Oligopoly Market Structure
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To gauge what future actions OPEC may take we have to understand the different market structures. A monopoly is a market structure wherein there is a single seller that dictates the price and production quantity of a good. Here the consumer is fully dependent on the single seller. An example of a monopoly is your local water utility service.
An oligopoly is a market structure where the industry is controlled by a few competing sellers who establish the price and production of goods thus considerably influencing the market. There is moderate to fair pricing in an oligopoly due to some competition involved in the market. An example of an oligopoly is our wireless service carriers.
A cartel is a different type of oligopoly. Here competing firms in the industry collude to create explicit formal agreements to fix price and production quantities among cartel members so as to fix their undifferentiated product at a higher price. In this situation cartel members benefit to the detriment of the consumers. An example of a cartel is OPEC.
There are certain welfare effects on society because of the inequalities involved in monopolies and oligopolies. In a monopoly, the seller has all to gain while the consumer loses. The consumer has to pay more for a good or may decide not to buy the good at all when price increases. This results in a deadweight loss to society, wherein consumers buy less than the competitive level of the good. In an oligopoly, firms restrict output quantity of a good to raise prices. However, because these firms are competing, price wars may occur. Society has to bear the wastage incurred by competing firms in an oligopoly for aggressive advertising and promotions. Firms also pass on to consumers the cost of time and energy they spend watching other firms in an oligopoly.
Game Theory is a study in how firms act in deliberate situations. In oligopolies, it suggests that a firm will base its quantity decision given that two dominant firms are equally positioned in the market, compete on quantities produced rather than price and assume that the other firm’s actions will not change. Firms in an oligopoly are interdependent, meaning the action of one will affect the profitability of the others, and as such are always considering the behaviour of their competition when making their own economic decisions. In a cartel, Game Theory suggests that cartels are essentially unstable due to their Prisoner’s Dilemma behaviour. Each member of a cartel can realize higher profits by breeching the agreement. However, should all members break the agreement, then they would all be worse off.
OPEC’s economic purpose is to limit oil production for higher prices for its oil. It sets the amount to be produced by the cartel members in order to maximize its profits. In the past five years, with the increasing demand in oil and geopolitical events, we have experienced a continuous increase in the prices of oil in the market.
OPEC is a cartel of countries producing oil, a homogenous product. These oil producing countries have formed a formal organization in order to limit the quantity of oil produced by its members in order to command a higher price for its product in the world market. OPEC has been busy monitoring its members to reign in those who have attempted to breech the agreement of the cartel. In the past years, a number of their members have broken the agreement by producing more oil for short-term profitability. With the continuous increase in demand for oil and unsettling geopolitical events in the Middle East, OPEC will continue to limit quantity of oil produced. However, they may try to restore prices to a reasonable level so as to prevent non-cartel members and the fuel alternative industry from getting a share of the market.