and the

economics of cartel

Presented bySanjay Gupta - Lakshmi Varma - Lakshmi Nair - Shibin T Renjith

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Outlines1. Oil – A basic necessity

2. OPEC (Information on OPEC)

3. OPEC Side Line Objectives

4. Competitive Dynamics of OPEC

5. OPEC Acting like a Cartel

6. OPEC and the economics of cartel

(Why Did OPEC Fail to Keep the Price of Oil High?)

7. OPEC and Demand & Supply

8. OPEC – A Cartel Or Oligopoly

9. Cartelisation and Its Affect

10. Conclusion

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Oil – Life Blood of World Economy

OIL - One of the life bloods of our World economy is oil.

The impact of oil in today’s economy has been witness by

consumers many times.

We have seen how human spending and travel got

affected as the price of oil fluctuates. In contrast almost all

energies are generated using oil, to mention few; Cars,

Trucks, railways, Plane, use oil in order to run their engine.

Therefore if oil supply disturbed for one day we can

imagine how the Indian economy can be affected greatly.

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OPEC - Introduction About OPEC (pronounced oh-peck) - Organization of the Petroleum Exporting

Countries - Organization of the Petroleum Exporting Countries, established in

Bagdad, Iraq in 1960. OPEC as a cartel, manipulate supply of oil in the market, in

hopes of keeping prices, and profits, high.

It is comprised of 12 members – Algeria, Angola, Ecuador, Islamic Republic of Iran,

Iraq, Kuwait, Socialist People’s Liberian Arab Jamahiriya, Nigeria, Qatar, Saudi

Arabia, -United Arab Emirates and Venezuela with headquarters in Vienna, Austria.

according to the official website.

Oil is the main marketable commodity and foreign exchange earner. Thus, for these

countries, oil is the vital key to development – economic, social and political. Their oil

revenues are used not only to expand their economic and industrial base, but also to

provide their people with jobs, education, health care and a decent standard of living

Together, the 12 member-nations control nearly 80% of the world’s oil reserves, and

44% of the world’s daily production—a powerful force used to manipulate oil prices

around the world.

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OPEC VS Non–OPEC Crude Oil Reserve

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Main Purpose & Objective of OPECThe Main purpose of OPEC is to coordinate and unify petroleum policies among Member Countries to ensure a steady income to the producing countries, a steady supply of petroleum to the consuming nations as well as a fair return of capital for investors in the petroleum industry itself.

Main Objectives are Stable oil market, with reasonable prices and steady supplies to

consumers

OPEC was made to make sure that the price of the oil in the world market will be properly controlled.

Their main goal is to prevent harmful increase in price of oil in global market and make sure that nations that produce oil have a fair profit

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Sideline Objective

Manipulate supply of oil in the market, in hopes of

keeping prices, and profits, high by producing less oil

than the market needs.

While OPEC always wants to maximize profits for

themselves, they also don’t want to kill the golden

goose by driving prices so high that alternative energy

exploration becomes a top priority.

OPEC tracks the oil production of NON-OPEC nations

and then adjusts its own production to maintain its

desired barrel price.

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Competitive Dynamics Of OPEC

Before 1970 No Major Role played by OPEC

During 1970 Power of Price setting shifted from MNC Oil Companies to OPEC

By 1973 OPEC countries changed the Pricing System

1975-1985 Oil Production Increase from 48% to 71%

Mid 1980 Survival became uncertain

Market shares fell from 52% 30% in 1985

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OPEC Challenges

Uncertainty in Global Demand

Structural shift in demand from developed world to

developing world.

Non-OPEC oil-producing nations (Russia , Norway,

Canada, Mexico etc.) often increase production when

OPEC cuts it.

Russia overtook Saudi Arabia as the world’s biggest

crude supplier in 2009.

OPEC’s share of production has gone down.

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OPEC Challenge’s Contd.

Problem of Member Cohesion within OPEC nations:-

Maintaining quota discipline within the cartel.

Existence of factions within OPEC.

Middle-Eastern Strife & Political instability in OPEC

oil-producing countries - Mostly authoritarian states

that use oil money as a means of sustaining political

power.

Future technological developments in areas of

renewable energy sources

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OPEC Acting like a Cartel

Quota Set by OPEC Production Ceiling set up was violated

1985- Price Dropped from $ 28 to $ 12

1990’s $30 per barrel

1993 - $ 15 per Barrel

OPEC BASKET Price Price Data collected

March 2000 – Set a price band mechanics in range of $ 22 -$ 28 per barrel

Production adjustment on basket price

Jan 2005 – Suspended price band mechanics

Market was tight in its price band

Unable to defend by cutting its production

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OPEC and the economics of cartelOPEC decides to increase OR reduce its collective production of OIL, which leads to increase / decrease in supply, therefore it has direct impact on demand, Supply and Price. The short supply makes OIL prices rise, partially due to less availability and partially due to a fear of a future shortage, which would have direct impact on other parts of the economy.

