Case Analysis: OPEC: A Case Study in Joint Profit Maximization
Note: Note: Read the the case case study study “OPEC: “OPEC: A Case Study in Joint Profit Maximization” Maximization ” to answer the
following questions.
Questions
1. Discuss why OPEC was created.
2. Discuss what factors have led to the emergence of Oligopoly market structure?
OPEC: A Case Study in Joint Profit Maximization
Although created in 1960, it took the Organization of Petroleum Exporting Countries (OPEC) 13 years to achieve its two main goals: to raise the taxes and royalties earned by member governments from crude oil production and to take control over oil production and exploration away from the major international oil companies. Since 1973 OPEC, in closely controlling the world market price of crude oil, has emerged as perhaps the most successful cartel in world history. Cartels are one species of oligopoly; what distinguishes a cartel from “looser”
oligopolistic market structures is the existence of a formal, explicit, and detailed plan for ma rket sharing and coordination of production levels and prices. * OPEC consists of 12 countries (in order of the size of their estimated oil reserves): Saudi Arabia, Kuwait, Iran, Iraq, Libya, United Arab Emirates (Abu Dhabi, Dubai, five others), Nigeria, Venezuela, Indonesia, Algeria, Qatar, and Ecuador. The top six OPEC countries have over 50% of the estimated world reserves of crude oil, and all 12 countries together account for more than two-thirds of world oil reserves. The OPEC countries are too small to use more than a fraction of their own oil reserves and thus are major exporters. Because they account for more than 85% of world trade in oil, they can literally control the world market. Europe and Japan are totally dependent on OPEC oil, and the United States imports about one-third of its oil from OPEC sources.
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Cartels flourished between World War I and World War II, especially in Germany where the legal system condoned and helped to enforce market-sharing agreements. Such industries as chemicals, explosives, glass, steel, and pharmaceuticals were prone to cartel organizations because of the large scale of operations required and the strong tendency to vertical integration from raw materials to distribution of the product. After World War II, industrial cartels virtually disappeared, partly because of the influence of U.S. antitrust regulations but mainly because of the rapid growth in world demand which made cartel organizations unnecessary. There did exist a number of “international commodity agreements” in such areas as tea, coffee, sugar, tin, copper, cocoa, and bauxite, but most of th ese were only marginally successful an d were generally undermined by the availability of substitutes or by the impossibility of preventing cheating by countries whose economic welfare was crucially dependent on the export of a single commodity.
Theoretically, the purpose of a cartel is to maximize the earnings of its members. This is accomplished by ignoring internal differences and preferences among members and setting a price that maximizes the profits of the group as a whole – joint profit maximization. When consumers are unable to substitute readily for the cartel’s commodity or do without it, the
price can be raised quite high without – in the short run – a great loss in volume of sales, with the result that total revenue is increased, perhaps dramatically. Indeed, this is precisely what OPEC accomplished when in 1973-1974 it established a world oil price that gave participating governments over $10 a barrel net revenue – a ninefold increase in four years. The OPEC countries caused the price of crude oil to jump by raising the excise tax on each barrel of oil produced in their oil fields. These taxes are treated as a cost of production by the oil companies drawing oil from OPEC wells so that increases in the excise tax effectively raise the price which the oil companies must receive in order to cover production costs plus the tax. OPEC’s dramatic profits were made possible by the fact that the short-run price elasticity for oil
has been estimated at –0.15. With demand so price inelastic in the short run, the OPEC price increases have been successful in raising OPEC revenues to over $ 100 billion per year. Nonetheless, with the passage of time, perhaps five to ten years, the OPEC cartel faces some longer-energy conservation measures, give consumers more opportunity to curtail their usage of petroleum-based energy. Additionally, high oil prices and increased profits have stimulated new efforts to expand exploration and production of crude oil; to the extent that alternative sources of crude oil supply are developed, OPEC’s control of the market is undercut. Long -run
price elasticity of demand for petroleum has been estimated as close to –1.0, where higher prices are completely offset by loss of sales volume and total revenue is unchanged. OPEC has recognized the danger to its position and has commissioned a number of studies to help it determine the profit-maximizing price level and the pattern of price change that it should impose in the future. It has also initiated studies to determine when and how OPEC can cut back on production if demand weakens as expected. Some estimates project that OPEC will have as much as 25 to 33 % excess production capacity by 1980. How OPEC would handle a surplus of this magnitude is a major concern because if some of the member countries should
become dissatisfied with their assigned quotas, the seeds of discontent and dissension could break up the cartel. Venezuela has long suggested a pro-rationing scheme that would formally assign each OPEC country a rate of production based upon population, economic needs of the nation, and oil-producing capacity; however, several other OPEC nations have opposed such criteria. There are two major groups of countries in OPEC, and their interests tend to diverge on price and production policies. On one side are such countries as Iran, Venezuela, Iraq, and Algeria with large populations and ambitious economic development plans. These countries want maximum revenues now and are n ot overly concerned about the erosion of OPEC’s market by high prices over the long term. Moreover, they have substantially fewer years of reserves left at current production rates. The second group of countries, which includes Saudi Arabia, Kuwait, and the United Arab Emirates, now has more money coming in than it can use and is more concerned about maintaining the long- run viability of OPEC’s market control. A number of observers are of the opinion that OPEC’s price of oil in the mid -1970s overshot by
a wide margin the price of oil which will prevail in the 1980s. They believe that OPEC is following a very sophisticated strategy of price discrimination based upon time. In their view, OPEC has calculatedly chosen to charge high prices now because alternative energy sources are virtually nonexistent and because the alternatives on the horizon have long lead times and require massive capital investments. Supposedly, OPEC will lower prices slowly over the future not only to discourage development of new energy alternatives but also to create uncertainty over where the price of crude oil is going to end up and confusion over just how profitable alternative energy sources will ultimately be in comparison to oil. By deliberately trying to increase the profit risk inherent in developing energy alternatives, the cartel hopes to forestall the emergence of substitutes for oil. If this view is correct, then the internal strains on the cartel of cutting back oil production in order to keep prices propped up may be avoided. Nonetheless, others profess confidence that the internal differences within OPEC in terms of oil reserves, population, economic development plans, and military ambitions will eventually cause the cartel to break up.
Although acknowledging that success of the cartel has probably made the participating countries more alert to the dangers of each country trying to go its own way by cutting price in order to reach its desired market share, they still regard cartels as inherently unstable whenever underlying economic conditions turn unfavourable. Experts have generally used a three-step analysis to determine the internal strain which may be placed on OPEC countries: Step 1 involves predicting world demand for oil each year to 1985. Step 2 is to estimate how much oil will be available from non-OPEC sources, including increased production capacity within consuming nations (such as oil from offshore United States and the Alaskan North Sea Slope). Step 3 is to subtract the estimated non-OPEC supply from estimated world demand to give a figure for the world market open to the OPEC countries. By comparing this to the total productive capacity the OPEC nations will have in place on an annual basis. One gains an indication of how great a problem OPEC would face in allocating output among its members. Will OPEC be a model for others to copy? When OPEC succeeded in gaining control over the world price of crude oil, there was widespread speculation that what could be done with oil could also be done with other staple, basic commodities such as copper, coffee, and bauxite. In fact, an association of copper-producing nations was formed. But in 1975 copper prices declined about 65% over prevailing 1974 levels. The copper cartel met in late 1975 to discuss how to stop this price erosion; however, the consensus which emerged was that little could be done by the cartel to stop it. The falling copper price was attributed to a surplus of copperproducing capacity resulting from the 1974-1975 worldwide recession.
