Oligopoly

An oligopoly is a market form in which a market or industry

is dominated by a small number of sellers (oligopolists). The

word is derived from the Greek for few (entities with the

right to sell). Because there are few participants in this type

of market, each oligopoly is aware of the actions of the

others. The decisions of one firm influence, and is

influenced by the decisions of other firms. Strategic

planning by oligopolists always involves taking into account

the likely responses of the other market participants. This

causes oligopolistic markets and industries to be at the

highest risk for collusion.

In an oligopoly, firms operate under imperfect competition

and a kinked demand curve which reflects inelasticity below

market price and elasticity above market price, the product

or service firms offer are differentiated and barriers to

entry are strong. Following from the fierce price

competitiveness created by this sticky-upward demand

curve, firms utilize non-price competition in order to accrue

greater revenue and market share.

"Kinked" demand curves are similar to traditional demand

curves, as they are downward-sloping. They are

distinguished by a hypothesized convex bend with a

discontinuity at the bend - the "kink". Therefore, the first

derivative at that point is undefined and leads to a jump

discontinuity in the marginal revenue curve.

Above the kink, demand is relatively elastic because all

other firms' prices remain unchanged. Below the kink,

demand is relatively inelastic because all other firms will

introduce a similar price cut, eventually leading to a price

war. Therefore, the best option for the oligopolist is to

produce at point E, which is the equilibrium point and,

incidentally, the kink point.

Classical economic theory assumes that a profit-maximizing

producer with some market power (either due to oligopoly or

monopolistic competition) will set marginal costs equal to

marginal revenue i.e. MC= MR.

This idea can be envisioned graphically by the intersection

of an upward-sloping marginal cost curve and a downward-

sloping marginal revenue curve (because the more one sells,

the lower the price must be, so the less a producer earns

per unit). In classical theory, any change in the marginal

cost structure or the marginal revenue structure will be

immediately reflected in a new price and quantity sold of the

item. This result does not occur if a "kink" exists. Because of

this, jump discontinuity in the marginal revenue curve,

marginal costs could change without necessarily changing

the price or quantity.

The motivation behind this kink is the idea that in an

oligopolistically competitive market, firms will not raise

their prices because even a small price increase will lose

many customers. However, even a large price decrease will

gain only a few customers, because such an action will begin

a price war with other firms. The curve is, therefore, more

price-elastic for price increases and less so for price

decreases. Firms will often enter the industry in the long

run.

Cartels

Cartels imply direct agreement among competing

oligopolists. 

The aim is reducing uncertainty and maximization of

joint profits.

The firms appoint a central agency, which decides not

only the total quantity and the price but also the

allocation of production among the members of the

cartel and distribution of profits among them.

 

Forms of Cartels

There are two forms of cartels -

Cartels aiming at joint profit maximization.

Cartels aiming at sharing of the market.

In any cartel, success in the short run sets in motion events

which make maintaining success nearly impossible. A

successful cartel raises prices which encourage consumers

to cut demand and potential producers to enter the market.

OPEC (Organization of Petroleum Exporting Countries) is a permanent, inter-governmental

organization, established at the Baghdad Conference held in

Iraq, 10-14 September 1960, presently working with 13

nations. Its objective is to coordinate and unify

petroleum policies among Member Countries, in order to

secure a steady income to the producing countries, an

efficient, economic and regular supply of petroleum to

consuming nations; and a fair return on capital to those

investing in the petroleum industry.

In this report, we are going to analyze how the OPEC is

acting as oligopoly in petroleum industry, how OPEC has

impact on oil prices and how it impacts the economy of

world countries.

History of OPEC

Venezuela was the first country to move towards the

establishment of OPEC by approaching Iran, Iraq, Kuwait

and Saudi Arabia in 1949, suggesting that they exchange

views and explore avenues for regular and closer

communications between them.

In September 1960, at the initiative of the Venezuelan

Energy & Mines Ninister, Juan Pablo Pérez Alfonzo, and the

Saudi Arabian Energy & Mines Minister, Abdullah al-Tariki,

the governments of Iraq, Iran, Kuwait, Saudi Arabia and

Venezuela met in Baghdad to discuss the reduction in price

of crude oil produced by their respective countries.

OPEC was founded in Baghdad, triggered by a 1960 law

instituted by American President, Dwight Eisenhower, that

forced quotas on Venezuelan oil imports in favor of the

Canadian and Mexican oil industries. Eisenhower cited

national security, land access to energy supplies at times of

war.

