The basis of game theory is that rational behavior tends to be predictable (most of the time). After all, we form expectations of how firms are likely to behave in cases of interdependence by assuming rationality (maximization of payoffs). However, can you think of a scenario where IRRATIONAL behavior may actually be predictable?
Time permitting, our classroom discussion will take place on Thursday, April 26.
Posted by Prof. C-S
Discussion on “Game Theory for Swingers: What states should the candidates visit before Election Day?” by Jordan Ellenberg (Slate Magazine, October 2004).
Summary
In the article “Game Theory for Swingers: What states should the candidates visit before Election Day?” author Jordan Ellenberg tackles the topic of game theory as it relates to a hypothetical political showdown between George Bush and John Kerry. Ellenberg defines game theory as the division of mathematics that aids in solving the tactical problem that occurs when two players’ actions are dependent on one another. The theory contains dominant solutions for each player where each player has an optimal outcome, independent of what the other player does. In the article, this is painted as both Bush and Kerry deciding to visit Ohio to have their best chance at winning both Ohio and Florida.
In a case where both players’ optimal solutions are the same, Nash equilibrium occurs. Nash equilibrium is defined as where, “B and K would each be satisfied with their current strategy, even if they knew in advance what their opponent’s strategy would be.” Sometimes, it appears that two players cannot reach Nash equilibrium. However, there is typically a more subtle way of arriving at this result: mixed strategy.
Mixed strategy occurs whenever chance is involved in determining a player’s action. In the article, this is painted as both Bush and Kerry flipping a coin to determine which state to visit on their final day of campaigning. This element of chance makes what would be a non-equilibrium outcome into Nash equilibrium. However, mixed strategy only works when actors are acting simultaneously; if Kerry has a week to counter Bush’s chance-determined visits, he can execute an even more optimal pure strategy, thereby gaining an advantage over Bush.
This article on game theory relates to our classroom topics when it comes to competitive oligopolies. A firm competing in a small market means that a firm’s choices have a large impact on other firms due to the interdependence present in these markets. Game theory is extremely relevant in this situation, as it is the study of interdependent actions, and can aid in helping firms form rational expectations about what decisions other firms might make.
Commentary
At one point in the article, Ellenberg states, “The key is that rational behavior tends to be predictable, and in a game of strategy, predictability will leave you with a decided disadvantage.” While predictability may be prized in certain economic pursuits, it can be detrimental for an opponent in a game of strategy. From an economist’s perspective, predictable behavior is the result of the “rational person”. The rational person will behave in such a way as to maximize their utility. As a result, all will logically proceed in this pursuit leading to a very predictable course of events. In the case of a game of strategy, this condition necessarily provides the opponents with each other’s decisions.
Consequently, rational behavior will ultimately lead to the predetermined demise of one opponent. However, this rationale simplifies a very complex issue. Recently, the importance of behavioral economics in finance has been recognized. It acknowledges the limited scope of the concept of the “rational person.” In our quest to solve economic questions with calculus and the manipulation of theoretical graphs, it is easy to neglect behavioral aspects which can be significant. The article references the game of rock, paper, scissors and the inevitable doom you face if your opponent can accurately guess your next move. In such a case, the most “random” act will be the most successful. While this is true, there are websites and groups devoted to the strategy of rock, paper, scissors. Some studies reference the behavioral implications associated with different “random” moves. Finally, it is prudent to recognize outlying factors in every situation. As proven in the real world, behavior cannot always be predicted because of human irrationality and biases. Not all situations can be analyzed by the delineation of a series of algebraic equations, as noted in the article.
Real World Application
Another real-world application of game theory is determining how to maximize one’s GPA going into final exams (which seems morbidly appropriate considering the current time of year). The scenario here is that Jeff, a college student, has two exams left to take, and both are tomorrow. Given his results on assignments and tests leading up to these finals, he is able to calculate his chances of getting certain grades in these two classes based on whether he splits up his study time evenly or spends an extra couple of hours on one of these two subjects. However, since these classes’ grades are based on a curve, the time allocation decisions made by Jeff’s classmates are tied to his final grades, as well. As a result, Jeff must decide on his appropriate amount of study time while keeping in mind that his final grades are dependent on the choices of his classmates, as well as his own choices. This is where game theory comes into play, since Jeff must be able to predict his classmates’ decisions to the best of his abilities if he wants the best chance of getting an optimized GPA.
