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TERM

PAPER
OF
MANAGERIAL ECONOMICS

Submitted to :
Mr .Mandeep Singh
Submit
ted by :
Manjo
t Kaur
Roll
no.-RS1001B59
Reg.no.
11011354
INTRODUCTION
Oligopoly
The oil refining industry is an oligopoly. An oligopoly is a market
or industry where there are only few sellers of a certain product
or service. Since there are only a few sellers each seller has
large market power. Each company is aware
of the actions that the other company makes and therefore
they influence each other in their actions. Each firm must use
strategic planning based on what other firm’s actions are or are
going to be. This type of market creates a high risk for
collusion. When there is a formal agreement of collusion it is
called a Cartel. OPEC is a cartel of oil producing countries that
have profound market power. OPEC decided to flex their
muscles in the market in the 1970’s and created an artificial
lack in supply which drove gasoline prices sky high. Oil
companies 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 pumps
that fill up cars they have immense market power. When oil
companies merge or vertically integrate it usually costs the
consumer more money. According to a USA Today article ("Gas
costs rose after big mergers," 5/27/2004. That story details a
recent US General Accounting Office (GAO) report that tracked
2,600 petroleum mergers from 1991 to 2001. Most of the
mergers 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 planning by 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.
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 of dead weight loss is hard to
measure. The study of product differentiation indicates 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 producing
where 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
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 firm
is 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 SPECIAL


REFRENCE TO OPEC(Organization of Petrolium
Exporting Countries)

OPEC (Organization of Petroleum Exporting 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 P�rez 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.

How OPEC is an Oligopoly


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.
DEMAND CURVE:

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. This
idea can be envisioned
graphically by the
intersection of an
Demand Curves for an Oligopolist 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 (how much it costs to make each additional
unit) or the marginal revenue structure (how much people will pay for each additional
unit) will be immediately reflected in a new price and/or 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 or


monopolistically 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.

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

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.

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

Production is dominated by a relatively small number of nations (whose oil


supplies are nationalised assets, and controlled by their governments.) If OPEC and
other oil exporters did not compete, they could ensure much higher prices for prices
for 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. By
September 1986, the price fell to US$22 per barrel. In March, 1987, the price of
crude 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 by
production quotas that are set for each member nation. OPEC could become an
effective cartel or uncompetitive market supplier, if all its members agreed to
''carve up'' the market, and restrict sales. However, the temptation to ''cheat'', and
produce 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


themselves it is called Collusion. When two or more organizations agree to set their
outputs 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 could
ensure 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 $34.00
in the late 1970's: an increase of 3400% in ten years).
The relative success of OPEC can be attributed to the following advantages it has
enjoyed relative to other cartels:

1. The low price elasticity of oil demand implies that moderate output restrictions
increases price in short run - a favorable environment for a cartel. In 1973 OPEC
output
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 OPEC’s oil
reserves,.

4. Exploration, production and building new supplies is time consuming and this
mitigates the threat of any challenge to OPEC from increased production by non
members.

5. Policies of oil importing nations like US have benefitted


OPEC e.g. low prices discouraging production and exploration ;environment
restrictions on the mining and use of coal slowed the transition to coal as another
energy alternative. On one hand domestic consumption was encouraged
and production was discouraged resulted in additional demand for oil from
OPEC.

CRITICAL ANALYSIS:
The Organization of Petroleum Exporting Countries has a membership of 11 countries
ranging from United Arab Emirates to the Socialist People's Libyan Arab. The
members of OPEC currently supply more than 40 per cent of the world's oil and they
possess about 78 per cent of the world's total proven crude oil reserves.

Our world economy depends upon petroleum; petroleum, in fact, has shaped the
modern world. It has dictated production technologies and methods. It has
facilitated the emergence of a worldwide transportation network. It has allowed cites
to grow and expand, and determined the spatial landscape of regions. Due to our
great 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 oil
from their reserves.
Twice a year, the OPEC MCs meet in Vienna, Austria to coordinate their oil
production 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. This
policy 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 exporting
compared to total exports of country.

Total Value of Value of Petroleum Percent of Total Exports


OPEC Member
Exports (Million US Exports (Million US Made Up of Petroleum
Country
Dollars) Dollars) Exports
Venezuela 18543 13737 74%
Nigeria 12087 11724 97%
Algeria 11046 7008 63%
Libia 7960 7763 98%
Saudi
50183 42502 85%
Arabia
Iraq 567 461 81%
Iran 18346 14944 81%
Indonesia 45417 6441 14%
Kuwait 13036 12217 94%
Qatar 3610 2987 83%
United Arab
24028 12349 51%
Emirates

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

The above 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 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 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, 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 $ 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 the
demand for oil worldwide.
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 from
oil exporting countries (including non-OPEC). In the above graph, the blue line
indicates what is the demand of oil from 2001 to 2008 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' 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 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.

1973 oil embargo

Main article: 1973 oil crisis

Long-term oil Prices, 1861-2007 (orange line adjusted for inflation, blue not
adjusted).

The persistence of the Arab-Israeli conflict finally triggered a response that


transformed OPEC into a formidable political force. After the Six Day War of 1967,
the Arab members of OPEC formed a separate, overlapping group, the Organization
of Arab Petroleum Exporting Countries, for the purpose of centering policy and
exerting pressure on the West over its support of Israel. Egypt and Syria, though not
major oil-exporting countries, joined the latter grouping to help articulate its
objectives. Later, the Yom Kippur War of 1973 galvanized Arab opinion. Furious at
the emergency re-supply effort that had enabled Israel to withstand Egyptian and
Syrian forces, the Arab world imposed the 1973 oil embargo against the United
States and Western Europe, while non-Arab OPEC members did not.

The 1980s oil gluts

Main article: 1980s oil glut


OPEC net oil export revenues for 1971 - 2007

After 1980, oil prices began a six-year decline that culminated with a 46 percent price
drop 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 to
help pay for the Iran-Iraq War. Overall OPEC lost its unity and thus its net oil export
revenues fell in the 1980s.

Responding to war and low prices

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

Leading up to the 1990-91 Gulf War, Iraqi President Saddam Hussein advocated that
OPEC 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. Once
supply disruption fears that accompanied these conflicts dissipated, oil prices began
to slide dramatically.

After oil prices slumped at around $15 a barrel in the late 1990s, concerted
diplomacy, sometimes attributed to Venezuela’s president Hugo Chávez, achieved a
coordinated scaling back of oil production beginning in 1998. In 2000, Chávez hosted
the first summit of heads of state of OPEC in 25 years. The next year, however, the
September 11, 2001 attacks against the United States, the following invasion of
Afghanistan, and 2003 invasion of Iraq and subsequent occupation prompted a surge
in oil prices to levels far higher than those targeted by OPEC during the preceding
period. Indonesia withdrew from OPEC to protect its oil supply interests.

On November 19, 2007, global oil prices reacted strongly as OPEC members spoke
openly about potentially converting their cash reserves to the euro and away from the
US 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. 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 less.
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 affect
fixing 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 on


OIL & GAS Reckoner

 OPEC Annual Reports

 Organization of the Petroleum Exporting Countries Monthly Oil Market Report,


July 2008

 www.google.co.in

 www.wikipedia.com