OPEC is an international cartel aimed at securing interests of the oil producing countries by restricting the oil production levels. The market structure of a cartel is similar to an oligopoly, the only difference being collusion between the dominant players. The paper attempts to understand these market structures, their welfare benefits and how the firms respond in certain situations. Game theory explains the incentive for firms to cheat in a cartel. The future strategy for OPEC is suggested based on synthesis of these concepts. It includes maintaining an active dialogue, designing a detailed disincentive plan and innovation.
Keywords: collusion, cartel, OPEC, oligopoly, monopoly, competition, market structure
Market structure is the typical arrangement of buyers and sellers in a market. Market structure varies across industries and product lines. A firm decides its competitive strategies based on the structure of a particular market. According to Borg (2010), there are four distinct market structures based on the degree of competition, which are perfectly competitive, monopolistic, oligopoly and monopoly market structures.
While a perfectly competitive market constitutes of a large number of buyers and sellers and highly competitive market structure, a monopoly is characterized by a single firm selling a unique product that has no fear of competition. A perfect market structure is an ideal concept and does not exist in real life. The paper discusses the purpose of existence of Organization of Petroleum Exporting Countries (OPEC) and based on the economic concepts of monopoly and oligopoly market structure and strategies, it suggests the future strategy for the organization.
The paper is divided into six parts. The first part explains the monopoly and oligopoly market structure with an emphasis on cartel formation strategy and related examples. The second part discusses the welfare effects of these market structures. The third part illustrates the role of game theory in oligopoly and cartel structures. The fourth part describes the economic purpose of being of OPEC. The fifth part suggests future strategies for OPEC. The sixth part concludes the paper.
Monopoly, Oligopoly and Cartel
A monopoly is the existence of a single supplier for a particular economic good. A monopoly firm sells a unique product that practically has no fear of competition in the market. An oligopoly market structure is characterized by a few dominant sellers in the market. The characteristics of a cartel are similar to that of an oligopolistic market, the only difference being that the dominant players collude to make pricing and resource allocation decisions.
There are five key differences in these three market structures. First, a monopoly has one major player in the market, an oligopoly has a few large players and a cartel has a few large but colluded players in the market. Second, the pricing and output decision is made by the single dominant player in monopoly, influenced by the action of other players in an oligopoly and made by the congregation of players in a cartel.
Third, degree of competition is low in monopoly and cartel and high in oligopoly. Fourth, monopoly and oligopoly are legal but a cartel structure is not perceived entirely legal and has to be shielded by sovereignty. Fifth, monopoly firm sells a product that does not have a visible and viable alternative, but the products sold by the large firms in an oligopoly and cartel market are similar among the large players yet differentiated for any new entrant.
The Postal Service of the United States is an example of a monopoly market. The airlines industry in the United States is an example of an oligopoly market dominated by a few large players. The formation of OPEC is a typical example of a cartel structure organised internationally.
Welfare Effects of Monopoly and Oligopoly
Earlier studies on welfare effects of monopoly postulate that monopoly causes welfare losses, known as deadweight loss in the economic parlance. However, some of the recent studies have proven otherwise. A study conducted by Yao and Gan (20120) concludes that technical innovations brought about by monopoly increases overall societal welfare if the profits are shared with the majority. Posner (1975) also claimed that innovation lowers costs and allocative efficiency losses are set off by productive efficiency gains, thereby the gains overweigh the losses (Hinde, n.d.). Moreover, monopolies have the opportunity to exploit economies of scale to increase production efficiencies. Thus, if the distribution of benefits is shared with large number of people, monopoly creates welfare benefits for the society.
Players in the oligopoly markets create entry barrier for new entrants by investing heavily on fixed expenditures like long-term marketing activities, designing differentiation products and like. The high expenditure is passed on to consumers as higher product price, causing welfare losses. However, recent studies economists claim higher welfare benefits from oligopoly. Baumol (2002) argues that the market structure that fosters innovation best is oligopoly (tutor2u.net, n.d.). He claims that the oligopoly market is competitive and players compete with each other to differentiate their products as far as possible to attract customers and offer best price. Telecom industry is an example of oligopoly industry that has high entry cost, high competition and players strive to get technological and price advantage to attract customers.
