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 Countnes (OPEC) decided to raise the world price of 011 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 (adjusted 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 countnes. 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 199Os. In the early 2oo0s, the price of oil rose again. driven in part by increased demand from a large and rapidly growing Chinese economv. but it did not approach the levels 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,  the short run supply and demand curves are steep When the supply of oil shifts from SI to S2. the price increase from PI 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 conservation, for instance by replacing old inefficient cars with newer efficient cnes Thus, as panel (b) of Figure 8 shows, the long-run supply and demand curves are more elastic. In the long run, the shift in the supply curve from SI 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 less 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.

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