Posted by Eric, Mary and Stefan (Section 4)
Discussion on “Game Theory for Swingers: What states should the candidates visit before Election Day?” by Jordan Ellenberg (Slate Magazine, October 2004).
The 2004 article by Jordan Ellenberg, an associate professor of mathematics at the University of Wisconsin, uses the real-world example of the Bush v. Kerry presidential race to how game theory applies to politics. Specifically, Jordan discusses the three swing states, Pennsylvania, Florida, and Ohio and how Bush and Kerry should go about campaigning in these states for the best chance to win. Each candidate’s decision depends in part on the other (interdependence, the key point to making this an example of game theory as we discussed in class). Kerry needs Pennsylvania to win, but focusing his assets there would leave Ohio and Florida up for grabs. Bush could go pick off Pennsylvania, but then it leaves Florida open for Kerry. Game theory helps solve this dilemma. Jordan simplifies the problem by narrowing it down to just the three states (rather than include the other 47), and sets the percent chance Bush has of winning each state’s electoral votes. The first scenario that Jordan discusses leaves Bush with a dominant strategy in which the option is clear: campaign in Ohio for the best chances to win. Because campaigning in Ohio is also the dominant strategy for Kerry, that result is a Nash equilibrium. The second scenario that Jordan discusses is a bit more complex, one with a much more subtle Nash equilibrium, this one dependent on chance. Because of that, the second scenario finds equilibrium through a mixed strategy (rather than a dominant one). Jordan sums up the example by reminding the reader that the true situation is not this simple, and that finding the actual percent chances of victory in the separate states is difficult. However, he successfully describes how game theory can be applied to politics. As previously mentioned, connections from this article to our class discussions come through Jordan’s mention and explanation of dominant strategies, mixed strategies, and the Nash equilibrium.
To look at game theory in a different light, let’s comment on a quote Jordan used in the article: “The key is that rational behavior tends to be predictable, and in a game of strategy, predictability will leave you with a decided disadvantage.” When interdependence determines what strategy should be used, predictability leads to a party’s demise. If a party’s actions are predictable, his opponent is allowed the opportunity to counteract his predictable move in order to strategically win. Randomness allows a “player” to conceal his strategy so that his opponent cannot absolutely anticipate his move and act accordingly. This decreases the opponent’s certainty of “winning.” Thus, it is strategically to a party’s advantage to act in a spontaneous function. Consider a shootout in soccer. A kicker can position the ball to the left, to the right, in the corner, on the ground, etc. If a kicker clearly positions his body in a way that is indicative of where he intends to position the ball, the goalie’s chance of blocking the ball is increased. However, if the kicker approaches the ball straight on or in a position that is not consistent with how he will actually place the ball, the goalie may not have any indication as to where he will kick it, or will be misled. Here, the kicker has used the element of surprise to his advantage.
While Jordan uses the party system as one real world example of game theory application, another real world application of game theory is the prisoner’s dilemma. This is a thought experiment essential to game theory. An example of the prisoner’s dilemma is this: prisoner A and prisoner B have both been arrested for robbing a bank. They have been placed in two separate cells. Each of the prisoners has been given two options; they can either confess or remain silent. They are both told the same thing by the police: “If you confess and your partner remains silent, then you will go free and your testimony will be used to make sure that your partner will serve 15 years in jail. On the other hand, if you remain silent and your partner confesses, then they will go free and you will serve 15 years. If you both confess, then you will get early parole after 10 years. If you both remain silent, you will each get 2 years or less.
There is a dilemma here because each of the prisoners is better off confessing than remaining silent. However, the result of them each remaining silent is much better than the result of the both confessing. This creates a dilemma and a clash between decision-making based on self-interest versus the best interest of the group. There are many conflicts of interest that arrive from this.
