eco term paper mba

8/7/2019 ECO TERM PAPER MBA

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TERM

PAPER

OFMANAGERIAL ECONOMICS

Submitted to :

Mr .Mandeep Singh

Submitted by :

Manjot Kaur


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Rollno.-RS1001B59

Reg.no.11011354


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INTRODUCTIONOligopolyThe oil refining industry is an oligopoly. An oligopoly is a marketor industry where there are only few sellers of a certain productor service. Since there are only a few sellers each seller haslarge market power. Each company is awareof the actions that the other company makes and therefore

they influence each other in their actions. Each firm must usestrategic planning based on what other firms actions are or aregoing to be. This type of market creates a high risk forcollusion. When there is a formal agreement of collusion it iscalled a Cartel. OPEC is a cartel of oil producing countries thathave profound market power. OPEC decided to flex theirmuscles in the market in the 1970s and created an artificiallack in supply which drove gasoline prices sky high. Oilcompanies try to vertically integrate every process of the oil

industry. If the oil company owns the wells that produce the oil,the refineries that separate the different grades and the pumpsthat fill up cars they have immense market power. When oilcompanies merge or vertically integrate it usually costs theconsumer more money.According to aUSA Today article ("Gascosts rose after big mergers," 5/27/2004. That story details arecent US General Accounting Office (GAO) report that tracked2,600 petroleum mergers from 1991 to 2001. Most of themergers led to price risers on average, two cents higher (on the

West Coast up to seven cents higher).IN oligopoly the decisions of one firm influence, and are influenced by, the decisions

of other firms. Strategic planningby oligopolists needs to take into account the likely

responses of the other market participants. Oligopolistic competition can give rise to

a wide range of different outcomes. In some situations, the firms may employ

restrictive trade practices (collusion, market sharing etc.) to raise prices and restrict

production in much the same way as a monopoly. Where there is a formal agreement

for such collusion, this is known as a cartel. A primary example of such a cartel

is OPEC which has a profound influence on the international price of oil.
http://en.wikipedia.org/wiki/Strategic_planninghttp://en.wikipedia.org/wiki/Competitionhttp://en.wikipedia.org/wiki/Collusionhttp://en.wikipedia.org/wiki/Monopolyhttp://en.wikipedia.org/wiki/Cartelhttp://en.wikipedia.org/wiki/OPEChttp://en.wikipedia.org/wiki/Strategic_planninghttp://en.wikipedia.org/wiki/Competitionhttp://en.wikipedia.org/wiki/Collusionhttp://en.wikipedia.org/wiki/Monopolyhttp://en.wikipedia.org/wiki/Cartelhttp://en.wikipedia.org/wiki/OPEC


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Firms often collude in an attempt to stabilize unstable markets, so as to reduce the

risks inherent in these markets for investment and product developments. There are

legal restrictions on such collusion in most countries. There does not have to be a

formal agreement for collusion to take place (although for the act to be illegal there

must be actual communication between companies)for example, in some industries

there may be an acknowledged market leader which informally sets prices to which

other producers respond, known as price leadership.

In other situations, competition between sellers in an oligopoly can be fierce, with

relatively low prices and high production. This could lead to an efficient outcome

approaching perfect competition. The competition in an oligopoly can be greater than

when there are more firms in an industry if, for example, the firms were only

regionally based and did not compete directly with each other.

Thus the welfare analysis of oligopolies is sensitive to the parameter values used to

define the market's structure. In particular, the level ofdead weight loss is hard to

measure. The study ofproduct differentiationindicates that oligopolies might also

create excessive levels of differentiation in order to stifle competition.

Characteristics of oligopolistic market

Profit maximization conditions: An oligopoly maximizes profits by producingwhere marginal revenue equals marginal costs.

Ability to set price: Oligopolies are price setters rather than price takers.

Entry and exit: Barriers to entry are high. The most important barriers are

economies of scale, patents, access to expensive and complex technology, and

strategic actions by incumbent firms designed to discourage or destroy nascent firms.

Number of firms:"Few" a "handful" of sellers. There are so few firms that the

actions of one firm can influence the actions of the other firms.

Long run profits: Oligopolies can retain long run abnormal profits. High barriers

of entry prevent sideline firms from entering market to capture excess profits.

