The Organization of the Petroleum Exporting Countries (OPEC) was formed in 1960 to unify the policies of oil exporting countries in the Middle East (About Us). During the 1973 Arab-Israeli War, the United States and Netherlands helped Israel in this war with supplies. This angered OPEC countries and acted as a catalyst for the 1973 oil embargo (Reid). Many countries in OPEC and most notably Saudi Arabia, wanted Israel to retreat from territories they gained during the war (Reid). The embargo that resulted caught many Western countries flat footed and sparked a global recession.
In October of 1973, OPEC announced that it would increase the price of oil by 70% by cutting production by 25% and a production cut of 5% each month after (Yurgin). At the time, oil was selling for $3. This shock caused the price to increase to $5.12 (Reid). Two days after this initial shock, the price increased again to $11.65. This would cause a new aggregate supply curve left of the original supply curve (decrease in supply). This didn’t have a great effect on demand because oil demand was calculated at the time to have a -.3 to -.35 slope (Issawi). The slope is otherwise known as inelastic demand. The price of oil would increase without there being much of an effect in demand. The price of oil increased by four times, but the world oil output only decreased 7%.
In the classical sense this should have only had a minor effect. The classical economics view is completely supply side. It specifically states that changes in price level do not cause changes in output because the aggregate supply curve is a vertical line. Clearly this is not the cause of what happened. Classical economics states that only real factors affect output, such as workers preference. Unfortunately, this does not hold to this particular instance because the embargo caused unemployment due to companies laying off workers or reducing worker hours (Origin). Oil played an integral part during this time in every Western developed nation. Oil was the main fuel for energy. Power plants used oil over coal during this time because it was cheaper than other fuel including coal. Oil was a cost in nearly all forms of production. In order for a US firm to produce a good, energy was used. This cost was then passed on to the consumer. This created unemployment. Looking at the Keynesian view of demand, output would decrease in this situation. Consumption=a+b(Output-Taxes). With output decreasing, the consumption would decrease by the difference of b(Output-Taxes) before the embargo and b(Output-Taxes) after the embargo. Since output has decreased, consumption in this view would be decreased. Savings, which is shown as S=-a+(1-b)(Output-taxes), would also decrease. The difference would be (1-b)(Output-taxes) before the embargo and (1-b)(Output-Taxes) after the embargo. The difference in Output is what ultimately determines the new savings and consumption levels. Now that savings has decreased, Investment would also decrease to hold up the equation Investments + Government Expenditures = Savings + Taxes. With less investment, the growth rate decreased and unemployment resulted. Before the oil embargo, the United States was increasing its dependence on oil up to 1973. Between the years of 1967 and 1973, the United States increased their oil consumption by over 10% yearly (Issawi). America accounted for 33% of oil consumption with only 6% of the world’s population (Origins). During this same period, the Japanese and Western Europe increased their own oil consumption as well. This left oil reserves dwindling and the West more vulnerable to oil supply (Issawi). On top of all this, Western oil corporations invested heavily in the Middle East region for oil (Origins). The reason these corporations invested so heavily in this region is that because it costs less than any other region to extract oil. In some instances, oil is bubbling up from the...