Posted by Maddie, Dalton, and Jed (Section 3)
Resources:
Discussion on “Game Theory for Swingers: What states should the candidates visit before Election Day?” by Jordan Ellenberg (Slate Magazine, October 2004).
Summary
Jordan Ellenberg’s article, “Game Theory for Swingers,” uses the 2004 election to explain game theory. Ellenberg describes a scenario in which each candidate believes on the last day of the election that Pennsylvania, Florida, and Ohio are key to winning the election. Each candidate can improve their chances of winning one of the states by visiting it on the last day before the election, but this is dependent on what the other candidate does. In one scenario we assume that Kerry will win Pennsylvania and the election comes down to Ohio and Florida. We assume that Bush has a 30% chance of winning Ohio and a 70% of winning Florida. Both candidates can increase their chances of winning by 10% by visiting one state on the final day before the election (unless both candidates visit the same state, since the increases would cancel each other out). In this scenario, both candidates should visit Ohio and ignore the other candidate since it increases both of their odds regardless of what the other does. This is an example of a Nash Equilibrium.
Say Bush and Kerry both visit Ohio. Their odds of winning both Florida and Ohio remain the same at (.7)x(.3)=.21. If Bush visits Florida and Kerry visits Ohio, both candidates’ odds of winning both decrease to (.8)x(.2)=.16. If Kerry visits Florida and Bush visits Ohio, both candidates’ odds of winning both states increase to (.4)x(.6)=.24. As mentioned above, both candidates are better off visiting Ohio, no matter what the opponent does. However, it is not always this simple. If each candidate had a 50% chance of winning each Florida and Ohio and each candidate’s odds increased 10% by visiting a state, there would be no Nash Equilibrium because each candidate will be better off if he chooses the state the other candidate did not select. There would be a Nash Equilibrium if the odds of which candidate will go to which state are considered, however. If each candidate flips a coin to determine which state to go to, each of their odds of winning will be (.5)x(.5)x(.5) (the coin flip times a 50% chance of winning each state if both candidates go to the same state) + (.5)x(.6)x(.4) (the coin flip times a 60% chance of winning one state and a 40% chance of winning the other state if the candidates choose different states)=.245, the Nash Equilibrium.
The element of chance from the coin flip reduces predictability and is called a mixed strategy. In order for a mixed strategy to work, both candidates must act simultaneously. It should be noted that this simulation ignores 47 states in the election and the differences in electoral votes from each state.
Class-Room Relevance
Game theory applies to managerial economics because producers are constantly trying to predict how competitors are going to price their goods. Especially in a monopolistic competition, where there is a possibility of long-run profit, it is important for companies to accurately predict how the competition will price substitutes for the goods it is producing so that it can swiftly react to changes in the market.
Commentary
he article states that “rational behavior tends to be predictable, and in a game of strategy, predictability will leave you with a decided disadvantage.” This means that people expect you to act in a rational manner, so if you act rationally it is easier for your competitor to anticipate what you are going to do. For example, suppose Apple comes out with a new iPad. The market for iPads has boomed with the price set at $499 for an entry-level model. The competition has adjusted to this price point, and have even started selling tablets at a loss to try to undercut Apple’s price. Common sense would dictate that Apple would continue to sell the iPad at $499 even if costs go down since it is such a hot seller. But Apple could also choose to cut into its margins and drop the price to $399 just to take sales away from the competition. History and common sense tell us that Apple would not cut into its margins, especially with a product selling as well as the iPad, and that is why such a move would cause such a stir in the market.
The article states that an element of chance, such as flipping a coin, helps keep your moves random and therefore more difficult for your competition to predict. Apple would not leave a pricing decision such as this up to chance since it has so much market power, but Amazon has changed the market for tablets by offering a tablet for $199, a move many saw as unexpected. Even though they are selling the tablets at a loss, they make up for it by controlling the content sold on the devices. The Amazon Kindle Fire may not be outselling the iPad, but it has been more successful than any other iPad competitor because it offered a different and unexpected pricing strategy: a tablet nearly as good as the iPad for less than half of the price. In short, tablet makers should learn to expect the unexpected and make decisions that their competition will not be ready to combat.
