The Beechmont Crest Guide to Economics
IS OPEC RATIONAL?
HOW SUPPLY AND DEMAND INTERACT
At the time of this writing (February 2009), oil prices are hovering around $40 per barrel. Just last summer, the price of oil surged to a record $140/barrel!
What happened? There was no major increase in supply, but demand dramatically decreased due the worldwide economic downturn that began in late 2008.
Not surprisingly, oil producing nations like Saudi Arabia are less than thrilled with $40/barrel. OPEC has therefore proposed a reduction in output.
By the basic interaction of supply and demand, this should result in a total revenue increase for oil producers. Right?
Well, not necessarily. It all depends on the demand curve.
As shown from the two cases below, a decrease in supply can result in an increase in total revenue when demand is high (i.e., there is a steep demand curve.)
However, a supply cut will result in a net decrease in revenue when the demand curve is flat---even though the per-unit revenue increases.
In both scenarios below, the initial condition is an intersection of supply and demand at $50 per barrel.
Scenario A gives the producer an increase in total revenue when supply is cut. In Scenario B, a supply cut results in a net loss of total revenue. (Note the difference in the slope of the demand curve in each case.)
The Birth of Plenty : How the Prosperity of the Modern World was Created
Scenario A: Here the demand curve is steep, indicating high demand
Scenario B: Here the demand curve is nearly level, indicating weak demand.
