Collusion and OPEC

When I teach market structures, it seems taken as a given that the most empirically obvious form of market - an oligopoly - begets collusion. Consequently there is a real concern that collusive behaviour is a typical outcome of market exchange. Firstly, this view misses the issue because an oligopoly (unlike perfect competition and monopoly) is a real world phenomena. It's defined as a market structure where 3-4 firms have 80%+ market share. By contrast perfect competition is a thought experiment that does not exist in the real world. The arguments in favour of free markets is NOT based on an assumption of perfect competition.

But secondly, it's important to actually look at the possible effects of collusion. Although there's an incentive to collude, the first response is to investigate the probability that this will actually occur. For all sorts of reasons, collusion is immensely difficult to maintain (there's an incentive to free ride, etc). For now though, I want to focus on an empirical case that many view as the classic example of collusion: OPEC. Whereas most examples are suspected collusion, OPEC is an actual cartel.

Here's the story as I know it:

• OPEC produced >50% of global oil in 1973. At this point they significantly reduced output (thus raising the price of oil) and by 1985 their production had fallen by 12%
• This led to a rise in price in crude oil, from $8 per barrel in 1971, to >$27 per barrel in 1973/74*
• [Note that already we face problems. Consider this account "During the Yom Kippur Arab-Israeli war Opec  raises prices by 70%-100%". Many people believe that OPEC "raised prices" - they didn't. They reduced supply, which led to a higher market price for oil. The first explanation pre-supposes that cartels determine the price of their product. If this is the case, we don't need to explain anything.]
• Since the price rose, the incentive for other countries to produce oil dramatically increases
• Non-OPEC countries therefore increase their production of oil
• "Stimulated by the high price, oil production in oil-producing regions had been increasing rapidly. All these contributed to a surplus of oil supply on the international oil market."
• OPEC's market share falls from 55% to 30%
• In 1980 crude oil was almost $50 a barrel* but by 1986 it was under $15 a barrel*
• Price fall by half from $30 in 1985 to $15 in 1988
• According to the BP "Table of World Oil Production".pdf, in 2005 OPEC produced 40% of world oil
• According to WorldOil.com, in 2005/2006 OPEC produced 35% of crude oil

Conclusion:

"OPEC faces the classic problem of all cartels: overproduction and cheating by members."

"In 1982, in order to defend the oil price, OPEC started to impose production quota on every production country. However, the measure stimulated OPEC members to fight for more market shares using price as a weapon, which directly led to a slump of oil price in the second quarter of 1986 to just six to seven dollars per barrel."

Even with relatively successful collusion such as OPEC, they are significantly limited in the extent to which they can control the market. The negative consequences associated with the 1970s oil shocks (i.e. queuing for petrol) were the result of domestic policy decisions that rationed resources through non-price
mechanisms. I'm deliberately ignoring current events, because I don't see how we can begin to understand them when the lessons of the 1970s are still so far from being widespread.

--
*1990 prices

Comments

[Gabriel M.]

>> "The arguments in favour of free markets is NOT based on an assumption of perfect competition."

Well, *some* are. :-)

But more to the point... given the OPEC history, wouldn't it have been better if these events never had occured? Real output was lost, welfare suffered.

A non-persistent mess is still a mess.

[aje]

sure but we live in the real world and need to compare likely alternatives... in other words lets compare learning mechanisms rather than idealised responses.

[Edward]

Am ok