Hello readers, welcome back to my blog. Last time I discussed a concept proposed by Adam Smith: the diamond and water paradox. I hope that you found this interesting and can now start to see how economics permeates all aspects of our lives.
Having recently researched and read into game theory as well as having discussed one of the most famous examples of game theory in action, the prisoners dilemma, in an earlier post, I thought it would be useful to examine how it can be used to describe collusion within OPEC and the global economic effects of low oil prices.
Although I looked into OPEC and oil prices last year, I had not come across game theory at that stage and so in this post I aim to focus on the game theory aspect of OPEC. If you can’t remember much about the organisation or oil prices in general or need a reminder on game theory, then you might want to relate back to my previous posts to refresh your memory.
From reading Dixit and Nalebuff’s, ‘The Art of Strategy’, it becomes clear that most ‘games’ in life are cooperative, many are competitive and others are perverse. You will come to realise by the end of this post that the market for crude oil could be described as perverse.
OPEC is an oil cartel made up of 14 countries who collectively control about one-third of global oil production. They determine oil prices by agreeing to limit their oil production and therefore reducing oil supply in the global market. Both a freeze and a cut in production have the same goal – lower supply in order to raise prices-simple demand & supply laws of economics. In both cases, a situation very similar to the Prisoner’s Dilemma is created – if one country violates the agreement while the other abides, prices stay low and the country that violated the agreement benefits by selling more oil while the other has to sell the agreed amount of oil at a lower price. If both violate, output remains high and prices remain low. If both abide, prices climb and both players profit. The following chart portrays the possible outcomes. (You will notice it is very similar to the options that the prisoners were faced with in the prisoners dilemma game):
According to Game Theory, each country will make the choice that is most beneficial for themselves independent of the other country’s strategy. In this case, both countries have a dominant strategy – violate the agreement – in which their own outcome is greater regardless of the strategy of the other country. Therefore, Game Theory implies that the countries in OPEC will make the choice that results in the lower outcome for both countries. Meanwhile, the most optimal outcome would occur if all of the countries abided by the agreement and limited production. Similarly in the prisoner’s dilemma, two parties that would benefit from cooperating together tend not to do so because of other incentives that if both follow, they will both end up in a worse place.
Two of the main problems that OPEC are currently facing:
- Saudia Arabians and Iranians do not want to take any action that would benefit the other, even if it would help themselves.
- It is almost impossible to keep member nations in OPEC, from cheating and producing more than their quota.
Game theory is based on having ‘rational-decision makers’. We have to remember that in reality people do not always make rational decisions and that the neoclassical model of man as a maximizer of utility or profits does not always follow. People and nations are envious, and will make do with less if it means those that they dislike are worse off. The Saudis may be burning through their financial reserves quickly, but virtually everyone else in OPEC is worse off. The Saudis may think that they can drive a better deal inside OPEC when almost everyone else is desperate.
We must also consider a number of external factors that could come into play:
- Weaker growth
- Higher energy taxes
- Further technological refinements that lower crude oil production costs further
- Continued improvements in solar, wind, and energy storage (primarily battery) technology.
These factors would reduce the global demand for oil as suitable substitutes are developed and may result in countries oversupplying in an attempt to sell as much oil as they can before its too late-see my post, “What happens when we no longer need oil from the Middle East”.