Venezuela's President, Romulo Betancourt, reacted seeking

an alliance with oil producing Arab nations as a preemptive

strategy to protect the continuous autonomy and

profitability of Venezuela's natural resource, oil.

As a result, OPEC was founded to unify and coordinate

members' petroleum policies. Original OPEC members

include Iran, Iraq, Kuwait, Saudi Arabia, and Venezuela.

Between 1960 and 1975, the organization expanded to

include Qatar (1961), Indonesia (1962), Libya (1962), the

United Arab Emirates (1967), Algeria (1969), and Nigeria

(1971). Ecuador and Gabon were members of OPEC, but

Ecuador withdrew on December 31, 1992 because they were

unwilling or unable to pay a $ 2 million membership fee and

felt that they needed to produce more oil than they were

allowed to under the OPEC quota.

Similar concerns prompted Gabon to follow suit in January

1995. Angola joined on the first day of 2007. Indonesia re-

considered its membership having become a net importer

and being unable to meet its production quota.

The United States was a member during its formal

occupation of Iraq via the Coalition Provisional Authority.

Indicating that OPEC is not averse to further expansion,

Mohammed Barkindo, OPEC's Secretary General, recently

asked Sudan to join. Iraq remains a member of OPEC,

though Iraqi production has not been a part of any OPEC

quota agreements since March 1998.

In May 2008, Indonesia left the OPEC group because of the

soaring prices and the rising oil demand in East Asia.

Economists think that the withdrawal of Indonesia will have

little effect on OPEC and on the oil prices even though it has

a high percentage in world oil production.

OPEC has stood the test of time, and since its creation, has

proven to be one of the most prosperous and effective

industrial monopoly alliances the world has known.

Notwithstanding OPEC's success as a market controlling

power, noncompliance and cheating by members have

caused some problems along the way. In order for a cartel to

successfully control a market, there must be complete

cooperation and trust among members.

OPEC's history exemplifies and supports this statement. In

1973 and 1974, all of OPEC's member nations worked

together under the parameters established by the

organization, and in turn, were able to raise the price of oil

four-fold. Contrarily, in 1995, OPEC set a price target of

twenty-one dollars, but as a result of deception and a lack of

trust among member states, some members exceeded their

quotas and the over-production and consequent flooding of

the market caused the price to fall well below the twenty-

one dollar goal. Still, despite devious actions by some

members taking advantage of the organization, OPEC

continues to hold sway over the trading of petroleum

globally. OPEC became oligopolist, because of its

competitors.

The success of OPEC in the 1970s triggered conservation,

substitution, and new production in the 1980s. While oil

prices are currently stable, it is clear that in the history of

OPEC and demand for oil will continue to rise. Moreover,

the lack of major oil finds in the last twenty years implies

(but obviously does not guarantee) that supply will grow

only slowly. Unless a cheap alternative source of energy is

discovered in the meantime, this combination of effects will

create an environment conducive to cartelization.

Impact of OPEC on Oil Prices

This table shows us how much the OPEC countries are

depending on oil exporting compared to total exports of

country.

OPEC

Member

Country

Total Value

of Exports

(Million US

Dollars)

Value of

Petroleum

Exports

(Million US

Dollars)

Percent of Total

Exports Made

Up of Petroleum

Exports

  

Venezuela18543    13737    74%   

   Nigeria 12087    11724    97%   

   Algeria 11046    7008    63%   

   Libya 7960    7763    98%   

   Saudi

   Arabia50183    42502    85%   

   Iraq 567    461    81%   

   Iran 18346    14944    81%   

  

Indonesia45417    6441    14%   

   Kuwait 13036    12217    94%   

   Qatar 3610    2987    83%   

   United

Arab

   Emirates

24028    12349    51%   

Data collected from official website of OPEC

(www.opec.org)

The table shows how much oil is being exported by OPEC

countries which are compared to the total exports of the

particular OPEC country. This total export is almost 41% of

total production oil worldwide and 15% of total production

of natural gas.

In the table, Libya, Saudi Arabia, Iraq, Nigeria, Iran,

Kuwait, Qatar are the countries which are exporting 80% of

oil in their total exports. These are the countries named as

oil ores of world . These 7 countries are exporting above

50% of share of OPEC exports and 30% in total exports of

oil worldwide.

