Wednesday, September 15, 2010


Recently, the Organization of Petroleum Exporting Countries (OPEC) celebrated its 50th anniversary (link). The organization was founded in 1960 with the purpose of regulating world's oil prices and controlling the supplies of oil. Currently, OPEC controls 80 percent of world's proven oil reserves and its 12 member states oil production capacity accounts for 40 percent of world's total oil production.

OPEC's oil production and the world economy
Source: The Economist (link)

As a profit-maximizing monopolist, OPEC is faced with a downward sloping demand curve and upward sloping marginal cost curve which represents the market supply curve of the orgaization's 12 member states. As a profit-maximizing agent, OPEC countries equate marginal cost of production and marginal revenue from oil supplies and thus extract the entire consumer surplus from oil importing countries such as the United States, Japan and the European Union. There are several plausible explanation of OPEC's monopoly power in the world oil market. First, oil is a good with no close substitutes. Thus, the price elasticity of oil demand curve is significantly price inelastic. The average empirical estimate of the world price elasticity of demand for oil is -0.4, suggesting that a 10 percent increase in the price of oil would, on average, reduce the market demand for oil by 4 percent, ceteris paribus.

The relationship between the total revenue of the monopolist and the elasticity of demand suggests that the unit elasticity of demand is the revenue-maximizing point elasticity of demand for the monopoly firm such as OPEC. As the graph shows, OPEC's price spikes occured mostly during external shocks such as the 1973 oil shocks, Arab-Israeli war and the recent financial crisis. The spikes in the world price of oil reflected the pure logic of OPEC's cartel. By pushing the price upward, OPEC countries realized that, in the short run, the price elasticity of demand for oil is even more inelastic, thus reducing the consumer surplus of oil importing countries while expanding the producer surplus of OPEC member states.

The strategic behavior of OPEC mostly depends on the nature of external shocks affecting the production capacity and reserves of world's oil supplies. During political conflicts, the short-run demand for oil spiked and, therefore, the price elasticity of demand for oil decreased, increasing OPEC's short run producer surplus. Thereupon, OPEC member states set oil production quotas which exactly reflected the organization's intention to extract the entire consumer surplus from oil importing countries. Also, during the pre-2008 economic boom, the economic growth in emerging markets further inflated the world price of oil since the OPEC's short run production capacity outpaced the quotas set by the organization. But during the recent financial crisis, the short-run response of OPEC has been the reduction of per barrel oil price as an strategic step towards maintain the stability of market demand for oil. During the recent crisis, personal consumption and incomes have fallen substantially and therefore, assuming the positive income elasticity of demand for oil, the world demand for oil decreased considerably. The change in the aggregate consumption of oil has led to relatively more price elastic demand for oil. Partly, the increase in the price elasticity of oil is explained by the technological innovation and market access to long-run substitutes of oil such as fuel-efficient and electric vehicles and electric cars.

The technological development of fuel-efficient vehicles has decreased the monopoly power of OPEC by increasing the price elasticity of demand for oil due to the availibility of closer substitutes. In the follow-up of the financial crisis, the OPEC set the per barrel price of oil at $75. Given the downward sloping market demand curve, the short-run oil consumption increased and OPEC thus raised the relative price of oil's substitutes since it acknowledged the switching costs of changing the consumption of durable goods which complement the consumption of oil. What OPEC did is that it attempted to establish the short-run price elasticity of oil close to unity and, thereby, effectively increase the total revenue of the organization's member states. However, if in the long run, the market demand for oil was elastic, the net effect of increasing the price of oil, would incidentally fall on the burden of OPEC producers. Therefore, relatively price inelastic demand and price elastic oil supply is the main source of OPEC's monopoly power in the world oil market.

The rationale behind the cartelled market organization of oil supply is the stability of demand for oil across the world. Could OPEC's monopoly power, in effect, be broken if one country would set asymmetric prices on the global oil market. The desire of OPEC member states to fully collude in the cartel is the well-known phenomena from industrial organization known as the trigger strategy. According to trigger strategy, a member of the cartel is likely to divert from the cartel's strategy only if long-term gains outpace short-term losses of acting in accordance with the cartel's strategic behavior. In purely theoretical terms, if Nash equlibrium exists in the long-term benefits of cooperation, the diversion from cartel's strategic behavior, will not be feasible.

Even though some OPEC member states face asymmetric market demand curves in the short run, the stability of world oil demand embodied in the relatively price inelastic oil demand decrease the feasibility of defection from the cartel's strategic targets, discounted benefits from the collusion far outpace potential short-term losses.

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