We all always have, knowingly or unknowingly, discussed amongst ourselves various types of markets. We often use these terms very loosely. Basically, there are three forms of market structure.
- Monopoly – This can be defined in simple words as the absence of competition. A single company or a group totally or nearly owns all markets for a particular type of product or service.
- Perfect Competition – In perfect competition, there is a presence of various firms. No restrictions on entry or exit of firms. The product is homogeneous, and if one dominating company changes its price structure then other firms have to change their prices in order to remain in the competition.
- Oligopoly – oligopoly is a type of market structure in which there is a very small number of firms that have maximum market share. Every firm is well aware of the actions of other firm and decisions are made according to that.
As the oil and gas industry is considered a perfect example of an oligopoly type of market, we will mainly focus on the oligopolistic nature of oil.
An oligopoly is a type of industry that is dominated by a few firms which show highly relative and coordinated behavior. Some of the examples of an oligopoly include the telecommunication industry – in some countries such as the US and Canada where a small number of companies control a majority of the market, and the oil industry- where prices of crude oil largely depend upon geopolitics and relationship between major producing nations.
Characteristics of oligopoly include:-
- Dominating firms functions in accordance with each other so as to maintain output and pricing which results in their healthy balance sheets.
- Significant obstacles to entry in the market due to high initial costs or limited resources. For instance, it is not easy to set up an operator firm to extract oil and gas.
- The technology involved in the production is stable. On the other hand, rapid innovation in technology encourages new entrants and price competition as firms with a technological and cost advantage will try to drive rivals out of business by lowering prices or by disrupting the supply-demand chain. (One can easily relate this with the recent downturn in the oil industry.)
A cartel is a group or an organization through which members conjointly take decisions about prices and production. This also results in the formation of center-spot from where the whole industry can be controlled or maintained provided that there are no other powerful firms or groups present. One of the well-known cartels is OPEC (the Organization of Petroleum Exporting Countries), whose member countries manipulate production in order to maintain oil prices.
W. A. Leeman in his book The Price of Middle East Oil: An Essay in Political Economy (1962) perfectly penned the nature of the oil industry which holds true even today despite the presence of a large number of firms. Oligopolists (major firms in oligopoly) hesitate to lower the oil prices in the fright of a decrease in profit margins, and they are also hesitant to increase the oil prices in the fear that rivals will not follow and in turn lose of market share. Therefore they rely over the long run to maintain oil price and earn handsome profit margins. Another description of the oil industry to be an oligopoly is the fact that the presence of a large number to consumers compared to the small number of sellers.
Oligopoly in Context of Petroleum Industry
In order to understand the oligopolistic nature of the industry, we will first prove how the petroleum industry is an oligopoly.
From the above statistical depiction of the ranking of major oil companies in the US according to their market value, one can easily point out that very few companies have control over the market. In order to understand it in a better way the calculations are shown in the adjacent table. The data in this table is extracted from the above graph. This shows that the top 5 companies in the country control over 80% of the total market.
One way to analyze such behavior of oil companies is by applying game theory. Game theory helps us in the analysis of strategies used in different scenarios where the outcome of one competitor’s choice of action depends analytically on the action of other competitors. This is an important tool in looking at activities in an oligopoly where individual firms are much aware of the behavior of other competitors.
Let us take an example of the current situation in the oil and gas industry. We have two countries viz. A and B that produce a good percentage share of total world oil and gas production. Country A recently developed a new technology by which it can produce at a mammoth rate from unconventional resources and that too at relatively lower prices, on the other hand, country B does not have such technology but still is a leader in production. These two countries, in terms of competitive behavior and market share, have the following option:
- They can compete by trying to challenge the other’s price, seizing the market and hoping to drive the competitor out of business, or
- They can cooperate on strategies, each maintaining their market share
Here we are making use of the payoff matrix to describe the basic competitive choices that they have at their disposal.
(Values considered here are for understanding purpose only.)
From the above matrix, we can see that at any given period they face two choices: either make an agreement and abide by it in order to avoid the price war, instead enjoy market share, or initiate a brutal price war to increase market share, which may or may not be successful.
- Assume that both the countries are keen to avoid price war and are mutually agreed to abide by the agreement and avoid price cutting. In such a case, we end up in the upper-left cell of the matrix and each country earns profits of $100 million.
- Alternatively, suppose Country A decided not to follow the agreement and wants to enjoy handsome profits by snatching the market share. In such a case, we end up in the upper-right cell of the payoff matrix and results in a tremendous increase in profits of country A. country B, due to this decision, experiences the loss of market.
- Or country B betrays country A and takes part in market share with the strategically planned new price structure. This will result in a loss of profits for Country A.
- Finally, both companies enter the competition by cutting prices. This triggers the brutal price war and also affecting other dependent industries. This will eliminate profits altogether. In other words, when each country acts exclusively in its own interest, a price war is unavoidable.