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Adjusting to Oil Price Shocks
Short-run and long-run demand and supply curves
Between December 1973 and June 1974, the Organization of Petroleum Exporting Countries
(OPEC) put up the price of oil from $3 to $12 per barrel. It was further raised to over $30 in
1979. In the late 1980s the price fluctuated, but the trend was downward. Except for a sharp
rise at the time of the Gulf War in 1990, the trend continued in the early 1990s. By 1996, the
price was fluctuating around $16 per barrel: in real terms (i.e. after correcting for inflation),
roughly the level prior to 1973.
The situation for OPEC deteriorated further in the late 1990s, following the recession
in the Far East. Oil demand fell by some 2 million barrels per day. By early 1999, the price
had fallen to around $10 per barrel – a mere $2.70 in 1973 prices! In response, OPEC
members agreed to cut production by 4.3 million barrels per day. The objective was to push
the price back up to around $18–$20 per barrel. But, with the Asian economy recovering and
the world generally experiencing more rapid economic growth, the price rose rapidly,
reaching over $35 in late 2000. The effect was to trigger protests around the world, with
pressure on governments to cut fuel taxes.
The price movements can be explained using simple demand and supply analysis.
The initial rise in price
P
S2
S1
P2
B
P1
A
D1 (short-run)
O
Q2
Q1
Q
Diagram (a) An initial restriction of supply
OPEC raised the price from P1 to P2. To prevent a surplus at that price, OPEC members
restricted their output by agreed amounts. This had the affect of shifting the supply curve to
S2, with Q2 being produced. This reduction in output needed to be only relatively small
because the short-run demand for oil was highly price-inelastic : for most uses there are no
substitutes in the short run.
Long-run effects on demand
The long-run demand for oil was more elastic. With high oil prices persisting, people tried to
find ways of cutting back on consumption. People bought smaller cars. They converted to
gas or solid fuel central heating. Firms switched to other fuels. Less use was made of oilfired power stations for electricity generation. Energy saving schemes became widespread
both in firms and in the home.
P
S2
P2
P3
S1
B
C
A
DL
D2
D1
O
Q
Diagram (b) Long-run demand response
This had the effect of shifting the short-run demand curve from D1 to D2. Price fell back
from P2 to P3. This gave a long-run demand curve of DL: the curve that joins points A and C.
The fall in demand was made bigger by a world recession in the early 1980s.
Long-run effects on supply
With oil production so much more profitable, there was an incentive for non OPEC oil
producers to produce oil. Prospecting went on all over the world and large oil fields were
discovered and opened up in the North Sea, Alaska, Mexico, China and elsewhere.
In addition, OPEC members were tempted to break their "quotas" (their allotted output)
and sell more oil.
The net effect was an increase in world oil supplies. This is shown by a shift in the
supply curve to S3. Equilibrium price thus fell back to P1 (point D). Note that the supply
curves in these diagrams are all short-run supply curves, since each one shows supply for a
particular number of oil fields.
Drawing a long-run supply curve is more difficult: it depends when in the story we start
and what assumptions we make.
We could draw a long-run supply curve linking points E and F. The reasoning is as
follows. After the limiting of supply to S2, OPEC members would have supplied at point E,
had the price remained at P1. After some years with the price set at P2 or thereabouts, more
suppliers enter the market. The supply curve shifts to S3. Had the demand curve not shifted,
equilibrium would then have moved to point F: the intersection of S3 and the original
P
S2
P2
P3
S3 S
1
B
C
A
P1
D
D2
D1
O
Q
Diagram (c) Long-run supply response
demand.
A long-run supply curve thus links points E and F.
Back to square one
By the late 1990s, with the oil price as low as $10 per barrel, OPEC once more cut back
supply. The story had come full circle. This cut-back is illustrated in diagram (a).
The trouble this time was that the world was recovering from recession. Demand was
shifting to the right. The effect was that the price rose above the $18–$20 per barrel OPEC
target. In September 2000, OPEC agreed to increase its production in order to bring the price
down to around $25 from the $35 mark it had reached. In other words, they agreed to shift the
supply curve back to the right somewhat.
Question
Give some examples of things that could make the demand for oil more elastic. What
specific policies could the government take to make demand more elastic?