Unstable Price Elasticity and High World Oil Prices

M. J. Hwang , West Virginia University

C. W. Yang, Clarion University of Pennsylvania

This paper generalizes the theoretical model through both demand and supply functions of the OPEC cartel. The cartel’s pricing policy is largely affected by its aggregate demand curve and related elasticities. This paper expands the elasticity theory first proposed by Greenhut, Hwang and Ohta (1974), which sheds light on the maximal price a cartel can extract under a stable demand structure. In particular, the theory of unstable price elasticity of demand helps explain some of the mystery in the pricing behavior of OPEC.

It is apparent that a cartel such as OPEC tends to promote higher price with low production. A higher price would generally create conditions where there is the potential for inflation and economic recession as it happened in the early 1980s. As a consequence of reduced demand and oversupply, the oil price would then drop. Also, a very low price elasticity sprouts substantial price hike. Such a roller coaster behavior in the oil price does not fare well with OPEC members. It is little wonder that a recent proposal of a price band between $22 and $28 may well be in the best interest of OPEC members.

In order to estimate the demand relations, we use the data from The Annual Energy Review and The Economic Report of the President. The sample period extends from 1949 to 1998. We will apply the Engle-Granger two-step cointegration techique to explore the cointegration relation. The cointegration result suggests the use of the error correction model (ECM) in estimating the demand relation. Since the structural break occurred in 1975, we report the estimation results for the two subsample periods (1949-1975 and 1976-1998).

Estimation of the elasticity of oil demand in the U.S. market (the world’s largest energy consumer) is used to understand and predict movements in the market price of crude oil. Our preliminary results indicate that neither the long-run elasticity for the entire sample period (-0.4065) nor the short-run price elasticity after the structural break (-0.2668) is close to the theoretical limit: k/(k-1) ( 1.05, where k is the marginal cost, as is expected by a profit-maximizing cartel. The discrepancy may be explained by the significant income elasticity. Since business cycle is both inevitable and unpredictable, a recession would certainly shift demand curve to the left. A continuous and gradual price hikes without disruption would have rendered price elasticity toward k/(k-1) in the long-run.

The market adjustment through price elasticity of demand would itself create a local equilibrium for the OPEC as can be evaluated by ECM term. Oil-consuming nations should promote policies, which would encourage alternative fuel use, conservation and increased production of domestic oil. The degree of monopoly power could be reduced by these measures, as the demand becomes more elastic. Most importantly, these measures would shorten the painful cycle of market adjustment suffered by oil-importing countries through increasing elasticity. With higher elastic demand in the long run, oil-importing countries would enjoy lower fuel cost, as the price of crude oil remains low.

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