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Petroleum Price Elasticity, Income Effects, and OPEC's Pricing Policy

Abstract:
A standard result from static economic theory is that a monopolist with zero cost will maximize profits by charging the price at which the demand has unit elasticity. Yet, the demand for petroleum, as seen by consumers, is price inelastic, and empirical estimates of the price elasticity for petroleum are typically less than one. Given the relatively low production cost for Middle East oil and the optimization rule referred to above, a natural question is whether OPEC, acting as a monopoly, has exhausted its potential for forcing price increases or whether it will ultimately be able to charge still higher prices as it tries to optimize its earnings. This possibility of higher oil prices is important for OPEC and for oil-consuming countries-for OPEC because the finite nature of resources implies that excess production today represents an irrecoverable loss; for consuming countries because of the high cost of oil and the adverse consequences of still higher oil prices on inflation and unemployment.

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Energy Specializations: Petroleum – Markets and Prices for Crude Oil and Products; Petroleum – Policy and Regulation; Energy Security and Geopolitics – International Energy Organizations

JEL Codes: Q31: Nonrenewable Resources and Conservation: Demand and Supply; Prices, Q37: Nonrenewable Resources and Conservation: Issues in International Trade, Q41: Energy: Demand and Supply; Prices, Q43: Energy and the Macroeconomy, L71: Mining, Extraction, and Refining: Hydrocarbon Fuels

Keywords: Oil price elasticity, Income effects, OPEC pricing policy, Inflation, unemployment

DOI: 10.5547/ISSN0195-6574-EJ-Vol5-No1-7


Published in Volume 5, Number 1 of The Quarterly Journal of the IAEE's Energy Economics Education Foundation.