Question

The challenge to the rule of Libyan leader Moammar Khadafi, and the ensuing conflict caused nearly all of Libya's 1.2 million barrels per day of oil exports to cease on February 20, 2011. As markets opened the next day, world oil prices jumped from 90 to 95 dollars per barrel.

a. Assuming perfectly inelastic short-run supply, and that total crude oil plus production was 82 million barrels per day before the loss of Libyan oil, what is the implied world short-run price elasticity of demand for crude oil? Explain how you derived your answer.

b. Oil futures markets anticipated that one year later, the price would fall to $92 per barrel, even if demand and OPEC production do not change since the loss of Libyan oil. Write one paragraph that explains some of the factors that explain why the demand and supply of oil are more elastic over a longer time horizon.

c. Suppose OPEC convened an emergency meeting to respond to the loss of Libyan oil. At the meeting, members proposed to adopt one of two choices: (1) leave all other countries' exports the same as before and enjoy the anticipated $92 price, or (2) allow each OPEC member (except Libya) to increase current production by 3 percent so as to bring world prices back to $90 per barrel. Venezuela could increase its output from its oil fields by spending $35 per barrel for each additional barrel produced. Saudi Arabia could increase its output from its oil fields by spending $15 per additional barrel. Iran could increase its output at a cost of $25 per each additional barrel. Which of the two options do you think each of the three countries would support? Explain why.

Answer 1

Quantity decreased by 1.2 million. As a result, price increased from $90 to $95.

(a) Assuming perfectly inelastic supply, and before the cease of 1.2 million, the equilibrium quantity was 82 million. The change in quantity is eaxactly 1.2 million, as the supply curve is vertical, and hence the change in equilibrium quantity is equal to the change in supply. The price increased by $5. Hence, the price elasticity of demand is or or or .

(b) The elasticity of any product can be determined by existence of its substitutes. In case of oil, the substitutes doesn't exist as much in case of product, but do exists in case of source of supply. The oil is geographically distributed among several nations in africa, asia, south america, etc. OPEC supplies are from the middle east, africa and south america. If OPEC changes price, then there is of course short run effect of relatively inelastic demand and supply, as oil trade is negotiated between nations, and the negotiation matters in the short run. But in the long run, other nations, such as south american nations exists, which would be negotiated for oil trade, and hence the long run demand and supply would be more elastic, and will response more with respect to price. Also is the factor that, in real world, the carteling doesn't work as much in the long run framework, as various international pressures exists along with trade institutions and negotiations.

(c) Suppose any of the nation produces q amount of quantity. Then, at the price of $92, they would earn $, minus their current cost. If they increase the production by 3%, then their cost would increase an extra upto $35, $15, $25, and a barrel of oil would be sold at $90. Hence, their earning would be $, $ and (as the extra cost would be only on the additional quantity) 3% , or $, $, $.

Hence, only in case of Saudi Arabia, the earning by increasing 3% is more than $, and hence, only Saudi Arabia will choose to produce 3% more at $90, and other would be reluctant to produce more, and will choose to sell at $92.