Supply and Demand in Microeconomic - Essay Example

Microeconomic: Supply and Demand In a competitive market, the forces of demand and supply determine much the price of services and goods. In other words, price is a function of the quantity of product supplied by producers and quantity demanded by users or consumers. This therefore means that there is always an economic equilibrium of quantity and price as normally depicted by the demand and supply schedules. The oil market in the world is one that has remained quite sensitive to the constantly changing forces of demand and supply. The following sections of this paper will use the oil crises of the 70s as a practical example of how these forces keep changing and how they may affect markets, product prices and people. The 1973 and 1979 Oil Crises In 1973 members of OAPEC (Organization of Arab Petroleum Exporting Countries) declared an embargo on oil (Hammes & Douglas, 502). In particular, the price of oil was raised by close to 70 percent – at 5.11 USD per barrel. OPEC countries agreed also to cut their production of oil by 5% and continuously increment this percentage over time for as long as their demands were not met (Hammes & Douglas, p.503). The price of oil later rose dramatically to 12 USD per barrel from the initial price of 3 USD. This was in response to the decision of the United States of America to start re-supplying Israel’s military with various products during the Yom Kippur War. OAPEC which consisted of Syria, Egypt and Arab members of OPEC proclaimed that it would stop or grossly reduce its oil supply to the USA and other countries if they gave any support to Israel in the Yom Kippur conflict. By extension, the embargo included Japan and several countries in Western Europe. By using their influence in the mechanism that sets the world’s oil prices, OPEC members managed to stabilize their revenues by raising the price of oil (Jordan & Albert, p.411). This action followed record declines in income in previous years following negotiation failures between OPEC members and Western oil companies. Since it was perceived by members of NATO that the actions of the US government initiated the oil embargo, a strong rift was emerged within the organization considering the possible long-term effects of high oil prices and recession caused by the disrupted supply of crude oil. Japan and European nations at that time sought to distance themselves from USA’s Middle East policy. The end of the embargo according to Arab oil producers would only come with the successful establishment of Middle East peace under the leadership of the US. This complicated further the situation. With an aim of addressing the prevailing difficult conditions, the US government led by President Nixon initiated parallel negotiations to halt the embargo. The Nixon Administration engaged in negotiations, to end the embargo with Syria, Egypt and Arab oil producers (Lenczowsk, 130). It also negotiated with the Israeli government to pull back its military from the Golan Heights and Sinai after the ceasefire. The Embargo was finally lifted in March 1974 and Israel withdrew its forces from the Golan Heights. The second oil crisis of the 70s occurred in the US in 1979. This was at the time when a revolution was happening in Iran. Following great protests in Iran, the country’s oil sector was shattered. With a new regime finally in place, oil exports resumed but much inconsistently and in less quantity. This condition forced prices to rise considerably in the international market. OPEC nations and Saudi Arabia increased their oil output so as to offset the shortage which amounted to about 4 %. Panic spread across the international market as a result of the shortage which eventually drove oil and fuel prices higher than the normal rates. In the US, the price of crude oil rose steadily over a period of 12 months from 15.85USD per barrel to 39.5 USD per barrel. At this time, the US government had adopted a phased deregulation strategy which led to an increase in the country’s oil output (Lenczowski, p.130-132). At the same time oil imports drastically dropped which led to shortage of oil in the country. The US government made the scarcity of oil worse by introducing price controls. The price of newly discovered oil was high while that of old oil was limited. This later resulted in the withdrawal from the market of old oil and the development of artificial oil scarcity (Perron, 23). The scarcity was countered by rationing of petroleum fuels; vehicles with even-numbered registrations would be fuelled only on even days while those with odd-numbered registration would only buy fuel on odd days. The control measures put in place by the government were meant to discourage the development of more efficient technologies and alternative fuels from being developed. This was so purposely to promote the exploration of oil. Effects of the Oil Crises The effects of the embargo in terms of oil prices led to high inflation rates across the world and lasted at least until mid 1980s. This is in consideration of the fact that many industries and sectors always relied on oil. In particular, industrialized economies such as the US and Japan relied heavily on OPEC as their main supplier of crude oil (Ian R, p.47-48). As a result of remarkable inflation that was experienced during the embargo, several countries responded in various ways. Some countries, for example, have instituted permanent initiatives to avoid further dependency on oil and OPEC. In the long term, Western countries have embarked on serious measures to prevent future inflations that may result from disruption in oil supplies. They have increased their energy conservation practices and oil exploration, and also adopted restrictive monetary policies that are aimed at fighting inflation. Following the 1973 and 1979 oil crises, Japan made efforts to shift from investing in industries that heavily depended on oil to electronics (Middlebury). While the US was most grossly affected by the embargo, Japanese vehicle manufacturers took advantage of the situation and concentrated on making smaller car models which were more efficient in terms of fuel consumption (Middlebury, n.d). These were indeed a better alternative to the common fuel guzzlers found in the US market at the time. As a result, up to the 80s, American Auto sales drastically dropped. In order to encourage growth, the central banks of many Western nations opted to cut sharply interest rates (Hammes & Douglas, p. 501-509). They viewed inflation only as a secondary concern. To some extent this measure resulted in stagflation which lengthened and deepened the unfavorable effects of the crisis. To date, suspicion hangs in the air in the public domain. Some people believe that some oil companies colluded with OPEC and therefore profited massively. Conclusion Following changes in demand and supply of oil in the international market, several changes that affect people across the world occur. Following a decrease in crude oil supply, for example, automakers are affected as some experience reduced sales while others change their strategies. This is seen in the case where Japanese auto-manufacturers change strategy and make fuel efficient models that effectively compete with their US-made counterparts. Central banks similarly have to respond in some way or another. In some cases they may raise their interest rates which in effect could lead to high inflation rates and recession. Similarly, government controls may aggravate or reduce the effects of market forces as seen in the case of the US government as it rationed fuel and limited its availability. Works Cited Hammes D. & Douglas W. “Black Gold: The End of Bretton Woods and the Oil-Price Shocks of the 1970s”. The Independent Review, v. IX, n. 4, Spring 2005. pp. 501-511. Ian R. Addicted to oil: America’s relentless drive for energy security. New York: I.B. Tauris. (2005). p. 47 Jordan J. P. & Albert P. B. “The Arab oil weapon-A threat to international peace”. The American Journal of International Law. Vol. 68, No. 3 (Jul., 1974), pp. 411. Lenczowski G. American Presidents and the Middle East. Duke University Press. (1990). pp. 130. Middlebury (n.d) The 1970’s Energy Crisis. Retrieved 13th December, 2009 http://cr.middlebury.edu/es/altenergylife/70%27s.htm Perron P. The great crash, the oil price shock and the unit root hypothesis. Econometric Research Program, Princeton University Princeton. NJ. (1988). 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