Real World Application
Game theory exists in many different negotiations and interactions in the real world. For example, one can see the theory at work in salary negotiations. This situation will be very relevant to us since we will all be working and receiving offers soon. Suppose that a company offers you a starting salary that doesn’t meet your expectations. You can either A:Take the offer or B: Try to negotiate a better offer. If you believe your skills and what is expected of you deserves a higher salary, you can request a higher salary and the company can either refuse to go higher, or accept it.
Another example of the game theory at work is when cigarette advertising was legal in the United States. The cigarette market realized that any advertising they did was cancelled out when another firm responded with the same amount of advertising. This created a prisoner’s dilemma. The firm had to advertise or they would lose customers to the rival, however it was very expensive to. Interestingly enough, when the government decided to ban cigarette advertising on TV, the companies at first fought the decision. However, tobacco firm’s profits improved after the ban.
Posted by Chris, Andrew and Mariah (Section 2)
Resources:
Discussion on “Game Theory for Swingers: What states should the candidates visit before Election Day?” by Jordan Ellenberg (Slate Magazine, October 2004).
Summary
This article uses the 2004 Presidential Election to explain game theory. It uses Florida, Ohio, and Pennsylvania, three states that are thought to be up for grabs. To simplify the situation, the model concedes Pennsylvania to Kerry. Bush then must win both Florida and Ohio to win the election. However, he only has enough time to visit one of the states before the election. Which then must he choose? For example Bush has a 30% chance of winning Ohio and a 70% chance of winning Florida. Visiting a state will increase his chances of winning by 10%. If Bush and Kerry both visit the same state, Bush’s chance for Ohio remains at 30%, and Florida at 70%, giving him a 21% chance at winning the election (0.3×0.7=21%). If Bush visits Ohio and Kerry goes to Florida, Bush has a 24% chance of winning the election (0.4 in Ohio x 0.6 in Florida=24%.) Finally, if Bush visits Florida and Kerry visits Ohio, Bush’s chance of winning is only 16% (0.2 in Ohio x 0.8 in Florida). Because Bush is better off visiting Ohio no matter what Kerry does, visiting Ohio is Bush’s dominant strategy. It, therefore, should not matter which state Kerry chooses to visit, Bush should always visit Ohio. However, since Kerry’s dominant strategy is also to visit Ohio, he will also always visit Ohio and their efforts will cancel each other out. This combination of actions in which both Bush and Kerry would be satisfied with their decision even if they knew their opponent’s strategy, is referred to as the Nash equilibrium.
If the numbers are changed so that Bush has a 50-50 chance in each state, Bush prefers to visit the same state as Kerry and Kerry prefers to visit a different state than Bush. At first there seems to be no Nash Equilibrium. There is, however, a Nash Equilibrium in this situation too. If both candidates relied on a coin flip to make their decision, both players’ actions would be random and unpredictable. Bush has a 50-50 chance of ending up in the same state as Kerry and a 0.245 (0.5×0.25+ 0.5×0.24) chance of winning. Since the same statistics apply to Kerry, a Nash Equilibrium is once again established. When chance determines a player’s best strategy, it is a mixed strategy. In order for mixed strategies to work, the players’ actions must be unpredictable and simultaneous so that one player can’t wait for another’s actions.
Though this model is helpful, it is not foolproof. Bush’s predictions for winning each state are only based on estimations from polls. The model also excludes the fact that each state has a different amount of electoral votes, which leads some states to be much more important than others. In addition, the other 47 states have been completely ignored in this analysis. Though it has some faults, game theory is an excellent tool to use to aid in the Presidential Election process.
Commentary
In his article Ellenberg says, “The key is that rational behavior tends to be predictable, and in a game of strategy, predictability will leave you with a decided disadvantage.” Unless there is a dominant strategy in which one action is the best action no matter what the opponent’s action is, it is important to remain unpredictable. For example if it is predictable that Kerry will put his efforts into Ohio, Bush can form the best reaction strategy based on this knowledge. Because it is so important to have unpredictable actions, the article suggests that when there is no dominant strategy it is best to leave a player’s actions to chance so that the actions are truly unpredictable. This is called a mixed strategy. To achieve a mixed strategy both candidates would have to flip a coin on the election eve to decide which state to campaign in. The actual coin flip makes the candidates’ actions random and therefore unpredictable and the fact that the coin flip is done on election eve ensures that the information remains unknown and therefore unpredictable. This inability to predict the opponent’s actions makes it impossible to properly strategize.
