Tuesday, January 13, 2009

The OPEC Cartel: Does It Work?

Due to slack demand, the price of oil has come down drastically in the last few months. To temper the price drop, OPEC cartel members have been slashing production in order to reduce supplies. Officially, OPEC member countries have each agreed to production quotas. However, from an economic point of view, each member has an incentive to produce as much as possible unofficially, resulting in an actual oil price not very far from a cartel-free oil price.

To understand this incentive, consider a duopoly where both firms (A and B) have decided to collude to control the price of the product they sell. Suppose if both firms cooperate, they will each benefit by $1 million in extra profits. But if one firm decides to cheat by producing more than what was agreed upon, it will earn $3 million while the other firm will lose $1 million. If both firms cheat, they are in competition as before and therefore derive $0 in benefits from their collusion.

While this is a simplification of the economic theory, the economics of a cartel do boil down to incentives of this nature: if a firm decides to comply, it can make either $1 million or lose $1 million, depending on the decision of the other party. If a firm decides to cheat, it can make either $3 million or $0. As such, assuming the other party will make the decision in its best interest, cheating provides the more appealing option.

While OPEC countries do have quotas, it is in the best interest of individual firms to "cheat" by selling as much oil as possible (as long as revenue is greater than variable costs), as per the discussion above. As such, announced production cuts do little to quell drops in the price of oil, as member countries will usually* do what is in their individual country's interest in order to maximize profits.

*When financial interests are not the chief concern of the member countries, such as during the oil embargo of the 1970s, a cartel of this nature can prove to be quite effective at controlling prices!

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