The 1973 Oil Crisis for the Eco-

nomics Student
Cartels, embargoes, spiralling currencies, stalled de-
velopment, and more
In 1973, a bunch of countries in the Middle East placed an oil embargo on the United
States of America, as retaliation to American support for Israel in one of the many Arab-Is-
raeli wars of the 20th century (this one in particular was called the Yom-Kippur War).

An embargo is essentially a complete ban on all free trade between two countries. For
students who have finished with Section 3 of the course, an embargo can be thought of as
a quota where the quantity allowed to be imported or exported is zero. In this case, these
Middle Eastern countries, together as part of a group called the OPEC (Organisation of
Petroleum Exporting Countries) decided that they will not export any oil to the US or its
allies.

Before we can evaluate the impacts of this decision on the world economy, it is important
to understand the nature of OPEC. The OPEC, consisting of 14 countries who have rich oil
reserves, function as a cartel, or a group of firms joining together to produce as one firm.
Cartels are usually formed by participating firms in markets for goods which have very low
elasticity, such as oil (case in point) or cocaine (illegal, but addictive, and the cocaine mar-
ket saw some of the most notorious drug cartels in the world).

In a cartel, all the firms function as one firm. The benefits include the fact that the firms can
fix a common price for their product, which is beneficial to all, and thereby avoid price wars
which can be very damaging. More importantly, being in a cartel allows the cartel to essen-
tially operate as a monopoly, controlling most of the market. In the case of OPEC, it con-
trols more than 50% of the global oil supply. That’s a lot. So OPEC, having price making
power as a monopoly, can decide to restrict oil supply to push up prices and increase their
abnormal profits. Countries can crib about it, but they can’t do anything.

According to the Office of the Historian of the US State Department:

The embargo both banned petroleum exports to the targeted nations and intro-
duced cuts in oil production.

So this meant that not only were the US and some of its allies going to get no petroleum
from OPEC (which, by the way, was their main source of petrol), but also that a global cut
in oil production would push up the oil prices which would have devastating impacts on the
world.

We will first discuss the impact on the US, which was, in their own words, ‘heavily depen-
dent on foreign oil.’ As a result, the shortage of oil created in the US due to no imports
meant that oil prices sky rocketed.
From the graph, you can see that the prices rose from 1973 onwards in absolute terms,
and when adjusted for inflation, the actual real rise in price is alarming.

This created a complicated situation for the USA and the world. On the one hand, this was
a recipe for imported inflation. Oil, which is a factor of production in almost every capital
good, was now costlier than ever. This would mean that production costs would rise lead-
ing to higher costs for goods produced in the domestic US market. However, on the other
hand, it is important to note that even the people who could pay higher costs for petrol
were unable to do so, because there was no petrol. Reserves had run dry, and a signifi-
cant part of the US economy was crippled.

For the rest of the world, it meant something else. A year or so prior to the crisis, the US
had decided to devalue the dollar, and allow it to float freely in the exchange market. This
was done because the US currency was thought to be overvalued in the 1960’s. So, when
OPEC instituted the embargo, the value of the dollar was already falling. With the OPEC
refusing to trade with US, the demand for US dollars fell further in the global market, be-
cause US would pay for oil in dollars and essentially the OPEC countries would be pur-
chasing the dollars, increasing and stabilising the demand for dollars. With the embargo,
the demand for dollar fell substantially.

This fall in the US dollar was horrible for free trade. Many countries had pegged their cur-
rencies to the dollar, and their currencies as a result also devalued. In the short term, a
devaluation can have a negative impact on the current account, which was definitely the
case, as imports and exports stayed price inelastic and the current account balance of the
US and many other countries worsened.

Development was impacted in many countries, where industries could not afford the high
prices of oil and stopped their work, leading to a loss of jobs as well as increase in prices,
a situation called stagflation.

Until the embargo was finally lifted, the world continued to stumble from one economic cri-
sis to another, and the OPEC was branded a global villain in the Western Media (which is
ironic, since they were doing what any sane monopolist would do; increasing their own
profits by cutting supply).