OPEC from a Game Theory Perspective - Term Paper Example

25th Nov OPEC from a Game Theory perspective Introduction Game theory is a theoretical framework that is used to explain howdecisions are made between parties. It was coined by Jonny Neumann who tried to explain how decisions can be made when people has concerns of other people. Game theory involves players making the decision that benefit themselves jointly or maximize individual payoff. It is commonly used in the business world where vital decisions are made concerning production, processing and marketing. Game theory involves the application of players, information, actions, strategies, payoffs, equilibrium and outcomes. The theory has its rules and game theorist uses them to predict equilibrium outcome. One of the world bodies that utilize game theory in its operation is OPEC. The study focuses to find the extent of game theory in OPEC and the effect of member’s and non member’s states on the strategies in production and market share. OPEC is an intergovernmental group formed by Venezuela, Kuwait and other countries in 1960. The organization aimed to seize the benefit of controlling the supply to maximize revenue of member states. The organization also aimed at stabilizing and bringing agreement in the marketplace of fuel to do good to both consumers and producers. This was a common strategy employed to try and influence the prices of crude oil. The idea of OPEC in the initial stages was to prevent the fall of prices after an all time high that enabled oil producing countries maximize on their utility. OPEC is referred to as a global cartel in the oil producing countries. Classical economist present a condition that monopolist utilize to maximize profit, MC= P (1-1/e) given that P is the price of oil, e is the elasticity of demand and MC represent marginal cost of oil production. Economist hint that oil price are inelastic in the short run, and OPEC can increase above the market price. (Source: Dye 2) Supposing that there are two firms in a cartel, the maximizing price would be where marginal cost 1 = marginal cost 2 = marginal revenue. The maximizing price would be where the two marginal costs meet marginal revenue. OPEC member’s state has a reserve of 79.3% of the world crude oil and was producing 63% of the global oil export in 2009. OPEC does not use market force s for marginal revenue and marginal cost to determine equilibrium price. Free market would result with some countries producing none while others benefiting so much to the extent of controlling production. For example, Saudi Arabia could benefit more than the rest of the country because it has vast oil reserves and therefore it can afford to increase production at a lower price. Therefore, free competitive market is not possible in the oil production industry and it explains the reason behind forming a cartel (Gambits 3). In order to maximize utility, OPEC considered strategies to control production through quotas system. Every nation state produces a certain percentage of production capacity. However, the challenges facing OPEC is on determining the actual or the maximizing quota that each member’s state produces. The solution to these challenges lies on game theory (Gately 1). The OPEC members have a duty to have the same opinion on a strategy to restrict output such that prices are prolonged at a high level. Nevertheless, some scholars like Friedman argued that Arab countries cartel on oil production would collapse because high prices of petroleum are not sustainable even if the output is put to zero. OPEC, unlike other bodies, is exceptional. The decisions agreed upon are of decisive to every member and failure to adhere has dire consequences. This strength of OPEC has ensured the sustainability of world prices today and will sustain even in the future. According to Osborne cartels faces inherent problem of cheating, and determining quotas and it is wrong to classify them as stable. Gately (3) says that the OPEC as a cartel is maintained at Nash equilibrium. At Nash equilibrium, every country benefits from a controlled price and output out of playing to counter each other strategy. Therefore, an attempt by one of the signatories to reduce price or increase output will result to the rest doing the same to counter on any loss of revenue or shared market. At Nash equilibrium, every player is assured that other players does not benefit more from cheating. OPEC also faces competition from non OPEC members and problem of unresponsive demand for crude oil. The organization has in the past decades used a ‘rule of the thumb’ strategy to determine the optimal price. OPEC is characterized by three players formed as association of likeminded partners with common needs and aspirations. The three players are the ‘moderates,’ who are Kuwait, Saudi Arabia, Qatar, Libya and UAE, the ‘price pushers’, who include Venezuela, Algeria and Iran, and finally the ‘expansionist fringe,’ that include Nigeria, Indonesia, Gabon, Ecuador and Iraq. In the game theory, the three players have got three options on which to control prices and output. First, the moderate, fringe and price pushers may agree on the price and output at which they are all better off. In the second option, the moderates and price pushers may agree on the price and output to be produced leaving the fringe to be an output maximize and a price taker. The last option all players set their own price and output, but the moderate being the price setters. Observing the behaviors of the player’s reveals that the price takers (fringe and price pushers) maximize on output and if they restrict their output they become supply restricting. On the other hand, the price setting players (moderate and price pushers) have a variety of strategies as price and output setters. When players act independently, only the moderate has control over the current prices and the supply restricting has no power since only the moderate control the market. According to Gately (6), supply restricting countries exists to ensure strategies are adopted. Hence, adoption of a common price and output strategy may be vetoed by fringe coalition. However, because fringe has no power in option two and three where they are price takers, it has no better option but to accept payoffs strategies of moderates and price pusher’s countries. The price pushers can veto a common decision by all parties and a coalition of them and moderates, but it have to accept payoff when moderates have their strategy to control prices. Payoffs to a given strategy by the three players represent a time flow to future profits calculated using present currency value of a profit stream. The uniqueness of the three players makes them have time stream of the future and present profits. The moderates have 3% while price pushers have 10%, and expansionist fringe