Recently, the decline in oil prices is not only due to

economical crisis around the world but due to impact of

U.S.A. on Kuwait, which is one of OPEC country. Due to sub-

prime crisis, U.S.A. faced lack of liquidity cash, and then it

forced Kuwait to increase the crude oil production, which is

against the rules of OPEC, then the price of one barrel

reduced almost to $ 75 from $ 147.

Factors Affecting Oil Prices

There are so many factors which influence oil prices.

Industrialization, globalization, scarcity of crude oil

resources are some factors.

Now we are going to analyze the availability of (capacity)

crude oil resources and the demand for oil worldwide.

Source: Outlook Profit, Sep. 2008, Supplementary on OIL &

GAS Reckoner

The graph explains the capacity of crude oil from oil

exporting countries (including non-OPEC). In the graph, the

blue line indicates what the demand of oil from 2001 to 2008

is and the bars indicate the capacity of OPEC and non-OPEC

countries. From the graph, we can say that the demand for

oil is going on increasing but the capacity of production of

crude oil is comparatively less, which will cause increase in

the oil prices.

But in recent times, the crude oil price is reducing because

of stagflation worldwide, so the availability of liquid cash is

less, and the purchase capability of industries is reduced

due to the fluctuating economic conditions around the

world.

Impact of Oil Prices on Countries' Economies

Oil price has its own impact on global economy and

individual countries' economy.

Changes in oil prices have been associated with major

developments in the world economy, and are often seen as a

trigger for inflation and recession. The increase in oil prices

in 1974 and then again in 1979 were important factors in

producing a slowdown in the world economy at a time when

inflation was rising. Recent increases in oil prices have

caused concern.

The Effects of a $ 10 Permanent Oil Price Increase on

Long Rates (Percent Points Different from Baseline)

Source: Outlook Profit, Sep. 2008, Supplementary on OIL &

GAS Reckoner

The above graph shows how the higher oil prices affect

output. In the long run, output falls in the US, Europe and

the Euro Area. The short run output effects are largest in

the US in part because of its higher oil intensity, and also

because the inflation effect is larger, and hence, the

monetary response is more immediate. As a result, real long

rates rise rather more than in the Euro Area.

Impact of Oil Prices on Pakistan Economy

Energy demand in Pakistan grew by 9.2 percent during

2004-05. Supplies from nuclear and LPG also showed slight

increase. The share of natural gas in primary energy during

2004-05 reached upto 50.4% followed by oil 29.4%and LPG

0.4%.

Petroleum products and gas consumption accounts for

approximately 70 percent of modern energy supply in

Pakistan. Electricity (15 percent), LPG and coal account for

the balance. The transport sector is the largest user of

petroleum products (61.5 percent), followed by power (23.5

percent); industry accounts for about 10.5 percent, and the

balance is used in other sectors – including the residential

sector. In the case of natural gas, the power sector is the

largest consumer (43.7 percent), followed by industry,

fertilizer and residential sectors (about 52 percent);

commercial and transport sectors account for the balance.

The large dependence of the power sector on petroleum

products results due to fuel oil-based Independent Power

Plants (IPP).

Petroleum Products Supply and Demand

The petroleum products account for approximately 40

percent of modern energy consumption in Pakistan.

Consumption of petroleum products grew sharply during the

1980s at about 7 percent per annum, but slowed to about

2.5 percent during late 1990s and has gained a momentum

in 2004-05 of 9.31%. Oil products consumption is highly

skewed, with nearly 83 percent in the form of high speed

diesel (HSD) and fuel oil (FO). Only 18 percent of the liquid

fuel supplies are met from local sources, and the balance is

imported in the form of either crude oil or finished products.

Natural Gas50.4%

Oil29.4%

Hydel11.0%

LPG0.4%Coal

7.6%

Nuclear1.2%

Over the past three years, gross imports of liquid fuels have

averaged 23.1million tons (MMT) per annum, generating an

import bill of some US$5.8 billion.

The consumption of petroleum products in the country

during 2003-2004 was 14.3 million tones. The drop in

consumption compared to previous year is mainly due to

lower demand of Furnace Oil because of conversion of

thermal power plants on gas and availability of additional

Hydel power. The demand is expected to increase around 17

million tones per annum by the year 2010-11. Thereafter, it

is expected to further increase to around 19 million tones by

the year 2017-18. The production of refined products by the

local refineries during the year 2003-04 was 10.27 million

tons. The deficit products import were 5 million tons in

2003-04 while it will remain around 5-6 million tons per

annum up to year 2010-11. Thereafter, it is expected to

increase to a level of around 8.0 million tons per annum by

the year 2017-18.

