Economics Module: The Impact of OPEC and the Oil Shock Analysis

This economics assignment examines the OPEC oil shock, focusing on the organization's role as an international cartel and its impact on the global economy. The assignment delves into the dynamics of cartels, explaining how OPEC, comprising major oil-exporting countries, influences oil prices and supply to maintain market stability. It further analyzes the economic consequences of oil supply restrictions, including the rise in production costs, unemployment, and the emergence of stagflation, a situation characterized by both inflation and economic stagnation. The analysis explores the challenges faced by central banks in designing monetary and fiscal policies to address stagflation, considering the limitations of traditional tools like expansionary or contractionary measures. The assignment uses a polynomial model to illustrate OPEC's production behavior and references scholarly articles to support its arguments. This document is a valuable resource for students studying economics, particularly those interested in international trade, macroeconomics, and the effects of supply shocks on economic stability.

Running head: OPEC AND THE OIL SHOCK
OPEC AND THE OIL SHOCK
Name of the Student
Name of the University
Author Note

1OPEC AND THE OIL SHOCK
Table of Contents
Answer to question 2:.................................................................................................................2
Answer to question 2:.................................................................................................................2
References..................................................................................................................................4

2OPEC AND THE OIL SHOCK
Answer to question 2:
A cartel is a business formation where a few numbers of firms colludes to form a
single business entity and operate in the market. The principle motive of these firms is to
maximize the overall return of the members in the cartel (Fudenberg & Tirole, 2013). Under
the cartel agreement, the firms decide a fixed price, amount of supply and all together
dominates the market. Their dominance creates an extensive restriction on the entry of new
firms and suppresses the freedom of the existing smaller firms. However, these firms remain
financially independent and any digression from the rules creates negative impacts on the
other firms. The OPEC is a major example of an international cartel. Under this agreement,
the major oil exporting countries of the world such as the Iran, Iraq, Saudi Arabia, Kuwait,
and Venezuela agreed to maintain stability in prices and supply of crude oil in the world oil
market (opec.org., 2019). They together operate to ensure efficiency in oil production and
stable supply with fair prices to the customers. As per Griffin, the OPEC cartel model is
defined as:
Qit = Pit Bi QitooBi
The above polynomial describes that each OPEC country’s production (Qit) is a part
of the aggregate production (Qitoo) of the other country. Their fixed real price for oil is Pit.
Moreover, market share of the OPEC country (Qo) is determined by measuring the gap
between the world demand and the non-OPEC oil supplies, like from the United States. Thus,
this model informs about the production behavior of OPEC countries.
Answer to question 2:
Either directly or indirectly, crude oil or petroleum are used as inputs in the
production of final goods in an economy. When there is a restriction over the supply of oil
there is an increase in the price of petrol products and oil. This increases the cost of

3OPEC AND THE OIL SHOCK
production and results in unemployment. Overall, this leads to stagflation in the economy.
Stagflation is a phase of fall in output levels and rises in both inflation and unemployment
(Naifar & Dohaiman, 2013). Rising inflation and unemployment creates a dilemma for the
Central Bank of a country to design a policy to combat the stagnation in the economy. This is
because, as per Philips, there lies an inverse relationship between unemployment and
inflation (Coibion & Gorodnichenko, 2015). A monetary policy either reduces inflation or
increase the economic growth of a nation. An expansionary and contractionary monetary
policy cannot be used together to combat inflation and recession. Additionally, fiscal policy
is adopted to stabilize aggregate demand in an economy, that is, it can either increase
productivity to raise employment or cut down production to reduce inflation (Smets, 2014).
Thus, monetary policy and fiscal policy are ineffective under stagflation. If one tries to
reduce inflation, unemployment will rise and vise-Versa. Thus, the Central Bank had to face
a severe dilemma when designing the policy to combat a stagflationary situation.

4OPEC AND THE OIL SHOCK
References
Coibion, O., & Gorodnichenko, Y. (2015). Is the Phillips curve alive and well after all?
Inflation expectations and the missing disinflation. American Economic Journal:
Macroeconomics, 7(1), 197-232.
Fudenberg, D. & Tirole, J., (2013). Dynamic models of oligopoly. Routledge.
Naifar, N., & Al Dohaiman, M. S. (2013). Nonlinear analysis among crude oil prices, stock
markets' return and macroeconomic variables. International Review of Economics &
Finance, 27, 416-431.
opec.org. (2019). OPEC : The Role of OPEC in the 21st Century. Retrieved 21 September
2019, from https://www.opec.org/opec_web/en/press_room/918.htm
Smets, F. (2014). Financial stability and monetary policy: How closely
interlinked?. International Journal of Central Banking, 10(2), 263-300.