Business

Abstract This paper discusses differences among monopoly, cartel, and oligopoly, welfare impacts of oligopoly and monopoly, use of game theory to understand companies’ interactions within cartels and oligopolies, OPEC’s economic significance and its actions over the next one year, and change in price of oil from 2004 to 2009. Market Structures Monopoly, Oligopoly, and Cartel Monopoly refers to an industry or market with single seller who has complete control over prices. In a monopoly, there is no close substitute for the products or services on offer. Typical examples of monopolies include public utilities, which operate in a natural monopoly because of the associated huge capital investment. In contrast, oligopoly refers to a market or industry environment characterized by a) small number of rival sellers, b) interdependence among the sellers due to their large size relative to that of the industry, c) substantial economies of scale, and d) excessive entry barriers to the industry. Examples include markets such as airlines, car rental, and automobile. On the other hand, a cartel refers to a form of oligopoly in which a group of companies agrees to coordinate their pricing and production decisions to earn monopoly profit. It is common among sellers of commodities such as steel and oil. OPEC (Organization of Petroleum Exporting Countries) is a classical example of a cartel (Baumol & Blinder, 2008) Welfare Impacts of Monopoly and Oligopoly From a social standpoint, monopolies undermine the welfare of consumers and allocate resources in a suboptimal way. This is because prices of goods and services are high, quantity supplied smaller and all the profit goes to the monopolies. If the monopoly is a local firm, this profit reflects transfer of income from some members of the society to others, who may be deserving. However, if a foreign one, the profit is transferred overseas, which implies a net loss to the society. Moreover, monopolies deny consumers the opportunity to spend marginal revenue on monopolistic goods or services, which forces them to use the revenue elsewhere. Such deprivation denies the consumers the extra value attached to the product or services giving rise to dead-weight loss. Welfare implications of oligopolies vary from case to case according to the behavior and interactions of companies within the oligopolies. Their prices and outputs may differ substantially from socially optimal levels because market conditions my not effectively restrain their interactions. For instance, when oligopolists organize themselves into a cartel (e.g. OPEC), they collude to elevate prices and decrease production. At some instances, price wars and misleading advertisements within oligopolies may lead consumers to purchase products they do not need and would otherwise not need. As such, they engage in behavior that seeks to wield economic power at the expense of consumers (Baumol & Blinder, 2008). Game Theory and Relations within Oligopoly and Cartel Game theory is applied in oligopolies and cartels to explain the interactions of companies. It examines oligopolistic behavior and interactions as a set of strategic moves and countermeasures among rival firms. For instance, game theory’s concept of prisoner’s dilemma has been applied to explain the price-setting behavior in oligopolies. This interaction results to a Nash equilibrium, which is a condition in which a firm selects the best pricing strategy given the strategies selected by other firms in the oligopoly. Cartels arise from such interaction when firms agree to collude to set a common price that seeks to maximize gains for each player. However, presence of incentives for firms to cheat on the cartels brings about price wars among the firms that eventually give rise to tit-for-tat situation within the oligopolies. In game theory, such situation refers to a strategy in repetitive games when a competitor in a single round of the play imitates previous round’s behavior of the other competitor. Game theorists believe this remains the only strategy to get the cheating competitor to cooperate. Another possible outcome in oligopolistic interactions is the coordination situation in which each firm in the oligopoly selects the same strategy to achieve the Nash equilibrium (Baumol & Blinder, 2008). OPEC and Oil Prices from 2004 to 2009 The twofold economic purpose of OPE is to a) set oil production limits that all members agree upon, and b) control prices and supply to guarantee sustainable profits for cartel members. Over the last five years, the prices of oil have been increasing substantially. Various events including Iraq war, Iran-USA animosity, hurricane Katrina, etc saw the price rise from around $35/barrel in 2004 to $60/barrel in 2005. The prices increased in 2006 to reach a value of $75 per barrel and close to $88/barrel in 2007. In July 2008, the price increased substantially to hit the $136.32/barrel mark and one year later, reduced to $65/barrel. Currently, the price has remained stable at around $80 per barrel (The Titi Tudorancea Bulletin, 2008). OPEC’s Actions over the Next One year Based on the above discussion, OPEC’s actions over the next year will certainly be based on presence of bio-fuel, technological change, and changes in oil demand. Production of bio-fuel has been on the rise over the past years and there is a high likelihood that quantity of bio-fuel produced will increase next year. As such, OPEC may be forced to urge its members to reduce oil production or prices because of reduced demand. OPEC will also call for adoption of upcoming oil production technologies to help member states cut on costs of production and to preserve sustainability of the industry. In this way, technological advancements will help cartel members to ensure sufficient oil production to meet demand fluctuations brought about by impacts of climatic changes on bio-fuel production. Market uncertainty due to the Iraq War and the Iran-USA political animosity, OPEC will take action to urge other member nations to ensure sufficient spare oil. The other action will involve controlling supply and prices of oil to satisfy demand of petroleum oil users. References Baumol, W.J., & Blinder, A.S. (2008). Economics: Principles and policy. (11th ed.). Florence, KY: Cengage Learning. Perloff, J. M. (2007). Microeconomics (4th ed.). New York: Pearson Addison Wesley. The Titi Tudorancea Bulletin. (2008, Feb. 6). World crude oil prices history and charts. Retrieved from http://www.tititudorancea.com/z/world_crude_oil_prices_graphs_history.htm