The Organization of the Petroleum Exporting Countries (OPEC) is an intergovernme

Question

The Organization of the Petroleum Exporting Countries (OPEC) is an intergovernmental organization of 13 nations, founded in 1960 in Baghdad by the first five members (Iran, Iraq, Kuwait, Saudi Arabia, Venezuela). As of 2015, the 13 countries accounted for an estimated 42 percent of global oil production and 73 percent of the world’s ”proven” oil reserves, giving OPEC a major influence on global oil prices that were previously determined by American-dominated multinational oil companies. Understanding this type of dynamics in which a few countries (or firms) dominate the market being able to set the price, yet unable to raise significant barriers to entry to keep smaller competitors from entering the market entails diving into a price leadership model.

Start with the following assumptions: The World Market demand for oil is given by P = 100 X in which X is the aggregate market quantity of crude oil barrels. This market is served by OPEC, a dominant block, and a set of infinitely many countries with smaller oil reserves which act as price-takers. OPEC is comprised of two dominating countries, denoted DC1 and DC2 with similar efficiencies: constant marginal costs such that: MCDC1 = MCDC2 = 50. The smaller countries3 have an aggregate marginal cost that can be expressed by MCSC =50+X.

1. What does the shape of this inverse market demand tells you about the nature of product differentiation in this market? Does it make sense in the oil market? Explain how you got to this conclusion.

2. What does constant marginal costs for the dominant countries tells us about the nature of the production function for oil in those countries? Does it make sense in the oil market? Explain how you got to this conclusion. (Tip: Think about the nature of scale of production upon costs and how it relates to oil extraction).

3. Derive the residual demand that OPEC will operate in. (Make sure to incorporate the structural break in residual demand with its respective output range)

4. How much will each country at OPEC produce?

5. What is the resulting price of the barrel in the oil market?

6. How much are the other countries aggregately producing?

7. What is the HHI in the oil market?

8. How do you anticipate your results would change if the number of countries at OPEC increase from 2 to 13? How did you get to this conclusion? (Notice that I am not asking you to resolve the model, but rather to utilize some of the intuitions and parallels we’ve derived in class to base your conclusion)

9. How do you anticipate your results would change if the countries in OPEC had distinct marginal costs?How did you get to this conclusion? (Notice that I am not asking you to resolve the model, but rather to utilize some of the intuitions and parallels we’ve derived in class to base your conclusion)

10. The fact that this market is spread out across the world, and players be- ing mostly countries instead of firms, implies that there is no type of antitrust or competition agency able to enforce rules. What does the lack of supranational competition agency entails? Would we want to have such an agency? What would be the pros and cons of something of this nature? (This question has an opinion component to it, and your answer will not be judged on whether you agree or disagree with the creation of a supra-national agency. Rather the grading will be based on the quality of the arguments used to arrive to such conclusion)

Explanation / Answer

1. The idea is that the oligopolistic firms are interdependent and concerned about their competitors. so they tend to stay at a fixed price P and they do not want to raise this price because they understand that the prices above P will face a very elastic demand curve. hence any price rise will lead to a loss of large number of customers. However, if the firms were to lower their price below P, they wont gain many customers because these firms will enter into a price war. Thus, the kinked demand curve with no incentive to increase or decrease the price. When cost changes, Marginal cost can rise without effecting the MR-MC position, with the equilibrium level of quantity remaining the same. So, change in cost leads to no change in quantity. Thus, the firms do not have to change the price even when the cost changes. In the oil market, firms are not fully exploiting their potential for product differentiation.

Thus the total revenue and marginal revenue function of the two dominant firms will be symmetrical with similar reaction functions.

2. Constant Marginal costs of the two dominant firms tell us that the production functions of these countries will be symmetrical and hence these firms will collude in determining how much output they should produce at the given price of the oil. The firms will indulge in profit sharing and any increase in the marginal cost of the firms will shift both reaction functions inward.

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