Real-World Application of Game Theory
One real life application of game theory is seen in the prisoner’s dilemma. The prisoner’s dilemma depicts prison terms for when two guilty people convicted of a crime are separated and asked to sell each other out. If both people tell that the other one is guilty, then both people get 3 years in prison. If one person tells on the other, but the other one does not, then the one who told goes free and the other gets 5 years in prison. However, if both parties stay quiet then they both get 1 year in prison. What is best for the prisoner’s individually is to cooperate with law officials, in which case if the other person does not talk then the prisoner is let free. However if the other prisoner also cooperates it would have been better for the prisoners individually and as a group to stay quiet. The incentive to cooperate therefore arises out of both the fear that the other prisoner has cooperated and the draw to cooperate and hypothetically be let free.
The idea of using the prisoner’s dilemma to draw out admissions of guilt from prisoners is used in many criminal cases in today’s time. This usually takes place in the form of plea bargains. A famous plea bargain example involved a group of 5 men in La Jolla convicted of murder in 2007 (Perry 1). Instead of sticking to the scenario of all remaining silent and trying to claim innocence, these men all pled guilty, lessening their sentences from murder to manslaughter. They all proved unwilling to gamble possible murder charges should some members of the gang admit to the crime. Often in cases like these if the defendants are unwilling to admit guilt and the prosecution has a weak case against them, the prosecution will offer very attractive plea bargains to members of the group in order to obtain incriminating information against the other defendants.
Posted by Kelly, Kayla and Chris (Section 1)
Resources:
Perry, Tony. “Four Men Accept Plea Bargains in Killing of La Jolla Pro Surfer.” Los Angeles Times. Los Angeles Times, 28 June 2008. Web. 23 Apr. 2012. <http://articles.latimes.com/2008/jun/28/local/me-surfer28>.
Discussion on “OPEC Production Cut Surprises the Market” by Stanley Reed (Business Week, September 2008)
The article discusses OPEC, one of the world’s largest cartels, decision to cut oil production in 2008. The decision was made in order to keep oil prices at over $100 per barrel. The article also focused on Saudi Arabia’s history of overproducing beyond the cartel’s set oil production levels. The article is relevant to oligopolistic competition, because cartels are usually formed in this kind of market. Moreover, it discusses how certain players in an oligopoly (i.e. Saudi Arabia) do their best to maximize their own profits under this scenario.
While it may be easy to argue that OPEC is unethical in its form of competition, the issue is more complicated than that. OPEC member countries often do not value free market competition which focuses on consumer benefit, in the same way that the United States does. Moreover, price fixing in the oil industry can stimulate the speed at which alternative energies become commonplace. OPEC’s actions often do not have their intended effect. Time and time again, member nations have deviated from their agreement in order to maximize their own profits.
Another example of oligopolistic competition is the investment banking industry. A few top firms determine similar rates for things like Initial Public Offerings. For some reason, smaller banks have not been able to break into the industry, and the few banks that are in the industry act as price makers.
Posted by Airi, Ryan and Magan (Section 4)
In class, we talked about how oligopoly theory applies in the real-world to video games, GM, Lady Gaga, the coffee cartels, MLB, and the democratic and republican parties. This real-world application looks at OPEC, which is potentially the most famous international cartel in existence. Several of the consequences of cartel power come at no surprise (high prices, low output), but some may be unexpected….
Our blog authors have weighed in, but you will have your chance in class — Can we argue that OPEC’s actions are unethical? Or, is this just the nature of the petroleum industry?
Time permitting, our classroom discussion will take place on Thursday, April 19.
Posted by Prof. C-S
Resources:
NY Times Topics, 3/17/10
Amuzegar, Jahangir. “Managing the Oil Wealth: OPEC’s Windfalls and Pitfalls,” Middle East Quarterly, Winter 2003.
