OPEC dysfunctionality

Thank you to SungJae Lim who found this article and coined the term “OPEC dysfunctionality”

Oil price dives after producers fail to agree output cap – http://www.bbc.co.uk/news/business-36070255

Although Saudi Arabia, the world’s biggest exporter, had been prepared to freeze output if all Opec members had agreed, some countries, such as Iran, are continuing to increase output. The outcome is that oil prices continue to fall, reducing member countries’ export revenues and tax revenues. Poorer countries, such as Angola, Venezuala and Nigeria are now running large Balance of Trade deficits (Angola has gone to the IMF for a loan) and rising budget deficits. Even Saudi Arabia is  trying to diversify its economy away from oil.

Therefore, why can’t they agree to cut output and thus raise prices? This can be explained by a classic game theory model.  For example, assuming just two OPEC members and that the pay-off matrix shows revenues in dollar terms, with Saudi Arabia’s revenue listed first in each cell, the pay-offs might be as below. They are calculated on the assumption that the demand for oil is price-inelastic. Thus, cutting output (shifting the supply curve left) will raise revenues. However, if just one country cuts output, while the other increases output, the latter country will be able to sell a relatively large amount at its reduced price (capturing a large part of the other country’s customers) because oil is relatively homogeneous.

Try to work out each country’s dominant strategy and see where the equilibrium is.

    SAUDI ARABIA
  Decision Cut output Increase output
IRAN Cut output 1000, 500 2000, −700
Increase output −700, 2000 −600, −300
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