05 October 2010: Managerial Economics - Groupe 5 Homework
(a)
In 1971 the OPEC countries had regrouped and agreed upon fixing the level of taxes on oil production. Algeria, Iraq, Kuwait and Lybia nationalized the majority of western oil assets between 1971 and 1974, which led to an oligopolistic situation for European and Asian countries where there was no substitute for crude oil and a strong dependency on OPEP crude oil. The US were nearly self sufficient (80%). This situation was further illustrated by OPEC’s decision to increase posted oil prices by 5.7% in 1973, and to use production levels as a weapon during the war.
Anyway, in Nov 1973, OPEC decided to cut production (supply) of oil by 25%.
Crude oil is the main input for the petro-chemical industry. Crude oil demand is therefore fairly inelastic in the short term due the time required by the industry to adapt the transformation processes: diversity of its uses, long transformation cycle and important number of economical agents involved in the process. So a cut in production generates scarcity as the demand does not decline in the short run and prices to rise.
Conclusion: OPEP raised price and cut production by 25% causing to shift the supply curve to the left, and the price to jump, as explained in the graph below:
[pic]
The price of crude oil climbs quickly against de demand curve when shifting Qs.
The same situation prevaled in 1978 when the Iranian revolution led to divide the Iranian oil production by 3. In 1979 Saudi Arabi cut its production by 9.5 millions barrels a day (more than 20% of world supply). Iran cancelled all contracts with the US companies which therefore decreased the worlwide oil supply importantly. The same phenomenon happened: inelastic crude oil demand and drop in supply led to scarcity and shift of the supply curve to the left causing a rapid increase in prices. This diminution of supplies was further accelerated by Iran-Iraq war when oil production facilities...