut OPEC price floor and earn more profits but reduce profits of OPEC suppliers. Thus, the chances of OPEC maintaining price floor above market price for even a short period of time becomes very less today.