Product differentiation: Product may be standardized (steel) or differentiated

(automobiles).

Perfect knowledge: Assumptions about perfect knowledge vary but the

knowledge of various economic actors can be generally described as selective.

Oligopolies have perfect knowledge of their own cost and demand functions but their
http://en.wikipedia.org/wiki/Price_leadershiphttp://en.wikipedia.org/wiki/Perfect_competitionhttp://en.wikipedia.org/wiki/Welfare_Economicshttp://en.wikipedia.org/wiki/Dead_weight_losshttp://en.wikipedia.org/wiki/Product_differentiationhttp://en.wikipedia.org/wiki/Product_differentiationhttp://en.wikipedia.org/wiki/Price_leadershiphttp://en.wikipedia.org/wiki/Perfect_competitionhttp://en.wikipedia.org/wiki/Welfare_Economicshttp://en.wikipedia.org/wiki/Dead_weight_losshttp://en.wikipedia.org/wiki/Product_differentiation


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inter-firm information may be incomplete. Buyers have only imperfect knowledge as

to price, cost and product quality.

Interdependence:The distinctive feature of an oligopoly is

interdependence. Oligopolies are typically composed of a few large firms. Each firmis so large that its actions affect market conditions. Therefore the competing firms will

be aware of a firm's market actions and will respond appropriately. This means that in

contemplating a market action, a firm must take into consideration the possible

reactions of all competing firms and the firm's countermoves. It is very much like a

game of chess or pool in which a player must anticipate a whole sequence of moves

and countermoves in determining how to achieve his objectives. For example, an

oligopoly considering a price reduction may wish to estimate the likelihood that

competing firms would also lower their prices and possibly trigger a ruinous price

war. Or if the firm is considering a price increase, it may want to know whether other

firms will also increase prices or hold existing prices constant. This high degree of

interdependence and need to be aware of what the other guy is doing or might do is

to be contrasted with lack of interdependence in other market structures. In a PC

market there is zero interdependence because no firm is large enough to affect

market price. All firms in a PC market are price takers, information which they

robotically follow in maximizing profits. In a monopoly there are no competitors to be

concerned about. In a monopolistically competitive market each firm's effects on

market conditions is so negligible as to be safely ignored by competitors.

OLIGOPOLISTIC MARKET WITH SPECIALREFRENCE TO OPEC(Organization of Petrolium

Exporting Countries)

OPEC (Organization of Petroleum Exporting Countries)


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History of OPEC

Venezuela was the first country to move towards the establishment of OPEC byapproaching Iran, Iraq, Kuwait and Saudi Arabia in 1949, suggesting that theyexchange views and explore avenues for regular and closer communicationsbetween them. In September 1960, at the initiative of the Venezuelan Energy &Mines Ninister, Juan Pablo Prez Alfonzo, and the Saudi Arabian Energy & MinesMinister, 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 bytheir respective countries. OPEC was founded in Baghdad, triggered by a 1960 lawinstituted by American President, Dwight Eisenhower, that forced quotas onVenezuelan 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 oilproducing Arab nations as a preemptive strategy to protect the continuous autonomyand profitability of Venezuela's natural resource, oil. As a result, OPEC was foundedto unify and coordinate members' petroleum policies. Original OPEC membersinclude 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 weremembers 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 theyneeded 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 onthe first day of 2007. Indonesia re-considered its membership having become a netimporter and being unable to meet its production quota.

The United States was a member during its formal occupation of Iraq via theCoalition Provisional Authority. Indicating that OPEC is not averse to further


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expansion, Mohammed Barkindo, OPEC's Secretary General, recently asked Sudanto join. Iraq remains a member of OPEC, though Iraqi production has not been a partof any OPEC quota agreements since March 1998. In May 2008, Indonesia left theOPEC 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.

How OPEC is an Oligopoly

In an oligopoly, firms operate under imperfect competition and a kinked demandcurve 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 revenueand market share.

"Kinked" demand curves are similar to traditional demand curves, as they aredownward-sloping. They are distinguished by a hypothesized convex bend with adiscontinuity at the bend - the "kink". Therefore, the first derivative at that point isundefined and leads to a jump discontinuity in the marginal revenue curve.

