Question

The OPEC countries produce about 40% of the world's crude oil. Suppose that OPEC cuts its crude oil production by 10%. Assume that no other nation changes its oil production during the time frame being considered and that the price elasticity of demand for crude oil over that period is −0.1.

What will be the percentage change in the world price of oil?

(Hint: First, calculate the percentage change in the world oil production as a result of OPEC's production cut. Then solve the price elasticity of demand equation for %ΔP.)

Suppose the current price of oil is $50 per barrel. What will be the price of oil after the OPEC's action takes effect?

(Hint: Use the midpoint formula to find the price change in dollars given the percentage change in price.)

Answer 1

Production by OPEC countries = 40% of the world's crude oil. Suppose that world oil production is 100 units so OPEC countries produce 40 units. Now OPEC cuts its crude oil production by 10% so that its production is reduced by 4. This is (4/100) or 4% of world production. Hence world production is reduced by 4 percent. Given that the price elasticity of demand for crude oil over that period is −0.1, the required percentage change in the world price of oil is -4%/-0.1 = 40%. Thus the price is increased by 40%.

Suppose the current price of oil is $50 per barrel. We know that

% change in P using mid point method = (P2 - P1)*100/(P1 + P2)/2

40 = (P2 - 50)*100/0.5*(P2 + 50)

40*0.5*(P2 + 50) = 100P2 - 5000

20P2 + 1000 = 100P2 - 5000

6000 = 80P2

P2 = 75

Hence the new price is $75 when the price of oil rises by $25.