OPEC CARTEL Essay

â€Å"OPEC As a CARTEL† There are two kinds of extreme market structure and they are perfect competition and imperfect competition. In a perfectly competitive market there are many numbers of sellers and many numbers of buyers selling and buying homogeneous products, therefore there is very little impact of a single buyer or seller changing the price of his/her product. In an imperfect competitive market there are few sellers and these sellers have some control over the prices and output of the product. Here, in this kind of market the whole market is affected by an individual changing his/her product price. In USA most of the industries fall between these two extreme market structures. But in this essay we’ll talk about oligopoly. It is imperfect competitive market state therefore here there are few no. of sellers. Oligopoly covers many kinds of industrial behaviours and structures because of its broad nature. Oligopoly is a market condition where few numbers of sellers (oligopolists) come together and form a market or an industry. An oligopoly may have 2 firms or 20 firms, selling and producing differentiated or undifferentiated products and services. There are few participants in this market structure therefore each participant is aware about the activities of other participants. The decisions are influenced by one another. As this market is operated by few firms, the price of the product and the quantity of production is fixed by the firms itself keeping in mind their self-interest and self-respect. Sellers (oligopolists) are acting and cooperating like a monopolist – producing a small amount of quantity of goods and selling these goods at a price higher than the marginal cost. These are some of the powerful incentives at work which hinder a group of firms from maintaining the monopoly outcome. An oligopoly is operated under imperfect competition; they follow a kinked  demand curve which shows that inelasticity below the market price and elasticity above the market price, offering differentiated services and products they have strong barriers to entry. Kinked demand curve is downward sloping curve. There is a discontinuity at the bend – the â€Å"kink†. Due to this there is a discontinuity in the marginal revenue curve. The demand above the kink is relatively elastic, therefore all other firms’ prices remains unchanged and demand curve after the kink the demand will be inelastic, therefore all the firms will have similar price cut, eventually leading to a price war. The best way to overcome this problem is to produce at the point E that is the equilibrium point and, coincidently the kink point. There are many industries in oligopoly conditions are automobile, cigarette, malt beverages (beer), small arms ammunition, oil and petroleum, etc. There are many kinds of oligopolies, a number of different oligopoly models have been structured. But we are going to further discuss about the structure of CARTEL. But before that if u examine all oligopoly models have a similar thing i.e. ‘The behaviour of any given oligopolistic firm depends on the behaviour of other firms in the industry comprising oligopoly’. According to the traditional economic theory the producer who is at the stage of profit maximizing and also has some market power (either due to oligopoly or monopolistic competition) would have set marginal cost equal to marginal revenue i.e. MC=MR. A cartel is an organisation of independent firms coming together, to control and limit the production and increase and decrease of price and profit. Cartels can be formed in an informal or formal manner with the agreement of every member. Cartels usually occur in an oligopolistic industry. The main aim of cartel is to increase individual profits by reducing competition. There are two kinds of cartels: Private cartels and Public cartels. In a public cartel there is involvement of government and such cartels are legally formed. Private cartels are formed by few industries and are subject to legal liability under antitrust laws now found in every country of the world. Private cartels have to often face competition laws. Private cartels are recognized and fragmented by the competition policy by most of the countries in the world. But finding out cartels and further proving them is very difficult because firms are not so careless to put such agreements on papers. Antitrust authorities have found that in last 200 years price increase achieved by cartels is almost 25%. There was a 28% price hike in private international cartels (cartels formed by one or more nations). Domestic cartels where at 18%, less than 10% domestic cartels failed to raise the market price. This study was possible after several economic studies and legal decisions. There are some differences in public and private cartels. It is said that public cartels are less harmful than private cartels because they are operated in the presence of government private cartels are more effective and, hence, possibly harmful, though there is no proof to prove this right. Government has all the authorities to establish and enforce the rules relating to prices, output and other such matters; this is in the case of public cartels. Examples of public cartels are export cartels and shipping conferences. There are also depression cartels permitted in some countries this type of cartel helps in stabilising the required price and production. For example, in Japan such type of cartel is allowed in steel, aluminium smelting, ship building and various chemical industries. In United States during the time of great depression of 1930, in industries such as coal mining and oil production public cartels were allowed by United States and they also remained after the World War-II. Germany’s economy was also affected by these cartels during the inter–war period. There were international cartels formed between governments of some nations by signing an agreement it was called as international commodity agreement which covered products such as coffee, sugar, tin, and oil (OPEC). Private Cartels are having huge different than public cartels, an agreement is signed on terms and conditions that provide mutual advantages, these terms and conditions should not be detected by outside parties. Private cartels are responsible for violating the antitrust Laws. Game theory means studying the oligopolistic behaviour of a series of strategic actions of a firm and reaction of the rival firm. According to this theory cartels are unstable, due to the behaviour