Discussion on “OPEC Production Cut Surprises the Market” by Stanley Reed (Business Week, September 2008)
In Stanley Reed’s article “OPEC Production Cut Surprises the Market” published in Bloomberg Businessweek in September of 2008, Reed discusses OPEC’s unexpected decision to cut oil production and the possible causes and effects of this decision. The 30% decrease in oil prices from July to September was indicated as a driving factor in this decision. In accordance with the basic laws of supply and demand, OPEC sought to cease this fall in prices by limiting oil production. Other causes cited as contributing to the decrease in oil prices were the easing of geopolitical tensions, weakening of the world economy, and strengthening of the dollar. Reed further states that this production cut may not even be enough to compensate for the decrease in demand for oil, and the cartel may need to take further action. As a cartel oligopoly, OPEC operates using a collective decision making system—maximizing profits by making decisions together. In this scenario, Saudi Arabia symbolically agreed with the collective decision to cut production, despite having different personal opinions on the matter. This situation appropriately illustrates the in class discussion on the nature of oligopolies and more specifically the structure of cartel.
The complexity of OPEC’s operational strategy back in 2008 is made even more complex and controversial by the ethical implications of oligopolistic economic practices. Oligopolies are often seen as unethical because they inherently undermine economic freedom that is of so much value in traditionally competitive market. The ability of OPEC to price fix and manipulate supplies often seems unfair and wrong, especially in the United States where oil consumption is of great and vital importance. However, the nature of the petroleum industry is that it is dealing with a limited resource that due to legal restraints is often controlled by nations rather than corporations. Nations have many good reasons to control their natural resources, and such control is not limited solely to the petroleum industry. It is this important consideration, that governments instead of pure businesses control oil production and supply, which makes the ethical obligations of member nations to OPEC increasingly complex. Furthermore, the great differences in opinion of OPEC member nations that is evidenced in the article summarized above indicates that the organization is not a villainous organization attempting to exploit industries, but is often attempting to control supply of a resource that can be highly volatile but incredibly important to virtually every industry around the world. Despite the often-ill side effects of oligopolies, the nature of a vital and limited resource coupled with the unique aspect of government control means that OPEC may not be unethical in its attempts to coordinate. This is further evidenced by its willingness to let prices drop, even though the nations theoretically could prevent such profit loss.
A second real-world application of the oligopoly market can be seen among U.S. cell phone network providers. It is estimated that the four major carriers—Verizon Wireless, AT&T, T-Mobile, and Sprint—control nearly 91% of the entire market. The reason for this is based largely on the enormous barriers to entry that are present within the industry. Purchasing wireless spectrum and building out complex networks have enormous up front costs for anyone looking to enter and compete in the industry. Even the big players attempt to avoid these costs by simply acquiring other providers. In the fall of 2011, AT&T attempted a bold acquisition of T-Mobile in an effort to overtake Verizon as the U.S.’s biggest provider. However, as with many oligopolistic markets, regulators were quick to denounce the possible merger, stating that competition would only decrease and leave consumers with fewer choices. Nonetheless, the four major firms do still compete fiercely on contracts and various bundling packages in an attempt to woo consumers to switch carriers. This interdependence keeps the market mildly competitive, but the industry is nonetheless another great example of an oligopoly market.
Posted by Clayton, Alyssa and Elizabeth (Section 3)
Resources:
Mourdoukoutas, Panos. “AT&T T-T-Mobile Merger Falls Apart; A Victory for Consumers.” Forbes. Forbes Magazine, 23 Nov. 2011. Web. 16 Apr. 2012. <http://www.forbes.com/sites/panosmourdoukoutas/2011/11/23/is-the-att-t-mobile-merger-limiting-or-fostering-competition/>.
Wang, Gigi. “AT&T/T-Mobile Merger: More Market Concentration, Less Choices, Higher Prices.” Focus Report. Yankee Group, Aug. 2011.
