Case and Questions
Case Study: Business Economics
The evolution of oil price and its relationship with elasticity of demand and supply
To begin with, let’s disregard the COVID-19 pandemic and its aftermath on the global economy.
Prior to the pandemic, the majority of global economic disruptions over the past decades have been
caused by fluctuations in the global oil market. Why are these disruptions significant events in the
economic history, what causes them, and how does the market respond to them? These questions
have their roots in the simple concept of elasticity.
The members of the OPEC abruptly increased the oil price in the early 1970s, primarily to boost
their own incomes. Since OPEC is an oligopoly that behaves like a monopoly (when making
important decisions), the only way they could increase prices was by indirectly regulating the
supply of oil. So even after adjusting for inflation, the oil price increased by as much as 50% from
1973 to 1974. Then, a few years later, OPEC repeated the same process, causing the oil prices to
double between 1979 and 1980.
Later on, however, OPEC found it difficult to maintain the same level of price increases. From
1982 to 1985, the price of oil steadily declined at a rate of 10% per year. There was a lack of
cooperation and dissatisfaction among the OPEC members. By 1986, the price of oil had dropped
down by nearly 45%; and by 1990, the price of oil (adjusted for inflation) had recovered to where it
had begun in 1970. It also remained low for much of the 1990s. In the early 2000s, it rose again,
which was driven mostly by a large and rapidly growing Chinese economy, but it never increased
to that extent again.
Figure 1. Fluctuations in the crude oil prices over the decades.
Figure 2. Short and Long run demand and supply of oil.
What is the key observation from the preceding events? The key observation is that supply and
demand behave differently in the short and long run. Why do they behave differently? It behaves in
a particular manner because the elasticities of demand and supply are different in the short run and
long run. Let’s examine this more clearly. Both supply and demand for oil are inelastic, or
relatively inelastic, in the short run. The supply is inelastic because neither new areas can be
discovered to extract oil nor new technologies can be developed to extract oil efficiently in the
short run. The demand is inelastic because the purchasing habits do not react as quickly as the price
fluctuations (considering the limited alternatives for oil supply back then). Therefore, the demand
and supply curves for oil in the short run are steeper. As a result, when the supply curve shifts, the
impact on oil prices becomes greater.
In contrast, the supply and demand become more elastic in the long run which can be due to many
reasons. In the long run, the supply is fairly more elastic because the suppliers have discovered
more efficient ways to extract oil, thus increasing supply and lowering costs. There may also be a
scenario in which more than one economy or company are now taking advantage of the newly
discovered oil reserves in their regions. The demand is more elastic in the long run maybe because
people have eventually developed new ideas and substitutes for oil. Alternatively, they may have
realised that rather than driving their own vehicles, they have other cheaper options available that
can transport them from one place to the other. In either case, any shift in the supply curve will
have little effect on price, like the ones observed in the first part of this case study.
Thus for the short term, the OPEC’s decision to reduce supply resulted in a significant increase in
prices and hence higher incomes for the OPEC members. While for the long term, the same
decision by the OPEC to reduce supply did not result in higher incomes for them, as the impact on
price was insignificant.
OPEC is still active today, and it has influenced the global oil prices by reducing the oil supply
from time to time. However, as you can see, the prices never returned to those of the 1970s. It is all
due to the long-term elasticities of oil demand and supply.
You can read more about the case here: Link
Questions
Q1. We saw in the case study that the Organisation of Petroleum Exporting Countries (OPEC)
raised the price of crude oil in 1973 for the global market. We also noticed that because the supply
and demand for crude oil was inelastic in the short run, the impact on the global market in terms of
price and the output supplied was greater. Based on this context, please give a brief explanation for
the following questions:
1a. What impact would OPEC’s reduction in the supply of crude oil have on the price of oil in the
global market and the subsequent quantity of crude oil demand in the short run? Please explain the
shifts in demand and supply curves with help of a relevant graph. (100-200 words)
Answer: Impact of OPEC’s Supply Reduction: In the short run, OPEC’s reduction in the supply of
crude oil would lead to a leftward shift in the supply curve, resulting in higher prices for oil in the
global market. Since the demand is inelastic, the quantity of crude oil demanded would not
decrease significantly, causing a substantial increase in price. This is depicted in a graph where
the supply curve shifts left (from S1 to S2), the price level rises sharply from P1 to P2, while the
quantity demanded decreases only slightly from Q1 to Q2.
