Category Archives: Oligopoly

Oligopoly

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)

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QUESTIONS FOR CLASSROOM DISCUSSION ON OLIGOPOLY

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….

  • OPEC’s actions have led to trade sanctions on member nations:  OPEC was created in 1960 to seek higher revenues for its members, at a time when the global oil business was dominated by Western Companies.  To counter OPEC’s search for dominance, Western nations decreased OPEC’s market share though energy conservation, efficient machinery, alternative energy sources, and oil sanctions that forced many nations to become debtors of the West.
  • OPEC members have earned significant revenues, despite sour economic conditions in their nations:   In the early years of OPEC, its members developed a “petrol-culture,” belief that oil income could solve all economic problems. Despite oil and gas revenues totaling more than $3 trillion in 1974-1994, many OPEC member nations experienced anemic growth, domestic inflation, and widespread unemployment.
  • OPEC desire to control price often creates turmoil among member nations: OPEC has been faced with inter-group cheating and difficulty in enforcing trade restrictions.  This has not only made setting the world price of oil virtually impossible, but also pitted member countries against one another for share of the market. 

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.

Oligopoly

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/&gt;.

Wang, Gigi. “AT&T/T-Mobile Merger: More Market Concentration, Less Choices, Higher Prices.” Focus Report. Yankee Group, Aug. 2011.

Oligopoly

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

Oligopoly

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