Given the model of the world oil market where price is determined by the intersection of demand and a world supply curve composed of both OPEC and non-OPEC producers, what are the conditions that would lead to an increase in the equilibrium price of oil?

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Figure 8.19 illustrates a scenario where the assumption of a competitive market with price-taking firms does not hold. It demonstrates how the OPEC cartel, by leveraging its substantial market share in the 1970s, gained considerable market power. By acting in coordination to restrict their collective supply, OPEC was able to significantly raise the world oil price, thereby increasing their profits.

Impact of OPEC Restricting Production Capacity on World Oil Market Equilibrium (Figure 8.19)

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In the diagram analyzing an OPEC supply cut, the producer surplus for the two supplier groups, referred to as profits, is visually defined. OPEC's producer surplus is the rectangular area bounded by the new, higher price (P1), the vertical price axis, the constant production cost (c), and its reduced quantity (Q-prime OPEC). The producer surplus for non-OPEC suppliers is the area above their new supply curve, below the new price line (P1), and to the right of OPEC's supply quantity.

Visualizing Producer Surplus (Profits) for OPEC and Non-OPEC Producers

A crucial skill in economic analysis involves determining if a simplified model can yield valid conclusions about real-world situations, especially when the model's assumptions are only approximately met. For instance, while the supply and demand model assumes price-taking behavior, it can still be used to understand markets like the 1970s oil industry. In that case, even though OPEC sellers had market power and restricted supply, the model remained useful because the price was still determined by the intersection of demand and the new, restricted supply curve.

Evaluating the Real-World Applicability of Simplified Economic Models

The world supply of oil in the OPEC model is depicted on a graph with quantity on the horizontal axis and price on the vertical axis. The supply curve is composed of two distinct parts. The first represents OPEC's supply, which is a horizontal line at a constant price 'c' up to a maximum quantity 'Q-bar'. At this point, the curve has a kink and begins to slope upwards, representing the 'original supply' from non-OPEC producers who require higher prices to increase their output.

Structure of the World Oil Supply Curve in the OPEC Model

The supply and demand model can be adapted to analyze markets where firms are not price-takers. For example, in the 1970s oil market, OPEC sellers acted as a cartel with significant market power, collectively restricting supply to increase prices. Despite this violation of the competitive market assumption, the model remains applicable. The market outcome can be understood by finding the equilibrium price at the intersection of the demand curve and the new, artificially restricted supply curve.

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