Why did OPEC fail to keep the price of oil high?

Many of the most disruptive events for the world’s economies over the past several decades have originated in the world market for oil. In the 1970s members of the Organization of Petroleum Exporting Countries (OPEC) decided to raise the world price of oil to increase their incomes. These countries accomplished this goal by jointly reducing the amount of oil they supplied. From 1973 to 1974 the price of oil 9adjsuted for overall inflation) rose more than 50 percent. Then a few years later, OPEC did the same thing again. From 1979 to 1981, the price of oil approximately doubled. Measured in 2004 dollars, the price of crude oil reached $91 per barrel and the price of gasoline was $3 per gallon.

Yet OPEC found it difficult to maintain a high price. From 1982 to 1985 the price of oil steadily declined about 10 percent per year. Dissatisfaction and disarray soon prevailed among the OPEC countries. In 1986, cooperation among OPEC members completely broke down, and the price of oil plunged 45 percent. In 1990, the price of oil (adjusted for overall inflation) was back to where it began in 1970, and it stayed at that low level throughout most of the 1990s. In the early 2000s the price of oil rose again, driven in part by increased demand from a large and rapidly growing Chinese economy, but it did not approach the level reached in 1981.

This OPEC episode of the 1970s and 1980s shows how supply and demand can behave differently in the short run and in the long run. In the short run, both the supply and demand for oil are relatively inelastic. Supply is inelastic because the quantity of known oil reserves and the capacity for oil extraction cannot be changed quickly, demand is inelastic because buying habits do not respond immediately to changes in price. Thus, as panel (a) of Figure shows the short run supply and demand curves are steep. When the supply f oil shifts from S1 to S2 the rice increase from P1 to P2 is large.

The situation is very different in the long run. Over long periods of time producers of oil outside OPEC respond to high prices by increasing oil exploration and by building new extraction capacity. Consumers respond with greater conversation for instance by replacing old inefficient cars with newer efficient ones. Thus, as panel (b) of Figure shows, the long run supply and demand curves are more elastic In the long run the shift in the supply curve from S1 to S2 causes a much smaller increase in the price.

This analysis shows why OPEC succeeded in maintaining a high price of oil only in the short run. When OPEC countries agreed to reduce their production of oil, they shifted the supply curve to the left. Even though each OPEC member sold les oil, the price rose by so much in the short run that OPEC incomes rose. By contrast in the long run when supply and demand are more elastic, the same reduction in supply, measured by the horizontal shift in the supply curve, caused a smaller increase in the price. Thus, OPEC’s coordinated reduction in supply proved less profitable in the long run.

OPEC still exists today, and it has from time to time succeeded at reducing supply and raising prices. But the price of oil (adjusted for overall inflation) has never returned to the peak reached in 1981. The cartel now seems to understand that raising prices is easier in the short run that in the long run.

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