Last Saturday we witnessed another meeting of the Organization of Petroleum Exporting Countries and its allies (OPEC+). This organization is what economists refer to as a cartel or an oligopoly with cooperative strategies. In other words, it is a group of producers cooperating to influence prices, primarily by reducing production in order to increase prices from the supply side for the benefit of cartel members.

It sounds simple, but it is not. As a result, it has become one of the classic cases studied in game theory, a discipline that examines the strategic interaction of rational decision-makers. Game theory has been applied in fields such as biology, computer science, and the social sciences, particularly economics, which is where we will focus our attention.

The logic of a cartel suggests that if all participants agree to reduce production and maintain a target price, everyone benefits from higher oil prices. As a result, producers can earn greater revenues with lower output and higher prices. However, while this may be the socially optimal solution for participants, it is not the dominant strategy.

For any country within OPEC+, the dominant strategy is for all other members to reduce production and raise market prices while it does not. In that scenario, prices increase while that country produces more and sells at higher prices. Consequently, the dominant strategy for each individual country is to defect while everyone else cooperates.

Imagine a group of friends agreeing to split a restaurant bill equally. The socially efficient outcome would be for everyone to order similar meals and pay similar amounts. However, knowing that the cost will be shared, one person’s incentive is to order the most expensive item on the menu and distribute the cost among everyone else. If everyone thinks this way, the final bill becomes so high that everyone pays more, or those who ordered less feel the arrangement is unfair. If this behavior becomes repetitive, the group may eventually decide that each person should pay only for what they consume.

For this reason, a successful cartel requires certain conditions: a limited number of producers, transparent reference prices, relatively homogeneous goods, barriers to entry for non-members, and a credible threat of punishment for members who fail to cooperate.

These conditions are increasingly difficult to achieve because, in recent years, the number of countries outside OPEC+ that nevertheless contribute significant production to international markets has grown considerably. In particular, the United States, Canada, Brazil, Norway, and the United Kingdom together account for more than 20 percent of global oil production.

As a result, the price targeted by OPEC+ must be high enough to incentivize its members while remaining low enough to discourage non-members. If oil prices remain above USD 40 per barrel, it is only a matter of time before independent producers in the United States, for example, begin flooding the market once again, forcing additional production cuts and making cooperation among OPEC+ members increasingly difficult.

If game theory teaches us anything, it is that coordinating oil-producing countries around a long-term strategy becomes extremely challenging when a significant portion of global production remains outside the agreement or is willing to refuse cooperation over the long run, as is the case with countries such as Mexico. Under such circumstances, maintaining a coordinated strategy is unlikely to be sustainable for very long.

This article was originally published by Business Insider México.
Date: June 10, 2020
Original Link:https://businessinsider.mx/teoria-de-juegos-en-los-paises-petroleros-opinion-energia-circular-paul-alejandro-sanchez/ [offline]
Archived Link: https://web.archive.org/web/20240225023731/https://businessinsider.mx/teoria-de-juegos-en-los-paises-petroleros-opinion-energia-circular-paul-alejandro-sanchez/[Archived]