The long term petroleum products demand/supply scenario

is indicated in the following table:-

PROJECTED DEMAND OF PETROLEUM PRODUCTS

(In million tones)

2003-

20042004-05 2010-11 2017-18

Demand of

Petroleum

Products

14.3 15.0 17.0 19.0

Production from

Local Refineries10.3 12.0 11.3 11.8

Surplus

Naphtha / Motor

gasoline available

for exports

1.3 1.3 0.8 0.8

Deficit of HSD

and FO5.0 5.0 6.5 8.2

Source: Ministry of Petroleum & Natural

Resources

PETROLEUM PRODUCTS CONSUMPTION BY SECTOR (In tones)

Sector 2005-06 2006-07 2007-08 2008-09Growth

Rate

Domestic 334,501 282,521 231,459 192,750 -16.1%

Industrial 1,611,995 1,604,068 1,493,080 1,542,398 -6.1%

Agriculture 225,742 196,747 183,506 142,062 -13.5%

Transport 8,018,777 8,082,273 8,464,042 9,024,783 1.7%

Power 6,305,419 6,019,958 2,739,763 3,452,581 -11.1%

Other Govt. 463,654 266,387 309,263 316,686 -1.8%

Total

Consumption

16,960,08

8

16,451,95

4

13,421,11

3

14,671,26

0-3.8%

Source: Energy Book 2009, Hydrocarbon Development

Institute of Pakistan.

IMPORT OF CRUDE OIL & PETROLEUM PRODUCTS(In million tones)

2003-

04

2004-

05

2005-

06

2006-

07

2007-

08

2008-

09

Import of

Crude Oil 4.45 7.03 7.07 7.14 7.84 8.28

Import of

Petroleum

Products 11.87 10.03 9.02 8.43 5.17 5.62

Total Imports 16.3 17.06 16.09 15.57 13.01 13.90

Value in

million US $ 2,783 3,326 2,655 3,096 3,119 4,534

Source: Energy Book 2009, Hydrocarbon Development

Institute of Pakistan.

4.457.03 7.07 7.14

7.84 8.28

11.87

10.03 9.02 8.43

5.17 5.62

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

2003-04 2004-05 2005-06 2006-07 2007-08 2008-09

Import of Crude Oil Import of Petroleum Products

EXPORT OF CRUDE OIL & PETROLEUM PRODUCTS (In

tones)

2005-

06

2006-

07

2007-

082008-09

Export of Crude Oil238,60

6

240,44

4

110,00

040,599

Export of

Petroleum Product

339,84

6

394,73

1

755,96

9955,754

Total Exports 578,45

2

635,17

5

865,96

9996,353

Value in million

US$114.95 160.55 203.78 354.92

Source: Energy Book 2009, Hydrocarbon Development

Institute of Pakistan.

355,881

433,425

238,606 240,444

110,00040,350

126,485

353,469

578,452 635,175

865,9691,011,995

0%

20%

40%

60%

80%

100%

2003-04 2004-05 2005-06 2006-07 2007-08 2008-09

Export of Crude Oil Export of Petroleum Products

Source: Energy Book 2005, Hydrocarbon Development

Institute of Pakistan.

Conclusion

From all the above discussions and data analysis, we

conclude that OPEC is an inter-governmental organization

which controls the major oil producing countries. Even

though the non-OPEC countries are also present but these

are not working under one umbrella which is causing

competition with each other, and there is no scope for other

countries to enter into the market because the crude oil

resources are limited.

Even the experts say that OPEC is monopoly, but due to the

presence of non-OPEC countries which will also affect the

oil prices and cause competition to affect fixing prices of

crude oil, which will shows us that OPEC is probably the

best example of oligopoly.

References

www.opec.org

Outlook Profit Supplementary September 2008 Edition,

which is published on OIL & GAS

The Economist

Organization of the Petroleum Exporting Countries

Monthly Oil Market Report, July 2008

www.google.com

www.wikipedia.com

www.worldbank.org

www.hdip.com.pk

www.dawn.com