Game Theory, Oligopoly and Cartels
Game theory refers to a decision making process that involves analysis of interaction between multiple individuals (Shah, n.d.). It is responding to a given situation in such a way that probable choices and responses of other individuals do not adversely affect one’s condition. The concept of game theory explains the way the firms will react in an oligopoly and a cartel market structure.
Considering that there are three dominant firms in an oligopolistic market. They maintain the same level of production and pricing. If one of these firms sets its level of production based on its analysis of total demand and expected reaction from other firms, it will get the first mover advantage and capture more market share (Shah, n.d.). Hence, instead of waiting for the others firms to react, each firm will try to maximum its profit by setting its own production levels. No firms will effectively make excess profit in this scenario.
A similar phenomenon is observed in the case of a cartel. In a cartel, the dominant firms operating in the same market collude and restrict their production levels to maintain higher prices (Shah, n.d.). But, it offers the firms with an incentive to cheat. If one firm increases its quantity produced, it is able to maximize its profit, given the high price levels. However, the other firms also have an option of returning to their original profit maximizing quantities, which will be loss making for all the firms. The longer this quantity is produced, the higher are the losses for the firms. This is an essential element of the games theory and prevents firms from cheating in a cartel.
Economic purpose of OPEC
OPEC is an international cartel of oil exporting countries. The members aim at extracting the benefits of a monopolistic structure from an oligopoly market by colluding. The economic purpose of the cartel is to restrict their level of oil production to maintain higher prices, thereby maximizing profits for all the participating countries. It ensures at stabilizing oil prices and eliminating unwanted price fluctuations so as to safeguard members’ economic interests. In spite of this purpose, the oil prices have been very volatile in the last five years posing difficulties to the member countries to plan their production. World oil demand fell dramatically in 2008 and 2009 (El-Badri, 2010). Hence, there is a need to refine the strategies of OPEC to enable the member countries to benefit out of it.
Future Strategies of OPEC
The concept of game theory is also applicable to the OPEC cartel. The members have an opportunity to cheat for fulfilling their short term interests. A member has the incentive to produce higher quantity of oil to gain advantage of the inflated price, thereby negatively impacting other members of the cartel. Moreover, production planning between the member countries is deeply affected by demand fluctuations and entry of a new seller. Drastic reduction in oil demand is a big trigger for the oil producing countries to act for individual interest rather than for the benefit of the cartel.
Thus, future strategies have to be in line with the posed challenges faced in maintaining a successful cartel. First, focus on active dialogue with the member countries emphasizing on the long term benefits of staying together in such a volatile economic scenario. Second, promote active communication between the cartel and the end consumers to have an overview of their future demands and avoid supply shocks due to sudden demand increase. Third, need to highlight the consequence of cheating by any member of the cartel, in terms of market distortion and long term losses to everyone. Fourth, penalize the deviating members through a detailed disincentive structure. Fifth, build on technical innovations to improve quality and reduce cost of product.
Typically, there are four types of market structures, which are perfectly competitive, monopolistic, oligopoly and monopoly market structures. Oligopoly and monopoly structures are common in the current economic scenario. A monopoly is a single-supplier market. An oligopoly market has a few dominant sellers. A cartel is similar to an oligopoly market, the only difference being collusion between the dominant players. Both monopoly and oligopoly enable welfare benefits due to innovation. Game theory explains how the firms behave in an oligopoly and a cartel market. Firms have short term benefit of cheating in both the cases. OPEC is an international cartel formed to safeguard interests of oil producers and restrict the production levels to benefit from higher prices. But, oil prices have shown high volatility in the past five years. Thus, future strategies have to ensure active dialogue between the member countries and with consumer countries to long term relationship and accurate demand estimation. Technological innovation is also a key to future growth and profits.
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