Above the kink, demand is relatively elastic because all other firms' prices remainunchanged. 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 bestoption for the oligopolist is to produce at point E, which is the equilibrium point and,

incidentally, the kink point.


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DEMAND CURVE:

Classical economictheory assumes that aprofit-maximizingproducer with somemarket power (eitherdue to oligopoly ormonopolistic

competition) will setmarginal costs equal tomarginal revenue. Thisidea can be envisionedgraphically by theintersection of anupward-sloping marginalcost curve and a

downward-sloping marginal revenue curve (because the more one sells, the lowerthe price must be, so the less a producer earns per unit). In classical theory, anychange in the marginal cost structure (how much it costs to make each additional

unit) or the marginal revenue structure (how much people will pay for each additionalunit) will be immediately reflected in a new price and/or quantity sold of the item. Thisresult does not occur if a "kink" exists. Because of this, jump discontinuity in themarginal revenue curve, marginal costs could change without necessarily changingthe price or quantity.

The motivation behind this kink is the idea that in an oligopolistically ormonopolistically competitive market, firms will not raise their prices because even asmall price increase will lose many customers. However, even a large price decreasewill 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.

Basically OPEC acts as monopoly not because of it's command over oil market, butdue to the following reasons.

OPEC has stood the test of time, and since its creation, has proven to be one of themost 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

Demand Curves for an Oligopolist


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cartel to successfully control a market, there must be complete cooperation and trustamong members.

OPEC's history exemplifies and supports this statement. In 1973 and 1974, all ofOPEC'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, in1995, OPEC set a price target of twenty-one dollars, but as a result of deception anda lack of trust among member states, some members exceeded their quotas and theover-production and consequent flooding of the market caused the price to fall wellbelow the twenty-one dollar goal. Still, despite devious actions by some memberstaking advantage of the organization, OPEC continues to hold sway over the tradingof petroleum globally. OPEC became oligopolist, because of its competitors.

ANALYSISThe Organisation of Petroleum Exporting Countries orOPEC has tried in thepast to influence the price of oil. OPEC is dominated by the Arab oil producers ofthe Persian Gulf, particularly Saudi Arabia. The world oil production market is anoligopoly. OPEC acts as a cartel- another name for an oligopoly of producers of acommodity.

Production is dominated by a relatively small number of nations (whose oilsupplies are nationalised assets, and controlled by their governments.) If OPEC andother oil exporters did not compete, they could ensure much higher prices for pricesfor everyone.

Oil refining is also another oligopoly, dominated by the ''seven sisters'';multinational oil companies like BP, Shell, and Exxon.

In March 1986, the ''spot'' price for crude oil (in US$ per barrel) was US$26.10. BySeptember 1986, the price fell to US$22 per barrel. In March, 1987, the price ofcrude oil slumped further, to US$18.00 per barrel. By December, 1987, the price

hit a record low of US$16 per barrel. What was going on?

OPEC can only influence world oil prices if all its members agree to abide byproduction quotas that are set for each member nation. OPEC could become aneffective cartel or uncompetitive market supplier, if all its members agreed to''carve up'' the market, and restrict sales. However, the temptation to ''cheat'', andproduce more than your quota proved impossible to resist for some nations,especially Iran and Iraq, which were involved in a bitter war throughout the 1980's.Both these nations needed oil revenues to pay for food and for military supplies.

If organizations behave in cooperative mode to mitigate the competitions amongst


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themselves it is called Collusion. When two or more organizations agree to set theiroutputs or prices to maintain monopoly it is called as collusive oligopoly.

OPEC acts as a cartel. If OPEC and other oil exporters did not compete, they couldensure much higher prices for prices for everyone.Output quotas of its members produced staggering price increases (from $1.10 to$11.50 per barrel in the early 1970's, and up to $34.00in the late 1970's: an increase of 3400% in ten years).The relative success of OPEC can be attributed to the following advantages it hasenjoyed relative to other cartels:

1. The low price elasticity of oil demand implies that moderate output restrictionsincreases price in short run - a favorable environment for a cartel. In 1973 OPECoutput

contributed two-thirds of the total world oil production.

