Oil is very important because it is used to produce many goods and mostly used in heating and transport. This is why the supply of oil is in the hands of a small number of producers who are based in countries where oil reserves are found. These countries get together and agree on the quantity of oil to produce and the price to charge. According to Mankiw et al., (2019), a group of firms acting in unison is called a cartel. They further explained that a cartel must agree not only on the total level of production but also on the amount produced by each member. This is the essence of an ‘oligopolistic’ market. An oligopoly is a market with limited competition in which a few producers control the majority of the market share and typically produce a similar/homogenous product (Lipsey and Chrystal, 2007). An example of a cartel and an oligopolistic market is the ‘Organization of Petroleum Exporting Countries’, abbreviated as OPEC.
The Organization of Petroleum Exporting Countries (OPEC)
OPEC is an intergovernmental organization of 14 nations, founded in Baghdad in 1960, by the best 5 member countries namely; Iran, Iraq, Kuwait, Saudi Arabia and Venezuela (Wikipedia.org). OPEC aims at coordinating and unifying the petroleum policies of its member countries and ensure the stabilization of oil markets so that they can efficiently supply oil to consumers (opec.org). OPEC decisions play a prominent role in the global oil market and international relations. Economist often cite OPEC as an example of a cartel that cooperates to reduce market competition, but Mankiw et al. (2019) argued that often, it is not possible to form cartels and earn monopoly profits. This is because there can be squabbling among members on how to divide the profits and this leads to disagreements/conflicts. At various times, OPEC members have had conflicts over their production costs, political circumstances, export capacities and reserves.
Causes of the 1970s Oil Crisis
In 1971, the US abandoned the gold exchange standard and because oil was priced in dollars, oil producers’ income decreased. In order to increase their profits, OPEC members increased their oil prices. As stated by Mankiw (2019), OPEC has always had trouble cooperating. The countries are not always able to coordinate policies to ensure their control over the market due to a large number of political and economic factors hence others sold at different prices.
Other nations increased their reserves by expanding their money supplies in greater amounts and this led to depreciation of the dollar as well. Quantitative easing is a monetary policy in which a central bank purchases government security in order to increase the money supply (Lipsey and Chrystal, 2007). Also, OPEC was slow to readjust the prices to reflect the depreciation. This led to expensive imports and it increased the cost of production and consumer price levels.
Low Supply of Oil and High Demand of Oil
In October of 1973, the Arab members of OPEC placed an embargo on the U.S. in response to its support of Israel and the Yom Kippur War (marketplace.org). The result was an oil shortage across the country. Since OPEC has the power to manage oil supply around the world, the supply and demand of oil puts pressure on prices to change. Mankiw et al. (2019) described this as ‘stagflation’ which is a period of falling output and rising prices. Due to the oil shortage, the supply curve shifts to the left from S1 to S2. The economy moves from point A to point B. This resulted in stagnation as the output (oil) falls from Y 1 to Y2 and the price level rises from P1 to P2.
Higher Prices and Inflation
The direct relationship between oil and inflation was evident in the 1970s, when the cost of oil rose from a nominal price of $3 before the 1973 oil crisis to around $40 during the 1979 oil crisis. This helped cause the consumer price index (CPI), a key measure of inflation, to more than double to 86.30 by the end of 1980 from 41.20 in early 1972 (opec.org). The price of oil and inflation are often seen as being connected in a cause-and-effect relationship. As oil prices move up, inflation follows in the same direction. Cost-push inflation caused by rising oil prices presents a dilemma to policymakers (Mankiw, 2019). Higher inflation usually requires higher interest rates to keep inflation on target.
In conclusion, the 1970 crisis was caused by political factors and not economic factors. This took a short-period of time and OPEC rose by the end of the 1970s. These effects are complex but of short duration therefore, OPEC did not lose its dominant power completely. Today, OPEC still has the control of oil pricing around the world, and despite the ongoing conflicts in the middle east; it is still operating as a great producer of oil.
- N. Gregory Mankiw, Mark P. Taylor, and Andrew Ashwin. (2019). Business Economics (3rd ed). Cengage Learning EMEA; United Kingdom.
- Richard Lipsey and Alec Chrystal. (2007). Economics. (11th ed). Oxford University Press Inc., New York.