Question

In this problem, you are to analyze the effects of the December 1973
OPEC oil embargo. Since 1974, the world oil market has been dominated by the
OPEC cartel. By collectively restricting output, OPEC has succeeded in pushing
world oil prices well above what they would have been in a competitive market. In
1974 OPEC accounted for about two-thirds of the world oil supply. Suppose the
supply of oil provided by non-OPEC members can be described by the linear
equation Q=5.4+0.15P where demand is measured in billion barrels of oil per year
and price is the price per barrel (in 1974 dollars). In 1973, OPEC supplied a fixed
amount of 12 billion barrels of oil per year.
A. Provide an equation for and graph the world supply of oil.
B. Suppose the world demand for oil can be described by the linear equation Q=18.9-
0.225P. Given the supply and demand, what is the world price for oil?
C. At this price, what is the elasticity of demand for oil?
D. In December of 1973, OPEC members agreed to reduce output by 25%
or to 9 billion barrels per year. What was the short-run price for oil after the
reduction in output?

Answer 1

(A) World supply (QS) = OPEC supply + Non-OPEC supply = 12 + 5.4 + 0.15P

QS = 17.4 + 0.15P

When P = 0, QS = 17.4 (Horizontal intercept). In following graph, S0 is the world supply curve.

(B) In equilibrium, world demand equals world supply.

18.9 - 0.225P = 17.4 + 0.15P

0.375P = 1.5

P = $4

(C) When P = $4, Q = 17.4 + (0.15 x 4) = 17.4 + 0.6 = 18 billion barrels

Elasticity of demand = (dQD/dP) x (P/QD) = - 0.225 x (4/18) = - 0.05

(D) New World supply (QS) = OPEC supply + Non-OPEC supply = 9 + 5.4 + 0.15P = 14.4 + 0.15P

Equating with world demand,

18.9 - 0.225P = 14.4 + 0.15P

0.375P = 4.5

P = $12