To understand what’s going on, we need to understand some key concepts.
Equilibrium:
Market equilibrium refers to a condition where a market price is established through competition such that the amount of goods or services sought by buyers is equal to the amount of goods or services produced by sellers. In absence of external influences, equilibrium will not change
1: If there is a shift in the demand curve towards the right, there is an increase in price per unit quantity
2: If there is a shift in the supply curve towards the right, there is a decrease in price per unit quantity
We might have understood by now that what we are seeing is the movement towards a new equilibrium price. Due to the current economic downturn, many industries using oil as energy have either closed down or reduced their production rate and demand for oil is reduced at considerable level. Thus, the prices are going down. In the last two years, OPEC had drastically increased production to tackle high oil prices. This supply is now in excess and is driving down oil prices thus forcing OPEC to cut supply.
Maximum Price controls (ceiling)
It is a situation where a maximum price is set below the equilibrium price which prevents producers from raising the price above it.In order to see that these prices are maintained, it becomes essential to increase supply.
Minimum price controls (floors) :
It is a situation where a minimum price is set below the equilibrium price which prevents producers from reducing the price below it.These prices can be maintained by reducing supply or by government interference such as buying the excess supply or setting a reserve.
Evaluation
OPEC is a group of oil producing nations whose aim is to coordinate the petroleum policies of Member Countries and to secure an efficient, economic supply of petroleum
OPEC can be regarded as a Commodity Agreement or a Price Control Manager. It intervenes regularly to prevent large fluctuations in oil prices.
OPEC sets a price band with highest possible and lowest possible price. It then intervenes in the market whenever free market forces push the price either too high or too low.
If there is excess supply, this has the potential to drive oil prices down. In such a situation, OPEC responds by asking member countries to reduce supply in order raise the price above bottom price. As shown in the below fig, the increase in supply causes the price to go below bottom price. To correct this, the supply needs to be reduced.
In a situation of low supply, which has the potential to drive oil prices extremely high, OPEC responds by asking member nations to increase supply in order to reduce the price below top price. As shown in the fig below, the low supply causes price to reach above maximum price.
These steps are advantageous as they help to stabilize prices.But, there’s also a setback. These steps undermine the ideals of the free market system according to which, the prices should be determined solely by market forces. If the current oil prices are low, consumers should be allowed to benefit from them. On the other hand, if the prices are high, producers should be free to benefit from them.
Also, there is a question of long term benefits of these steps. These steps will stabilize the prices only for a short period of time. Eventually, the market forces will act and destabilize the prices until the equilibrium is finally attained.
BIBLIOGRAPHY
Web Pages:
1)"OPEC agrees to cut output to boost prices." www.chron.com. 4 Nov. 2008 <http://www.chron.com/
>. Path: http://www.chron.com/disp/story.mpl/business/energy/6075946.html.
2) "Market Equilibrium." www.wikipedia.org. 4 Nov. 2008 <http://www.wikipedia.org/>.
Books:
Dorton Ian and Jocelyn Blink. Economics. London: Oxford University Press, 2007.