To illustrate the impact of OPEC’s reduction in the supply of crude oil on the price and quantity
demanded in the short run, we can use a supply and demand:
Price (per barrel)
|
| P2
| /|
| / |
| / |D
| / |
|/____ |________________ Quantity (barrels)
P1 Q2 Q1
D: Demand curve for oil, which is relatively inelastic in the short run23.
S1: Original supply curve before OPEC reduces supply.
S2: New supply curve after OPEC reduces supply, shifted to the left.
P1: Original equilibrium price.
P2: New higher equilibrium price after the supply reduction.
Q1: Original equilibrium quantity.
Q2: New lower equilibrium quantity after the supply reduction.
In this scenario, the supply curve shifts from S1 to S2 due to OPEC’s reduction in supply. Because
the demand is inelastic, the decrease in quantity demanded from Q1 to Q2 is not significant, but the
increase in price from P1 to P2 is substantial. This results in a higher price for oil and a slightly
lower quantity of oil demanded in the short run. The area between the curves and the axes
represents the market equilibrium before and after the supply shift.
1b. Consider the possibility of a war in the Middle East in the coming months. In this scenario, the
labour market is facing constraints as a large number of migrant workers in the Middle East are
returning back to their home countries. To prevent reverse migration, the government has decided
to increase the wages for the migrants workers. Considering this phenomenon, explain the effect of
the speculated war on labour demand and supply, as well as the price of labour in the OPEC with
help of a graph. (50-150 words)
Answer: Effect of War on Labour Market: The speculated war could cause a decrease in the supply of labor due to migrant
workers returning home. To counteract this, increasing wages would shift the labor supply curve to the right, from S1 to S2,
aiming to retain workers. However, if the wage increase is not sufficient to offset the effects of the war, the labor supply might
still decrease, shifting the supply curve to the left, from S1 to S3. This would result in higher labor prices and potentially lower
quantity of labor supplied, depending on the relative shifts of the curves. The demand curve for labor would likely remain
unchanged in the short term. The graph would show these shifts with the new equilibrium points reflecting changes in the price
and quantity of labor.
Wage Rate
|
| W2
| /|
| / |
| / | LD
| / |
|/____ |________________ Quantity of Labor
W1 Q2 Q1
LD: Labor demand curve.
LS1: Original labor supply curve before the war.
LS2: New labor supply curve after the war, shifted to the left due to migrant workers returning home.
W1: Original equilibrium wage rate.
W2: New higher equilibrium wage rate after the war.
Q1: Original equilibrium quantity of labor.
Q2: New lower equilibrium quantity of labor after the war.
In this scenario, the labor supply curve shifts from LS1 to LS2 due to migrant workers returning home2. The government’s
decision to increase wages to prevent reverse migration would shift the labor demand curve to the right, from LD1 to LD23.
This results in a new equilibrium with a higher wage rate (W2) and a potentially lower quantity of labor (Q2), depending on the
relative shifts of the curves. The area between the curves and the axes represents the market equilibrium before and after the
speculated war.