of members of a cartel is like the behaviour of a player who has a dominant strategy in a game. If a member does not abide by the rules in the agreement that member will make more profit than by following the agreement. The situation would be worse if all the partners break the agreement. Cartels do not sustain for a long run because members have cheating incentives. A Cartel can exist for only 5 to 10 years this was found by deep study of cartel. If the members intend to cheat on the agreement in order to earn short term profit so that they could cover the long term losses this depends on the situation if they have short term profits through break down of cartel than they’ll possibly break it down. How difficult it would be for a firm to, find out that other firms are following the agreement or not. If the other firms are not following than they are cheating and therefore the cartel becomes unstable. There are few ways to keep watch on a cartel: 1) Number of firms in the industry, 2) Characteristics of the products sold by the firms, 3) Production cost of each member, 4) Behaviour of demand, and 5) frequency of sales and their characteristics. The Organization of Petroleum Exporting Countries (OPEC) was initially created with efforts of 5 countries and then later on joined by 9 other countries. It is an intergovernmental organization which was formed by Iran, Iraq, Kuwait, Saudi Arabia and Venezuela, on September 10 – 14, 1960, in Baghdad. These five founding members were later on joined by nine other members: Qatar (1961), Indonesia (1962-2009), Libya (1962), United Arab Emirate (1967), Algeria (1969), Nigeria (1971), Ecuador (1973), Angola (2007), Gabon (1975-1994). Ecuador suspended its membership from December 1992 – October 2007. Initially headquarter of OPEC was in Geneva, Switzerland, and after 5 years it was moved to Vienna, Austria, on September 1, 1965. OPEC was found with some objectives. The objective of OPEC is to manage and unify petroleum polices among member countries and thereby secure the stability in the prices for petroleum producers. It was necessary that flow  is maintained in supplying petroleum at an economical rate, to the consuming countries, provided that the members investing in this industry get a fair return of capital. They also have a unique strategy that is allotting the production quota to a member country. This system helps in maintaining and stabilizing the price to a certain level. Developing its collective vision with some objectives and creating its secretariat, in Geneva and then in 1965, in Vienna, OPEC adopted a ‘Declaratory Statement of Petroleum Policy in Member countries’ in 1968. This policy stated that it is absolute right of the member nations to have a permanent rule over their natural resources and use them in order to increase the rate of national development. During 1970s OPEC became an international importance in the world market of petroleum and crude oil, it had a full control over the pricing. During this period there was a steep price rise in petroleum products. In 1980s the prices began to fall down as people started shifting from petroleum products. OPEC’s market share fell heavily to the third of the early rise. At this time member countries had to bare a heavy loss, but soon they regained their position with a little price hike almost half the early rise. OPEC started recovering its market share slowly. During the period of 1990s OPEC had a fall in prices same as it had in 1980s, but it had a solid recovery this time. During this period the prices were stable at some extent than in 1970s and 1980s. One of the member nation left OPEC and one suspended its membership. In 21st century OPEC had an innovative plan which helped in stabilising the prices of petroleum products in early years. The prices began to rise from 2004 and still it’s rising. During this decade one member activated its membership and another member suspended it. OPEC has not proved to be a successful cartel because it was unable to control the prices of petroleum products. Though OPEC had few members and that helped in reducing the conflicts. It was easy for the members to monitor one another’s activities and thereby adhering to the agreement. It was also easy to coordinate the price policy and the output policy according the agreement. It is simpler to form a cartel with few members. OPEC as a cartel is working effectively because 3/4th of its oil reserve is regulated by four countries they are: Venezuela, Saudi Arabia, Kuwait and Iran. There is only one threat to OPEC as a cartel, and that is increased production by  non-members. In the short run the price elasticity of demand for oil is quite low, according to this statement if enough production restrictions are implied than it will give a price hike this is a favourable environment for a cartel. Following this in 1973 OPEC contributed to two third of the total oil production of the world. Today if we compare the prices of crude oil than they are much higher than the early stages. To survive for such long period of 50 years OPEC had to face many challenges to fulfil its objective. The first challenge in front of OPEC is how to overcome the problem of supply of crude oil in all the countries keeping in mind the interest of the member countries of OPEC. Initially OPEC used to supply its crude oil to all type of countries like developing countries, under developed countries and developed countries but later on it was not able to fulfil the demand as it kept on increasing. Therefore, OPEC decided to first fulfil the demand of those countries with greater need and who provided with a fair deal and then look forward to those countries that had less demand for crude oil and offered a cheap deal. This decision was taken keeping in mind its own profit. The second challenge for OPEC is the NON-OPEC countries i.e. countries which are not members of OPEC. If these countries started production at high rate then these countries would take the major market share of OPEC and that was not good for member countries. NON-OPEC countries had no restrictions in production and pricing of crude oil. These NON-OPEC countries would take the short run profits because they can vary their prices. The third problem faced by OPEC is that United Nations (UN) was constantly pressuring OPEC in order to stop the wastage of gas which is emitted in high amount due to the usage of old technology. Technological issue is the fourth challenge for OPEC because they used old technology and