The Organization of the Petroleum Exporting Countries (OPEC) is an intergovernmental organization of 13 nations, founded in 1960 in Baghdad by the first five members (Iran, Iraq, Kuwait, Saudi Arabia, Venezuela). As of 2015, the 13 countries accounted for an estimated 42 percent of global oil production and 73 percent of the world’s ”proven” oil reserves, giving OPEC a major influence on global oil prices that were previously determined by American-dominated multinational oil companies. Understanding this type of dynamics in which a few countries (or firms) dominate the market being able to set the price, yet unable to raise significant barriers to entry to keep smaller competitors from entering the market entails delving into a price leadership model. Start with the following assumptions: The World Market demand for oil is given by P = 100 ? X in which X is the aggregate market quantity of crude oil barrels. This market is served by OPEC, a dominant block, and a set of infinitely many countries with smaller oil reserves which act as price-takers. In this simple example, OPEC is comprised of two dominating countries, denoted DC1 and DC2 with similar efficiencies: constant marginal costs such that: MCDC1 = MCDC2 = 50. The fringe countries have an aggregate marginal cost that can be expressed by MCSC = 50 + X. 1.
What does the shape of this inverse market demand tells you about the nature of product differentiation in this market? Does it make sense in the oil market? Explain how you got to this conclusion. 2. What does constant marginal costs for the dominant countries tells us about the nature of the production function for oil in those countries? Does it make sense in the oil market? Explain how you got to this conclusion. (Tip: Think about the nature of scale of production upon costs and how it relates to oil extraction). 3. Derive the residual demand that OPEC will operate in. (Make sure to incorporate the structural break in residual demand with its respective output range) 4. How much will each country at OPEC produce? 5. What is the resulting price of the barrel in the oil market? 6. How much are the other countries aggregately producing? 7. What is the HHI in the oil market? 8. How do you anticipate your results would change if the number of countries at OPEC increase from 2 to 13? How did you get to this conclusion? (Notice that I am not asking you to re-solve the model, but rather to utilize some of the intuitions and parallels we’ve derived in class to base your conclusion) 9. How do you anticipate your results would change if the countries in OPEC had distinct marginal costs? How did you get to this conclusion? (Notice that I am not asking you to re-solve the model, but rather to utilize some of the intuitions and parallels we’ve derived in class to base your conclusion) 10. The fact that this market is spread out across the world, and players being mostly countries instead of firms, implies that there is no type of antitrust or competition agency able to enforce rules. What does the lack of supranational competition agency entails? Would we want to have such an agency? What would be the pros and cons of something of this nature? (This question has an opinion component to it, and your answer will not be judged on whether you agree or disagree with the creation of a supranational agency. Rather the grading will be based on the quality of the arguments used to arrive to such conclusion)