Question

Since the early 1970s, the world oil market has been buffeted by the OPEC cartel and by political turmoil in the Persian Gulf. In 1974, by collectively restraining output, OPEC (the Organization of Petroleum Exporting Countries) pushed world oil prices well above what they would have been in a competitive market. OPEC could do this because it accounted for much of world oil production. During 1979-1980, oil prices shot up again, as the Iranian revolution and the outbreak of the Iran-Iraq war sharply reduced Iranian and Iraqi production. During the 1980s, the price gradually declined, as demand fell and competitive (i.e., non-OPEC) supply rose in response to price. Prices remained relatively stable during 1988-2001, except for a temporary spike in 1990 following the Iraqi invasion of Kuwait. Prices spiked again in 2002-2003 as a result of a strike in Venezuela and then the war with Iraq in the spring of 2003. Figure bellow shows the world price of oil from 1970 to 2003, in both nominal and real terms.

The Persian Gulf is one of the less stable regions of the world-a fact that has led to

later fell as supply and demand adjusted.
concern over the possibility of new oil supply disruptions and sharp increases in oil prices.

What would happen to oil prices-in both the short run and longer run-if a war or

The Persian Gulf is one of the less stable regions of the world-a fact that has
revolution in the Persian Gulf caused a sharp cut-back in oil production? Let's see how

led to concern over the possibility of new oil supply disruptions and sharp

simple supply and demand curves (can be used to predict the outcome of such an event.

increases in oil prices. What would happen to oil prices-in both the short run Because this example is set in 1997, all prices are measured in 1997 dollars.

and longer run-if a war or revolution in the Persian Gulf caused a sharp cut- back in oil production? Let's see how simple supply and demand curves (:anbe

used to predict the outcome of such an event.

Here are some rough figures:

Because this example is set in 1997, all prices are measured in 1997 dollars.

• 1997 world price = $18 per barrel Here are some rough figures:

• World demand and total supply = 23 billion barrels per year (bb/yr) • 1997 world price = $18 per barrel ~

• 1997 OPEC supply = 10 bb/yr
• Worlddemandandtotalsupply=23billionbarrelsperyear(bb/yr)

• Competitive (non-OPEC) supply = 13 bb/yr • 1997 OPEC supply = 10 bb/yr

• Competitive (non-OPEC) supply = 13 bb/yr15

The following table gives price elasticity estimates for oil supply and demand:16

15Non-OPEC supply includes the production of China and the former Soviet republics.

The following table gives price elasticity estimates for oil supply and demand:

Short-Run Long-Run

World demand: -0.05 -0.40

Competitive supply: 0.10 0.40

a) Using the estimated elasticities, calculate demand, competitive supply in the short run and Total short-run supply. Verify that the quantity demanded and the total quantity supplied are equal at an equilibrium price of $18 per barrel.

b) Using the estimated elasticities, calculate demand, competitive supply in the long run and Total long-run supply. Again, verify that the quantity demanded and the total quantity supplied are equal at an equilibrium price of $18 per barrel.

c) Saudi Arabia is one of the world's largest oil producers, accounting for roughly 3 bb/yr, which is nearly one third of OPEC production and about 13 percent of total world production. What would happen to the price of oil in short-run if, because of war or political upheaval, Saudi Arabia stopped producing oil? How would you answer this question from long-run perspective?

Answer 1

In the short run,the price will be more than double at $41.08 per barrel. As seen the above fig,the supply shifts from St To St1 and the price increases The equilibrium point chaanges from E to E1 where the new supply curve St1 intersects the D emand curve.

As seen in the above diagram, the demand and supply is more elastic in the long run so there will be a slight increase in the prices only. The new price is $21.75, as Supply curve shifts to St1and the point where it intersects the demand curve will be the new equilibrium point E1.

So,if Saudi Arabia stops producing oil,there is more than double increase in the prices in the short run but it will adjust in the long run as the demand falls.