Question

Iran supplies 10% of the world market in Crude oil. The market demand for Crude is price-inelastic, with εCC = -0.25. The Ayatollah has come up with a new idea – “we’ll withhold half of our oil from the market, raise price and get more revenue, given that demand is so inelastic. You are the economic advisor to the Ayatollah. a)Is the Ayatollah right? b)Explain your answer to (a).

Answer 1

a) Yes, the Ayatollah is right if the elasticity for the demand for crude oil is price-inelastic with εCC = -0.25.

b) Inelastic demand means that the quantity demanded changes in less proportion than the proportional change in the price. So, when the Ayatollah will decrease the quantity of their oil to half, the quantity supplied will decrease by half, the price would also rise, but the demand for crude oil will not decrease as much as the quantity supplied even with the increase in the price and therefore the Total Revenue would increase.

The formula for Total Revenue = Price * Quantity. Say for example, before, the price for Crude oil was 10 Iranian Rial per litre and the quantity supplied was a total of 100 litres. Then the Total Revenue = Price * Quantity = 10 * 100 = 1000 Iranian Rial. Now, when the quantity supplied decreases by say 50%, then the quantity supplied = 50 litres but since it is inelastic, the price increases by say 120% to 22 Iranian Rial. Then the Total Revenue = Price * Quantity = 22 * 50 = 1,100 Iranian Rial i.e the Total Revenue increases.