Economics Assignment II

Cartels and Game Theory:

Case of OPEC

Division D
Submitted by: Ankit Desai (34272) Ankit Deshpande (34273) Sukrit Kumar (34283) H.N. Prathap (34291) Sagar Rachh (34293) Kavya Sarraju (34299) Joshika Srinivasan (34302) Sanjoy Sarkar (34310)

Economics Assignment II

Game Theory: It is a breakthrough theory in the study of oligopoly, concerned with the choice of the best strategy to be adopted by a firm, organization, government or individual. The important components of game theory are: The players (the oligopolists) who are the decision makers. The strategies adopted by the players to have higher profits compared to its competitors. The payoff (outcome of the strategy adopted). The payoff matrix gives a list of payoffs (negative or positive) associated with all possible combinations of alternative actions and rival responses.

Honda City

Low

High

Volkswagen Vento Low (20.20) (50,10)

High (10,50)

(30,30)
*hypothetical figures in 000s

The table above depicts a payoff matrix to determine the most profitable pricing strategy for Volkswagen Vento against its rival Honda City. If Honda City keeps a low price, then Volkswagen would make the best profit of 20,000 on keeping the prices low. If Honda City increased its prices Volkswagen would again make the best profits (50,000) by keeping the prices low. So we see that irrespective of Honda Citys pricing strategy Volkswagens strategy remains the same being of keeping its prices low which is its Dominant Strategy. Similarly, if Honda has to decide its prices based on Volkswagens strategy, we see that Hondas dominant strategy is to keep the prices low. Since both will follow their dominant strategies of keeping their prices low, both will make a profit of 20,000 each. However we see that if both of them would have cooperated and agreed to keep a high price they would have made better profits, i.e. 30,000 each. This is a fundamental problem of game theory that demonstrates why two competitors might not cooperate even if it in their best interests to do so. Such a problem is called Prisoners dilemma.

Economics Assignment II

OPEC: (Organization of Petroleum Exporting Countries) is an intergovernmental organization of twelve developing countries made up of Algeria, Angola, Ecuador, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, the United Arab Emirates and Venezuela. It pursues ways and means to ensure the stabilization of prices in international oil markets to secure a steady income to the producing countries; to ensure an efficient and regular supply of petroleum to consuming nations, and a fair return on their capital to those investing in the petroleum industry. As of November 2010, OPEC members collectively hold 79% of world crude oil reserves and 44% of the worlds crude oil production. OPEC's influence on the market has been widely criticized, since it became effective in determining production and prices.

From the above graph it can be seen that after the formation of OPEC in 1960-61, there has been a lot of movement in the oil prices which was not prevalent before 1960. A cartel is a formal agreement among usually a small number of competing sellers involving a homogenous product with the aim to increase individual members profits by agreeing to fix prices, marketing or production. According to the earlier criticism mentioned, OPEC can also be referred to as a cartel as it can influence the crude oil prices globally by controlling the supply.

Economics Assignment II

OPEC and the Dictators dilemma Earlier, in the period of 1971-1974, it is observed that whenever there was a decline in the value of US dollar, the OPEC countries raised (or at least intended to raise) the price of oil so that it would benefit each of them. 1973 Oil Embargo : The Yom Kippur War was an attack on Israel by Syria and Egypt during which the military support provided by the US and other western countries to Israel made Arab OPEC members and Iran implement oil embargoes. The OPEC countries unanimously decided to cut productions by 5% and raised the price of crude oil by 70%. They further cut the output by 25% which created panic in the oil markets and the prices of crude oil quadrupled from $3 to $12 a barrel. This was one of the instances that game theory was actually applied, motivated by political will and not profits, without succumbing to Prisoners dilemma. In the current scenario, if the OPEC countries decide to marginally cut their output, each by say 200,000 barrels per day, to increase the prices by a desired level, say 25%, one of the following two situations might occur : One or a few countries might decide to cheat the cartel and continue to supply the same quantity or more quantity than before. If one country is cheating, then the overall daily supply will drop by 2,400,000 barrels per day (12 * 200,000) which will increase the prices by around 22% and not the desired 25%. So the cheating country will earn 22% more on each barrel than earlier. Since its production is also more than the others, it will earn 22% more on higher volumes too. This is what will entice each member of OPEC to not follow any supply cuts. If one country follows the decision of output cuts whereas the others cheat by increasing their output, then the overall output per day might be marginally lower than earlier or may even be higher. In this case the price per barrel might not change much. But the country adhering to the decision of reducing supply will get badly hit for both, reducing supply and receiving lower rates for less supply. It is due to this fear that the OPEC countries refrain from controlling the supply thus succumbing to the prisoners dilemma. So the OPEC countries, having vast natural reserves of oil, want to exploit it to the full extent as seen from the 1st scenario mentioned above. However, greed is not the only driving factor to force them to cheat (in terms of Prisoners dilemma). From the 2nd scenario mentioned above, it can be seen that lack of trust is also a major factor which is responsible for the members not cooperating and following a tit-for-tat strategy i.e If he cheats, then even I will cheat.

Economics Assignment II

Sensitivity of the oil markets As time went on, OPEC went on becoming unstable in terms of trust. Also due to the supply shocks of 1970s, countries like UK, Norway, Mexico and USA increased their exploration and production which resulted in the fall of OPECs share in global oil production from 55% to 40%. OPEC cannot control the oil prices as it used to. This is because of the following reasons: Globalization increased interdependency of nations: Although OPEC countries are rich in oil, they usually depend on imports for the other commodities. So there is a fear of backlash. Increasing influence of USA and China : The OPEC countries have a political pressure, indirectly, from these superpowers to stabilize the oil prices by increasing the production when the oil prices are high. But when the oil prices are down, as it happened after the 2008 sub-prime crisis, the OPEC countries are not pressurized by these superpowers to increase the price by decreasing the supply.

As seen above, the financial crisis of 2008 brought down the oil prices from 147$ per barrel to around 35$ per barrel in a span of 6 months. Market modernization : The price of oil is now determined by the market forces of demand and supply reflected by the crude futures contracts. So the market, not the oil producers, has more influence over the price of oil.