2. In 1975 OPEC countries had a substantial market power of 70 %.

3. The effectiveness of OPEC is further enhanced since just four countries(Saudi, Arabia, Kuwait, Iran and Venezuela) regulate 75% of OPECs oilreserves,.

4. Exploration, production and building new supplies is time consuming and thismitigates the threat of any challenge to OPEC from increased production by nonmembers.

5. Policies of oil importing nations like US have benefittedOPEC e.g. low prices discouraging production and exploration ;environmentrestrictionson the mining and use of coal slowed the transition to coal as anotherenergy alternative. On one hand domestic consumption was encouragedand production was discouraged resulted in additional demand for oil fromOPEC.

CRITICAL ANALYSIS:

The Organization of Petroleum Exporting Countries has a membership of 11 countriesranging from United Arab Emirates to the Socialist People's Libyan Arab. Themembers of OPEC currently supply more than 40 per cent of the world's oil and theypossess about 78 per cent of the world's total proven crude oil reserves.

Our world economy depends upon petroleum; petroleum, in fact, has shaped themodern world. It has dictated production technologies and methods. It hasfacilitated the emergence of a worldwide transportation network. It has allowed citesto grow and expand, and determined the spatial landscape of regions. Due to ourgreat need for petroleum, the scope of OPEC's power surpasses our prowess as an

economic superpower, considering OPEC regulates the output and the price of oilfrom their reserves.


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Twice a year, the OPEC MCs meet in Vienna, Austria to coordinate their oilproduction policies in order to help stabilize the oil market and to help oil producers(the involved countries) achieve a reasonable rate of return on their investments. Thispolicy is also designed to ensure that oil consumers continue to receive stable

supplies of oil.

OPEC COUNTRIES

Impact of OPEC on Oil Prices

This table shows us how much the OPEC countries are depending on oil exportingcompared to total exports of country.

OPEC MemberCountry

Total Value ofExports (Million US

Dollars)

Value of PetroleumExports (Million US

Dollars)

Percent of Total ExportsMade Up of Petroleum

Exports

Venezuela 18543 13737 74%

Nigeria 12087 11724 97%

Algeria 11046 7008 63%Libia 7960 7763 98%


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SaudiArabia

50183 42502 85%

Iraq 567 461 81%

Iran 18346 14944 81%

Indonesia 45417 6441 14%

Kuwait 13036 12217 94%Qatar 3610 2987 83%

United ArabEmirates

24028 12349 51%

Data collected from official website of OPEC (www.opec.org)

The above table shows how much oil is being exported by OPEC countries whichare 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 naturalgas. In the above table, Libia, Saudi Arabia, Iraq, Nigeria, Iran, Kuwait, Qatar are the

countries which are exporting 80% of oil in their total exports. These are the countriesnamed as oil ores of world. These 7 countries are exporting above 50% of share ofOPEC exports and 30% in total exports of oil worldwide.

Recently, the decline in oil prices is not only due to economical crisis around theworld but due to impact of U.S.A. on Kuwait, which is one of OPEC country. Due tosub-prime crisis, U.S.A. faced lack of liquidity cash, then it forced Kuwait to increasethe crude oil production, which is against the rules of OPEC, then the price of onebarrel reduced almost to $ 100 from $ 147.

This will show us how OPEC countries has influence over the oil prices.

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 thedemand for oil worldwide.


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

From the above graph, we are going to explain what the capacity of crude oil is fromoil exporting countries (including non-OPEC). In the above graph, the blue lineindicates what is the demand of oil from 2001 to 2008 and the bars indicate thecapacity of OPEC and non-OPEC countries. From the graph, we can say that thedemand for oil is going on increasing but the capacity of production of crude oil iscomparatively 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 isreduced due to the fluctuating economic conditions around the world.

Impact of Oil Prices on Countries' Economy

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 inoil prices in 1974 and then again in 1979 were important factors in producing aslowdown in the world economy at a time when inflation was rising. Recent increasesin oil prices have caused concern.


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OPEC net oil export revenues for 1971 - 2007

After 1980, oil prices began a six-year decline that culminated with a 46 percent pricedrop in 1986. This was due to reduced demand and over-production that produced a

glut on the world market. Around this period, Iraq also increased its oil production tohelp pay for the Iran-Iraq War. Overall OPEC lost its unity and thus its net oil exportrevenues fell in the 1980s.