Discussion on “OPEC Production Cut Surprises the Market” by Stanley Reed (Business Week, September 2008)
Stanley Reed’s “OPEC Production Cut Surprises the Market” discusses OPEC and its decision to reduce production of oil in September 2008, eliminating 520,000 barrels a day from the oil market. Regarded as one of the most prominent oligopolies, OPEC or the Organization of Petroleum Exporting Countries consists of 12 countries including Algeria, Angola, Ecuador, Iran Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, the United Arab Emirates, and Venezuela. It is referred to as a cartel, which means a “group of producers that attempts to restrict output in order to raise prices above the competitive level (par. 6).” Within OPEC, Saudi Arabia is the largest producer of oil and the most influential country in the group, meaning that the have the greatest ability to effect output. OPEC has all the key components of an oligopoly has we discussed in class—there are 12 different countries working together and all sell the same undifferentiated product. In addition, the capital required to extract oil is extremely expensive, providing substantial barriers to entry into the oil market. These countries work together to provide the optimal pricing strategy and maximize profit but must be aware of the demand for oil in setting output and prices.
The most glaring act of collusion from OPEC dates back to the oil embargo in the early 1970s and the resulting quadrupling of the price of oil. This embargo showed just how powerful a natural resource could be and that it could strategically be used as leverage in any political or economic situations that arose. Recently, however, OPEC has used that power to establish a cartel role primarily via its adoption of output rationing, which subsequently has profound effects on the price of crude oil by the barrel.
It is important to note that OPEC is not an exact price setter; rather, its decisions related to output influence price movements and keep the price within a range member countries are content with. OPEC is able to do this because of its tremendous supply of oil: member countries own 77% of proven world oil reserves and produce about 40% of the world’s oil supply, with their exports accounting for over 50% of the total oil export[1]. This ability to control price is the chief source of contention that OPEC fails to conduct its business in an ethical manner.
The purpose of forming a cartel is to utilize market power to drive prices higher than they would be under operating market conditions with the ultimate intent of gaining profits. OPEC achieves this through cutting production, as described in the article. The extent of the ethics lies in the degree to which OPEC abuses this power. Less production will result in higher prices, meaning greater gains and higher remaining oil supplies for members. This is what occurred in 2008-2009 as countries sought a return to high prices. Still, OPEC (and particularly Saudi Arabia, the most influential player of the group) has done the opposite in the past out of concern for long-run demand. This results in benefits for both firms and consumers, which isn’t completely expected from a colluding enterprise. Lower prices do a number of things: they shift profits from the short-run to the long-run for suppliers; the consumer base is more content with the value they receive per unit of spending; and in a forward-looking sense, they keep consumer nations away either conserving or from allocating large capital amounts to developing alternative energies that are not reliant on foreign trade. This is likely to be unpopular with citizens of member countries because the recognition of large profits is delayed into the future.
OPEC’s mission wishes to “ensure the stabilization of oil markets to secure an efficient, economic, and regular supply of petroleum to consumers, a steady income to producers, and a fair return on capital for those investing in the petroleum industry.” The attempt to balance these factors appears to be the driving force behind production increases or decreases, not an abuse of market power. The current price of oil stands at under $103 per barrel, a rate nearly equal to that mentioned in the article and close to the minimum level OPEC nations would be willing to drop to. Additionally, OPEC average production from February to March, 2012 increased by over 100,000 barrels per day[2]. This current position gives the impression that OPEC is operating in a fair manner to date.
Another good example of a real world oligopoly is the soft drink industry. The industry is dominated by a few large suppliers (Coke, Pepsi, and Cadbury-Schweppes). It is protected by high barriers to entry (i.e. the startup cost of what it would take to develop a company that can produce and distribute mass quantities of soft drinks). Additionally, all of the companies charge essentially the same price for their products, as the products are all substitutes. If you go into a store and buy a 20-ounce bottle of Coke and a 20-ounce bottle of Pepsi, for the most part they will cost the same. The prices remain rather consistent as well. You don’t see the prices of soft drinks fluctuating very much at all. Clearly, there are more than a few real-life applications of oligopoly, from the oil industry to the soft drink and beer industry, which can be analyzed by economists in terms of pricing strategies and market behavior.
