“Du siehst den Wald vor lauter Bäumen nicht”

 The English equivalent for the same can be given as “You don’t see the forest for all the trees”. It means that it is always important to see the big picture. In our day to day life, if we focus on the latest victories and failures instead of seeing our lives as a whole, we are vulnerable to fate’s whims and get frustrated easily. The question still remains is how is this related to the oligopoly and oil and gas industry. Well, in the petroleum industry it has always been about the big picture. This industry has seen ups and downs in the prices for a period of every 5-10 years, along with some disastrous events.

Prelude

The oligopolistic nature of the oil can be explained in a nutshell as the producers have perfect knowledge of the consumers but consumers do not have any information about the producers or their act of influencing the prices. This practice of influencing prices sometimes results in a negative effect on the national economy. In an oligopoly, there are few producers compared to a large number of consumers. So when one firm or producer becomes the market leader, it makes others follow it or dominate them to fix prices. The producers, due to an uncompetitive market structure, enjoy heavy marginal profit by increasing or lowering the prices. This practice attracts more customers as well as restricts entry of new competitors to the market.

An example, in this context, can be given by the Organization of Petroleum Exporting Countries (OPEC). It is an intergovernmental organization of 14 nations, most of them being oil exporters. OPEC’s stated mission is “to coordinate and unify the petroleum policies of its member countries and ensure the stabilization of oil markets, in order to secure an efficient, economic and regular supply of petroleum to consumers, a steady income to producers, and a fair return on capital for those investing in the petroleum industry”. OPEC is dominated by Arab countries to safeguard their interest and avoid unnecessary price fluctuations. As it controls approximately 80% of the total world’s oil reserves, they try to influence oil prices with the consent of each other and set the production quotas. This, in turn, results in an effective cartel.

Kinked Demand Curve

We know that supply and demand relationship greatly affects the economy. In an oligopoly, the kinked demand curve has large importance as it depicts an exact relationship between firms and their behavior. In economics, the demand curve is the relationship between the price of a certain commodity and the quantity of it that consumers are willing and able to purchase at any given price. In an oligopoly, the price change of the product is not constant or does not follow any certain pattern. It greatly depends upon consumer behavior and the market situation of rivals. Therefore, the demand curve of any firm would have a kink at the prevailing price of the product.

  1. So basically, there are two main features of the adjoining demand curve. DD’ and dd’ are two negatively sloped straight-line demand curves. Now, when one particular firm ‘A’ in the industry changes the price of its product, provided all other firms keep their prices unchanged, the firm A’s demand curve will be relatively flatter like dd’, i.e., the magnitude of the change in the demand for its product as its price changes would be relatively larger. This means if A reduces or increases the price of its product, the product of the firm becomes relatively cheaper or dearer, respectively than those of the other firms.
  2. On the other hand, if a particular firm in the industry changes the price of its product, and following this, all other firms also change their prices in the same direction, and, say by the same proportion, for the sake of simplicity, then the firm’s demand curve would be relatively more steep like DD’. This is because, in this case, as the firm decreases or increases the price, its product becomes neither relatively cheaper nor dearer. Therefore, now its demand curve would be less elastic, or steeper, than dd’—now the demand curve would be like DD’.

The important assumption in the kinked demand curve is that if a firm reduces the price of its product, the rivals would follow the suit, but if it increases the price, then the rivals would not follow it. This assumption can be explained in a better manner by game theory.

Let us suppose that p1 or Op1 is the initial price of the product and q1 or Oq1 is the demand for the product.

Case 1- If the firm increases the price of the product

If one firm increases the price of the product, the rivals will not follow the suit. Therefore, in this case, the firm’s demand would decrease along segment Rd of the relatively more elastic demand curve dd’.

Case 2- if the firm decreases the price of the product

In this case, other rivals have to follow the suit in order to remain competitive. Therefore, the quantity demanded of the product will eventually increase along the segment RD’ of the relatively steeper demand curve DD’.

Therefore, at the price p1, the firm’s demand curve would be dRD’. As a result, there would be a kink at the prevailing price p1, or, at the point R on the firm’s demand curve d RD’, i.e., the demand curve in this model would be a kinked demand curve.

 Economic effects of Oligopoly

  • Restriction on output

Due to the greater ratio of consumers to producers, demand will never decrease below a certain point. Therefore, there is a high possibility that the producer might restrict their production in order to gain higher profits. This implies that the oligopoly results in small output and high prices as compared to other market structures. When oil prices hit their lowest point last year, OPEC countries tried to control their production in order to stabilize and increase crude oil prices.

  • Price exceeds average costs

In an oligopoly, there always are restrictions on the entry of new organizations. It is easier for new organizations to enter the industry when there are open opportunities. Let’s take an example of a company that enters the market with a brand new technology There is very little friction from peers as there is less competition in that segment. In oligopoly product of the various firms is more or less the same. Therefore if a new company enters the market with the same product, existing organizations decrease their product’s price more than the average price which results in a natural barrier for the new entrant.

  • Lower efficiency

In an oligopoly, it is generally observed that the firms often lead to the non-optimum level of output. The main reason is that the output produced under oligopoly depends upon the market share captured by each organization. Since last year until the middle of 2017, we witnessed an invisible war for control over black gold. Countries were trying their best to gain market share of the crude oil market. Thus they fail to build the optimum scales of economies and achieve optimum output

  • Selling Costs

The oligopolists concentrate on engaging in high promotion tasks to attract customers in turn gain market share of their competitors. This results in wastage of a great number of available resources. To cover up these costs companies often sell their products at higher prices which do not really align with customer satisfaction. The government often plays a vital role in regulating prices.

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7 Comments

  1. Very nice numbers games and I am sure that this is the sort of thing OPEC members revel in. But it’s not the thing that gets you into a winning position. OPEC nations feasted on the top easiest oil layer for decades and some grew filthy rich on it. But once that top layer gets thinner and goes out the window, we go into a “work for your money” kind of world. And now suddenly its the better supplier, the one that serves the customer better, the one that can innovate quicker and learn from mistakes faster (assume that they are open to see mistakes), the one who actually does some competing that takes the crown. Its a lesson conventional oil producers will learn – but only in history classes.

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