Q2. Answer the following questions:
2a. While OPEC was successful in raising the price of crude oil in the 1970s, it was unable to do so
in the 1980s. Mention any two factors that prevented OPEC from sustaining this high price in the
1980s. Provide a well-researched answer, you may use the internet to strengthen your
reasons. (150- 200 words)
2b. Why is the supply elasticity usually greater than 1, in the short run or the long run? Please
provide two examples of goods (other than oil) or services that have a greater supply elasticity in
the long run. (100-150 words)
Q3. What type of market structure does OPEC operate in? Let’s assume that OPEC has added 23
new nations to its list of oil producers and exporters, what type of market will OPEC operate in
now? Support your answer with a brief explanation. (100-150 words)
Q4. Alabama Oil Ltd. is a company that extracts and exports crude oil. Let’s consider that it incurs
costs on machineries, rents, salaries, and transportation, and that the total cost accounts for both
variable and fixed costs. The industry demands are 4 million barrels of oil until the price falls
below or equals $32 per barrel. Following that, the industry’s demand drops down by 15%. The
individual demands are 2.5 million barrels until the price falls below or equals $34 per barrel.
Thereafter, the individual demand drops down by 20%.
The following is the cost schedule (collusion model) of Alabama Oil Ltd.
Price per
Industry Demand Individual
Quantity barrel Total
(per million Demand (per
(barrels) (in $) Cost
barrels) million barrels)
0 40 32.5
1 38.5 40
2 37 42.5
3 35.5 51
4 34 59.5
5 32.5 72
6 31 87.5
7 29.5 108
8 28 133
9 26.5 162.5
4a. Considering Alabama Oil Ltd. operates with the sole motive of profit maximisation, at what
level of production output does Alabama Oil Ltd. maximise their profit? What is the overall level
of sales revenue at profit maximisation output? (Write the final answer based on the calculations)
4b. Plot the cost schedule (table) into a well-labelled graph. Identify the point of profit
maximisation.
4c. At what profit level does the industry demands rise? At what profit level does the individual
demands rise?
Q5. Two major factors can cause a rise in crude oil prices in the global market. These include a rise
in global demand, especially from China; as well as cost shocks, such as the Iraq war or Hurricane
Katrina (in 2005). Inflation rates in countries are generally raised by such price increases. Answer
the following questions.
5a. What type of inflation would be triggered by an increase in oil prices, and give a brief
description about the factors that would trigger such inflation? Provide two past real-life examples
when such an inflation was witnessed. (150-200 words)
5b. Explain the aggregate demand–aggregate supply (AD–AS) model in the context of the events
mentioned in the case study. Describe and include the type of unemployment caused in any
economy that is heavily dependent on oil import in your response. (200-250 words)
Q6. Answer the following questions:
6a. A large increase in inflation causes a drop in the overall output of any economy, which is
referred to as a ‘short-term recessionary phase’. It is not a desired phenomenon by any government
in the world. Describe two resources that the Reserve Bank of India (RBI) can adopt to help the
country recover from such a short run recession phase in the country. (300-350 words)
6b. Take a look at this excerpt from the news, “India is one of the largest importers of oil in the
world. It imports nearly 80% of its total oil requirements. This accounts for one-third of the
country’s overall imports. As a result, the price of oil has a major impact on India, according to a
report by Livemint.” Consider the scenario of low oil prices. What are the effects of falling oil
prices on fiscal balance? Mention two fiscal tools adopted by the government in such a
scenario. (200-350 words)
6c. Consider the following data from the country Baliga:
Price Price per Price per Number
Number Quantity
Year per Bread haircut of
of Cars of breads
Car ($) Loaf ($) ($) haircuts
2010 10000 200 2 500 25 700
2011 12000 200 3 600 25 800
2012 12000 350 3 650 22 900
Considering 2010 as the base year calculate the nominal and real GDP for 2011 and 2012. For each
year.
Q7. The pound sterling depreciated after the Brexit referendum in June 2016, resulting in
significant impacts on trade flows between the United Kingdom and the European Union. The
currency depreciation lowers the purchasing power and has an impact on imports and exports.
Mention two advantages and two disadvantages of the depreciated pound on the British
economy. (100-200 words)