has 15 % (Gately 6) The world market faces a lot of challenges and uncertainty. It is not difficult to known or speculates short and long run elasticity of prices for OPEC and non OPEC demand and supply, the growth of future income, elasticity of demand and expectations of market for members and non members. The uncertainty increases more when future technological change and exploration of new oil reserves are unknown. If future challenges were certain, it would be easier for OPEC to determine payoffs strategies and present it in a matrix form. This would enable the OPEC members in determining the best payoffs that maximizes utility. However, because the situations are different the price and output determination is different, and this explains the variance in degree of cooperation. In a Cournot model, the operation of OPEC members can be explained using the “prisoner’s dilemma’ game theory strategies (Zhen 21). Decision making on price and output is the doubting task of all OPEC members. Presented with the high price of oil, there is pressure in the organization to increase production, but some of the members have strong economies and disregard further increase of oil prices. Countries such as Saudi Arabia view increase in prices of crude oil as an ‘evil act’ to escalate the global price level. The OPEC cartel members are faced with a ‘prisoner dilemma’ phenomenon. According to the ‘prisoner’s dilemma,’ there arises questions on whether the introduction of the quota system helps members state collude. Moreover, if they do not, is there a possibility those others members will comply with rules or they would not comply. Moreover, if members failed to comply and produce more crude oil, the cost per a barrel of crude oil will drop. Therefore, OPEC members are in a dilemma of whether to comply with quotas and earn a substantial income or cheat and face consequences of price decline. For example, if all members decide to comply with organization quota then they are said to have a dominated strategy. Member’s who pretend to observe quota, but cheat on the sideline has a dominating strategy over other member’s state. Therefore, defecting and non compliance is a dominating strategy to maximize profits (Stanford University 8). According to Zenz the dilemma among the OPEC members on whether to capitalize on individualism when determining prices and output demonstrate the harmful effect the group can undergo. Zenz says that the ‘prisoner dilemma’ in OPEC explains why the free market where actors aim to maximize utility may not achieve maximum utility. The organization vision was to limit production, but it has faced difficulties in ensuring that all members comply. Some of the OPEC members have been ruled by dictators, who have relied on oil revenue to grip into power, thus the temptation for non compliance. The realization of cheating of other oil producing country enables increased supply and relative low prices. Zhen (24) argue that though OPEC is a cartel, it does follow the rule of other cartels in drugs and other ventures. The organization does not exercise absolute monopoly in determining the market price of oil. It determines output and prices of members state. The determination of prices involves subtracting the supply of non member’s state from the market demand and then allocating the remaining market demand to its members. According to Selten’s theorem, repeated game with unique equilibrium maintains its equilibrium in infinite repeated games. OPEC having a characteristic of Nash equilibrium cannot raise prices above it set equilibrium price as demonstrated in the graph (Vincent 9). OPEC Quotas The Economist argue that though the problem of cheating is real OPEC with countries like Venezuela and Nigeria leading the park, some members would want to comply with the organization set guideline because cheating would bring negative impact in the market. OPEC supplies 40% crude oil in the world every year with the rest supplied by non member’s states. However, it has the biggest share of oil reserve in the globe. According to The economist, cheating would require countries such as Saudi Arabia to produce more oil in expectation of increased revenue. Nevertheless, this would increase the supply and bring down the prices of petroleum. This would be detrimental given that some countries rely solely on oil revenue to drive their economies. Therefore, the strategy of cheating has an advantage to non OPEC members who encounter high cost of production. Conclusion OPEC members face a lot of challenges in organizing the strategies to maximize revenues from the production of oil. OPEC was established to harmonize output to enable the cartel control the global prices of oil. However, from time to time members has cooperated and realized Nash equilibrium. From other times, some countries eager to make more profit has been increasing production quota ways beyond the expected level. In subsequent adjustment members caught cheating destabilized the Nash equilibrium and prompts other countries to respond by increasing production. According to the ‘prison dilemma’ suspicion of the other player’s strategy in order to realize maximum benefit ends up in ruining the outcome. The organization has succeeded in the past decade but faces a greater challenge in the energy market. The world is now tilting to renewable sources of energy there is technological advancement, there is increased energy conservation and non OPEC members are producing more crude oil. Therefore, OPEC members cannot now hike the price arbitrarily rather they have to reconsider their strategies Vis a Vis the entry of new members in the market and the capabilities of oil importers. The prices of petroleum have stabilized for the reason that of the above factors have put checks on the OPEC. Work Cited Dye, A. Intermediate Microeconomics. Web Strategy &Cartels. Web. 25th Nov. 2013. . Gambits, Latin. Game Theory Problem Set: OPEC Strategy Memo. Web Berkeley Feb. 2012. Web. 25th Nov. 2013. < http://faculty.haas.berkeley.edu/rjmorgan/mba211/OPEC%20Strategy%20Memo_Latin%20Gambits.pdf>. Gately, Dermot. OPEC pricing and Output Decisions. A partition Function Approach to OPEC Stability. Web nyu edu May 1978. Web. 25th Nov. 2012. http://econ.as.nyu.edu/docs/IO/9405/RR78-09.pdf. Stanford University. Principles of Game Theory. Web Stanford Education. Web. 25th Nov. 2013. The Economist. OPEC Lying Low. Web The Economist, 2nd Jul. 1998. Web. 25th Nov. 2013. Zenz, Kurt. OPEC and the Prisoner's Dilemma. The Bulletin of the Atomic Scientists. Web Yale Global 25 Dec. 2008. Web. 25th Nov. 2013. < http://yaleglobal.yale.edu/content/opec-and-prisoners-dilemma>. Zhen, W., Juan X., and Hongyan W. “A Game Theory Analysis of the OPEC's Influence on World Oil Price.” School of Business Administration.3 (4) (2006) 25-25. Print. Read More