Posted by Carlos, Peter and Tori (Section 2)
[1] IBISWorld Industry Report—Global Oil & Gas Exploration & Production; Feb 2012
[2] http://www.telegraphindia.com/1120408/jsp/business/story_15347411.jsp#.T4z-Ac1094U
Discussion on “OPEC Production Cut Surprises the Market” by Stanley Reed (Business Week, September 2008)
Summary & Relevance
The article discusses OPEC action during 2008. OPEC, the Organization of Petroleum Exporting Countries, experienced a fall in oil prices during the year, and through cutting oil production, hopes to stabilize the price around $100 per barrel. The organization’s plan could take 520,000 barrels a day off the market. Price hawks, such as Iran, Venezuela and Algeria, are enthused by the potential maneuver, while Saudi Arabia, the largest producer of oil within OPEC, would suffer a loss. Saudi Arabia has been working to lower oil prices in the recent months due to the weakening of demand they had observed from consumers, particularly in the West and Japan. A deliberate decrease in supply would undo the progress they had made thus far. Saudi Arabia and a few other OPEC countries are also afraid high prices on gas will drive the innovation of alternative energy sources by alienating key customers. Finally, there is speculation that Saudi Arabia’s recent increase in production and resistance to OPEC’s plan to cut oil production was due to an under-the-table deal with the United States.
The OPEC article is relevant to class because OPEC is an example of an oligopoly. The major oil exporting countries of the world formed the organization for the benefit of the countries involved. Such an alliance allows for substantial control over supply, and consequently, equilibrium prices. The article provides a direct example of how oligopolies can manipulate the supply of goods within a market to benefit from a subsequent increase in consumer prices.
Commentary
While many argue OPEC’s dominant control over the oil market is unethical, there is another side to the story that needs to be explored. OPEC operates as a cartel and achieves its dominance over the market through the process of collusion. These oil-producing nations were blessed with the incredible fortune to sit on bountiful reserves of oil, giving them the opportunity to control one of the world’s most desired resources. However, it can be argued there is no ethical mandate for these countries to provide oil and share it. If this is the view taken by an individual, that person can hardly argue what OPEC has done to develop a stake in the oil market is unethical. Historically, it is evident that the formation of OPEC owed greatly to the previous dominance of Western companies like Shell Oil. The dominance of OPEC and the subsequent effect of monopolistic price control has had unintended positive effects for non-OPEC countries, as high oil prices has spurred investment in cleaner alternative energy sources. Finally, it is important to consider the effect OPEC has on citizens of OPEC nation; it is reasonable to expect that the price controls implemented by OPEC in external markets benefit the consumers in the home countries. In short, demonizing OPEC may be easy to do, but readers should at least consider an alternative viewpoint.
Real-World Application
A great example of another oligopoly is the wireless industry. Together four wireless providers in the U.S., AT&T, Verizon Wireless, T-Mobile, and Sprint Nextel, comprise 89 percent of the market. These carriers have control over the industry and are interdependent, reacting to the decisions of the other firms. Within this market, there are substantial barriers to entry. Setting up wireless networks around the country is costly and difficult, thus new firms will not likely enter. The oligopoly structure allows these companies to control their services, thus they do not offer much freedom to consumers. They only allow you to choose one phone approved by them, you must pay to upgrade or wait until your contract expires, and if you attempt to install your own software to the phone, your warranty will be terminated. Additionally, this type of market structure does not necessarily allow for great innovation. The companies are permitted to do things their way and are not necessarily incentivized to invent anything new. However, it is important in these high investment industries that governments allow such market structures, because without guaranteed success or market share, there would be no reason for any company to invest in establishing wireless networks. The wireless industry is a great example here of the good and bad of oligopolies.
Posted by Chris, Barbara and Alex (Section 1)
Resources:
http://www.wired.com/epicenter/2010/06/wireless-oligopoly-is-smother-of-invention/
http://www.tech-faq.com/wireless-oligopoly-was-created-by-government-regulation.html
http://en.wikipedia.org/wiki/Oligopoly
http://en.wikipedia.org/wiki/Opec
http://www.petroleum-economist.com/Article/2730961/Ethical-oil-and-Opec.html
LEPRECHAUNOMICS 