to install new one it would take time and the market demand would not be fulfilled. Updating the technology was a big issue. The fifth issue was about maintaining large reserves of crude oil in order to sustain the sudden shift in demand. The sixth that is the last challenge is in the form of question that how OPEC can overcome the financial problems occurring during the production of oil because producing oil needs heavy capital investment? There is a big risk taking and uncertainties involved in this process and these uncertainties can be overcome with the help of proper  planning. If OPEC is unable to fulfil the challenge than there, is a fear of losing the whole market share against the NON-OPEC countries. Analysis of OPEC’s behaviour can be done through certain aspects. First, relying on a structural model is better than relying on the estimation approach. According to the analysis done in first step, in last 25 years all the theoretical models constructed for OPEC should be taken and then they should be properly tested. After this we compare and contrast it with equilibrium model of dynamic oligopoly. In the second step we consider organization as a whole and not considering the supply functions of individual countries. By doing this we would be able to estimate the collusiveness of OPEC. This helps us in identifying the switching periods between collusive and non-cooperative behaviour. OPEC has its own collusive behaviour and in many cases there was break down and price war between member countries. Price of crude oil depends on the demand and supply of it. There can be different variations maybe low or high, in price of crude oil, due to the imbalance in demand and supply – maybe little demand and more supply or more demand and little supply. The price of crude oil will be high if demand is more and supply is less and price will be low if supply is more and demand is less. Sometimes the prices fall down due to the non-cooperative act of members of OPEC or due to going against the agreement and cheating. Sometimes the reason for high price of crude oil may be other factors like taxation, governments of the countries of the world, natural disasters, etc. Factors like transportation, climate, capital, machinery, cost of production, etc. affect the prices of crude oil. As other cartels, OPEC also tries to raise the prices of crude oil by reducing the quantity of production of crude oil. When the price raises each member of cartel wants to increase the production by going against the agreement, so that they can get large amount of profit. OPEC member countries frequently agree to the reduction of production but then they cheat on the agreement. During the period of 1973-1985 OPEC was successful in maintaining the high-prices of crude oil, with the help of cooperation of  member countries. The price of crude oil per barrel rose steeply from $3 per barrel in 1972 to $11 per barrel in 1974 and then to $35 in 1981. After that there was absence in maintaining cooperation between member countries due to the argument on the topic of increasing production. Due to this the prices of barrel fell down by $13 per barrel in 1986. In this case OPEC has failed to work effectively because it was lacking in coordination and cooperation between member countries and this resulted in the instability of price of crude oil. According to the study there are approximately 1.5 trillion barrels of oil reserve in world. Out of which 81.33% i.e. 1193 billion barrels, is with the member countries of OPEC. In 2010, OPEC member countries produced 29.2 million barrels per day of crude oil that is about 41.8% of the world total output; this has increased to 69.7 million barrels per day. According to OPEC they have sufficient crude oil reserves that can last for 112 years. According to OPEC’s World Energy Model (OWEM) the demand for crude oil in 2006 was 84.7 million barrels per day. Due to the continuous growth in world’s economy the demand for crude oil in 2015 will rise to 96.1 million barrels per day, 102.2 million barrels per day in 2020 and 113.3 million barrels per day in 2030. OPEC as a cartel was unsuccessful to a certain extent and successful to a certain extent. There was high variation observed in prices of crude oil due to the instability of the Organisation of Petroleum Exporting Countries (OPEC). Lack of cooperation and coordination amongst the members of OPEC was seen because each individual member was tempted to earn high amount of profits and therefore he/she would cheat with the agreement. There was one thing observed that, when the price of crude oil rise than the members of OPEC intend to go against the agreement and they try to increase their production in order to earn short-run high profits. During any crisis in the world OPEC was not able to keep itself steady. There were some technological related issues with the members of OPEC. They used the old machinery to produce the crude oil and to overcome that they started updating their machineries, but during this period they were unable to handle the market demand for crude oil and therefore t hey failed to provide it to other  countries which resulted in price hike. If innovation is carried out properly than the cost of production will reduce to certain point and this will react in high rise in demand in international market, which will directly affect the profits of members of OPEC. In conclusion I would like to say that OPEC is a best form of oligopoly and both suit to each other because of the continuous development of OPEC as a cartel. In past 50 years OPEC has faced many heavy tasks; it failed to fulfil some tasks but still tried to recover the losses. OPEC has the largest oil reserve in the world. Amongst the NON-OPEC countries main competitor of OPEC is U.S.A because it has one of the largest reserves of crude oil. If we see in today’s market than OPEC as a cartel has a higher market share and it is the longest and largest living oil producing organization. OPEC is one of the longest survived cartels in the world. REFRENCE 1) http://en.wikipedia.org/wiki/Cartel 2) http://www.opec.org/opec_web/en/about_us/24.htm 3) http://www.scribd.com/doc/55875469/Oligopoly-OPEC 4) http://www.opec.org/opec_web/en/press_room/179.htm 5) Principles of Microeconomics (Indian edition) 4th edition, by N. Gregory Mankiw, published by Cengage learning India Pvt. Ltd., 356-357 6) Principles of Economics 8th edition, by Karl E. Case and Ray C. Fair, published by Dorling Kindersley India Pvt. Ltd., 310-311