EBF 200
Introduction to Energy and Earth Sciences Economics

 

Cartels

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A cartel is a form of market power in which suppliers collude with each other to manipulate supply. The most famous cartel in the world is OPEC, the Organization of Petroleum Exporting Countries. It turns out that crude oil is found in many countries in the world. In fact, there are probably oil wells in pretty much every country in the world. But there are a few countries that have large supplies of oil that is relatively cheap to produce.

The history of the international oil industry is convoluted and full of lots of stories about power, colonialism, and nationalism. The oil in many parts of the world was controlled for about half a century by a group of American and European companies called the "Seven Sisters." The countries in which the oil was found resented this control, as they believed that the price was being kept artificially low to benefit the consuming, and not producing countries. Several of these countries banded together to take control of their own resources and formed the organization we know as OPEC.

As I mentioned, there is a lot of fascinating history in the oil industry and OPEC. If you have more interest, I suggest you look at the Wikipedia page for OPEC for a quick overview, and if you are interested in investing a little more time, I recommend reading the book "The Prize" by Daniel Yergin. However, this is an economics course, and I want to focus on the economics of cartels.

OPEC is able to act somewhat like a monopolist, even though the oil industry is not a monopoly. OPEC countries produce about 30% of the world's oil. However, they produce a lot of low cost oil, so they are able to effectively control the supply curve and where it intersects the demand curve by restricting their output. This is shown in Figure 5.6 below.

OPEC S&D. 2 supply lines: OPEC and uncontrolled, 1 demand line. OPEC equilibrium point is much higher than competitive market equilibrium.
Figure 5.6 OPEC, Supply and Demand

As mentioned in Figure 5.6, OPEC controls the "low cost" part of the supply curve. By exercising control and reducing output from where it would be in an uncontrolled, competitive market, they are able to shift the equilibrium from the competitive point (P*, Q*) to what I call the "OPEC" point: (P(O), Q(O)), which gives us a price that is higher than the competitive market price.

I should make it clear that OPEC is not trying to maximize the price in the short run. Since the elasticity of demand for oil is quite steep in the short run, OPEC could raise the price quite a bit more with slightly lower production. However, such actions are likely to be damaging to the OPEC nations in the longer run: it will cause recession, which hurts long-term demand, but, more importantly, having a very high oil price will incentivize the development of alternative energy sources, which means that oil would then have substitutes, and its demand elasticity would not be as steep. OPEC would not, then, be able to control the price as much.

Instead, OPEC is playing a bit of a game, whereby they are trying to find the price that is as high as possible without spurring the development of alternatives. OPEC tries to "stage-manage" the price of oil to provide the long-term maximum profit.

It should be said that cartels are difficult to hold together. The principal reasons are as follows:

  1. As the number of member firms (or nations) increases, it is increasingly difficult for collusion to be effective - members all have an incentive to "cheat" on the cartel by producing "a little bit" more and earning a little bit more money. But if everybody cheats a little bit, the supply increases and prices get lowered, and we move closer towards a competitive market. This has happened a lot in OPEC, and it is periodically controlled by having Saudi Arabia open up the taps for a while to lower the price in order to get the message to other OPEC nations that they can punish cheating. This brings us to the second point:
  2. When it is difficult to detect cheating, it is hard for collusion in a cartel to hold. OPEC nations do not allow other nations, even other OPEC nations to independently verify what their production levels are. This is very different from western nations like the US, Canada, and Britain, where the volume of petroleum production is reported by private and public firms to the government, and these figures are collected and reported by the government. Because nobody is able to independently measure and police production quotas, there is a lot of cheating.
  3. The third point is that low barriers to entry - we will talk more about barriers to entry in the next lesson - make it difficult to control price. In the oil business, the barrier to entry is the presence of oil in a country. If there is oil in a country, that country can produce and sell the oil relatively easily, and it turns out that many, many countries have at least some oil. The OPEC nations have a big slice, but when OPEC drives up prices by successfully restraining production, every other country has an incentive to look for oil, and frequently find it. This increases production globally and tends to lower prices. High oil prices also provide incentives for the development of other forms of energy - the substitution effect - and the last thing that OPEC wants is for oil to become obsolete because somebody figures out a better, cheaper way to power our cars and planes. We used to burn a lot of oil to generate electricity and heat homes, but we do very little of that now because there are cheaper alternatives, and we are getting closer to the point where we have alternatives for powering our vehicles. We will talk a lot more about this topic in the last lesson or two of this course.

These are the main reasons why cartels like OPEC are difficult to maintain. Please read the full list on pages 248-249 in Chapter 11.