Short-run: supply and demand are inelastic

Decrease in supply: large increase in price

Long-run: supply and demand are elastic

Decrease in supply: small increase in price

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Why Did OPEC Fail to Keep the Price of Oil High?

In the 1970s and 1980s, OPEC reduced the amount of oil it was willing to supply to world markets. The decrease in supply led to an increase in the price of oil and a decrease in quantity demanded. The increase in price was much larger in the short run than the long run.

The demand and supply of oil are much more inelastic in the short run than the long run.

The demand is more elastic in the long run because consumers can adjust to the higher price of oil by carpooling or buying a vehicle that gets better mileage.

The supply is more elastic in the long run because non-OPEC producers will respond to the higher price of oil by producing more.

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A Reduction in Supply in the World Market for Oil

Price Price

Demand

P2

(a) The Oil Market in the Short Run

Demand

When the supply of oil falls, the response depends on the time horizon. In the short run, supply and demand are relatively inelastic, as in panel (a). Thus, when the supply curve shifts from S1 to S2, the price rises substantially. By contrast, in the long run, supply and demand are relatively elastic, as in panel (b). In this case, the same size shift in the supply curve (S1 to S2) causes a smaller increase in the price.

(b) The Oil Market in the Long Run

S1

S2

P1

1. In the short run, when supply and demand are inelastic, a shift in supply. . .

2. … leads to a large increase in price

P2

S1S2

P1

1. In the long run, when supply and demand are elastic, a shift in supply. . .

2. … leads to a small increase in price

Quantity 0 Quantity 0

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Change in Demand Curve The changes in the price Oil have not kept pace with change in my income.

When market price for petrol was Rs. 50, I could afford 100 Litres, that was a

filled tank for a month commute.

As the petrol price increased to 75 my equilibrium quantity has now 66 litres.

This is simply a movement along the demand curve, Quantity demanded is

changed due to changes in price that we have no control over.

My commute by car has now being substituted by commuting by

public transport system

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OPEC – A Cartel Or Oligopoly

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Is OPEC a monopoly or an example of a collusive oligopoly?

OPEC can be described as an oligopoly for several reasons.

It fits with the condition of being dominated by more than two

large firms; in this case it's Twelve.

It also practices price rigidity as they agree on both level of

output and therefore the price of oil is influenced by the

agreement of a certain supply.

The goods they provide are also homogenous. In oligopolies

firms also don't choose to maximise profits, and this can be

clearly shown in the OPEC case as they aim was to "secure fair

and stable prices for producers, and ensure an efficient and

regular supply of oil".

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Is OPEC a monopoly or an example of a collusive oligopoly? Contd.

There is also barriers to entry which is described in the

case study which states that the oil industry has "high fixed

costs and risk" associated with it,

It can be argued however, that it is also a monopoly. This is

due to the fact that OPEC has 60% of control over the oil

that it traded internationally.

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OPEC is a cartel: an organization of individual competitors that join to form a single monopolist.

1. Under competition, the price of oil is Pcomp and an individual OPEC member produces qcomp and earns just a normal profit. With a cartel, joint profits are maximized at Popec and Qopec.

2. Since Qopec < Qcomp, qopec must be less than qcomp for each OPEC member each member is assigned a quota, qopec.

3. At qopec, MR > MC profits rise if the country expands production. Produce at qcheat, where MR = MC.

4. But, if all members cheat, total production rises the price of oil falls competitive outcome

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OPEC countries can and do cheat When OPEC limits oil production, they keep the price of oil and

profits high. But those high profits give each member the incentive

to cheat a little. By producing a little more oil, an individual country

can earn more. Usually, cartels can’t last very long because of this

strong incentive to cheat.

As you can tell by chart below, OPEC countries can and do cheat.

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Cartelisation and Its Affect Price being affected due to Speculation

Fluctuation due to change in Quota Decision

1980 – OPEC made a mistake by increasing OIL price to $40 per

barrel. Result – Reduction in demand – reduction in price

Problem with Cartel

Maintaining the price

Allocate sales among OPEC countries

Growth Expectation?

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Conclusion

1. OPEC Still Exists today and still has considerable influence in

determining the price per barrel of petroleum by setting quotas, but

their best days are behind them. The cartel seems to understand

that raising prices is easier in short run than in long run.

2. Non-OPEC nations such as Russia, Canada and Mexico have

stripped the cartel of its power to single-handedly manipulate the

petroleum market

3. The World has benefited from the increased production of

petroleum by Non-OPEC nations and thus reduced their annual

imports from the OPEC countries in recent years

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References

1. OPEC.Org2. www.slideshare.net3. OPEC A Cartel (Emma

Vkpanaha)4. OPEC a Price Power

(Bastam Fattoum – Oxford Institute Of Energy Studies)

5. Gregory ManKiw – Managerial Economics

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