Responding to war and low prices

Main articles: Oil price increase of 1990andOil price increases since 2003

Leading up to the 1990-91 Gulf War, Iraqi President Saddam Hussein advocated thatOPEC push world oil prices up, thereby helping Iraq, and other member states,service debts. But the division of OPEC countries occasioned by the Iraq-Iran War

and the Iraqi invasion of Kuwait marked a low point in the cohesion of OPEC. Oncesupply disruption fears that accompanied these conflicts dissipated, oil prices beganto slide dramatically.

After oil prices slumped at around $15 a barrel in the late 1990s, concerteddiplomacy, sometimes attributed to Venezuelas president Hugo Chvez, achieved acoordinated scaling back of oil production beginning in 1998. In 2000, Chvez hostedthe first summit of heads of state of OPEC in 25 years. The next year, however, theSeptember 11, 2001 attacks against the United States, the following invasion ofAfghanistan, and 2003 invasion of Iraq andsubsequent occupation prompted a surgein oil prices to levels far higher than those targeted by OPEC during the precedingperiod. Indonesia withdrew from OPEC to protect its oil supply interests.

On November 19, 2007, global oil prices reacted strongly as OPEC members spokeopenly about potentially converting their cash reserves to the euro and away from theUS dollar.

Conclusion

From all the above discussions and data analysis, I conclude that OPEC is an inter-governmental organization which will control the major oil producing countries. Eventhough the non-OPEC countries are also present but these are not working underone 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 less.
http://en.wikipedia.org/wiki/Iran-Iraq_Warhttp://en.wikipedia.org/wiki/Oil_price_increase_of_1990http://en.wikipedia.org/wiki/Oil_price_increases_since_2003http://en.wikipedia.org/wiki/Gulf_Warhttp://en.wikipedia.org/wiki/Saddam_Husseinhttp://en.wikipedia.org/wiki/Iraq-Iran_Warhttp://en.wikipedia.org/wiki/Iraqi_invasion_of_Kuwaithttp://en.wikipedia.org/wiki/Hugo_Ch%C3%A1vezhttp://en.wikipedia.org/wiki/September_11,_2001_attackshttp://en.wikipedia.org/wiki/War_in_Afghanistan_(2001%E2%80%93present)http://en.wikipedia.org/wiki/War_in_Afghanistan_(2001%E2%80%93present)http://en.wikipedia.org/wiki/2003_invasion_of_Iraqhttp://en.wikipedia.org/wiki/Occupation_of_Iraqhttp://en.wikipedia.org/wiki/Occupation_of_Iraqhttp://en.wikipedia.org/wiki/Iran-Iraq_Warhttp://en.wikipedia.org/wiki/Oil_price_increase_of_1990http://en.wikipedia.org/wiki/Oil_price_increases_since_2003http://en.wikipedia.org/wiki/Gulf_Warhttp://en.wikipedia.org/wiki/Saddam_Husseinhttp://en.wikipedia.org/wiki/Iraq-Iran_Warhttp://en.wikipedia.org/wiki/Iraqi_invasion_of_Kuwaithttp://en.wikipedia.org/wiki/Hugo_Ch%C3%A1vezhttp://en.wikipedia.org/wiki/September_11,_2001_attackshttp://en.wikipedia.org/wiki/War_in_Afghanistan_(2001%E2%80%93present)http://en.wikipedia.org/wiki/War_in_Afghanistan_(2001%E2%80%93present)http://en.wikipedia.org/wiki/2003_invasion_of_Iraqhttp://en.wikipedia.org/wiki/Occupation_of_Iraq


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Even the experts says that OPEC is monopoly, but due to the presence of non-OPEC countries which will also affect the oil prices and cause competition to affectfixing prices of crude oil, which will shows us that OPEC is an oligopolist.

References www.opec.org

Outlook Profit Supplementary September 2008 Edition, which is published onOIL & GAS Reckoner

OPEC Annual Reports

Organization of the Petroleum Exporting Countries Monthly Oil Market Report,July 2008

www.google.co.in

www.wikipedia.com

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