CASE STUDY: OPEC INCREASES THE PRICES OF OIL

OPEC understands the concept of price elasticity of demand. OPEC knows that one of the
determinants of elasticity is the number and closeness of substitutes and that oil and petrol have
very few substitutes. Goods, which have duty on them such as petrol, tobacco and alcohol, are
likely to have inelastic demand. The second issue relates to market power. A business will have
market power if it is in a position to influence the price of a product. It can do this through
affecting the supply of the product on the market or it could simply set price and then look to set
its output levels to meet demand.

OPEC was set up to represent the interests of countries for whom oil is a key product and
the export of which represents a major proportion of their national income. The Organization of
the Petroleum Exporting Countries (OPEC) is a permanent intergovernmental organization,
created at the Baghdad conference on September 10 – 14, 1960, by Iran, Iraq, Kuwait, Saudi
Arabia and Venezuela. The five founding members were later joined by nine other members:
Qatar(1961), Indonesia(1962) (suspended its membership from January 2009,Socialist People
Libyan Arab Jamahiriya (1962), United Arab Emirates (1967), Algeria (1969), Nigeria (1971),
Ecuador (1973) suspended its membership from December 92 to October 2007, Angola (2007),
and Gabon (1975-1994). Both Indonesia and Gabon having suspended their memberships, the
OPEC now consists of only 12 countries.

OPEC accounts for around 46% of total global oil production and has a 60% share in oil
exports. Therefore, OPEC acts as a cartel. A cartel is a group of businesses, individuals or
companies who agree to influence the price in a market by controlling supply. OPEC’s aims to
stabilise oil prices so that both producers and consumers are in a better position to plan ahead
and in the case of producers and consumers are in a better position to plan ahead and in the case
of producers to know what their revenues are going to be. Each country has a quota, which they
are obliged to adhere to. This highlights the problems that cartels can face. There is always
incentive for one or more group of the group to break the agreement to secure some personal
gain. Despite this, OPEC has been relatively successful in maintaining member relations during
its existence. OPEC is able to exert influence on the market partly because it accounts for such a
large proportion of oil production but also because it knows that the price elasticity of demand
for oil is low. It is chooses to cut supply therefore, it knows that the price will be likely to rise
but as the price rises, the demand for oil will fall by a very small amount and this helps to
maintain or to increase their revenue.

Questions:

a. Explain how OPEC would exercise its market power to earn more revenue?
b. Draw a diagram to show market sharing by a cartel. Assume that there are only
five original countries – Iran, Iraq, Kuwait, Saudi Arabia and Venezuela) in the cartel each
having a share of 30%, 25%, 20%, 15% and 10% respectively.
c. Draw a diagram to show the impact of price increase on demand and revenue by
OPEC given the fact that the demand for crude oil is relatively inelastic.
d. Discuss the features of Oligopoly market.