Question

OPEC is an intergovernmental organization of 13 nations. As of 2015, the 13 countries accounted for an estimated 42 percent of global oil production and 73 percent of the world's "proven" oil reserves, giving OPEC a major influence on global oil prices that were previously determined by American-dominated multinational oil companies.

Understanding this type of dynamic in which a few countries (or firms) dominate the market being able to set the price, yet unable to raise significant barriers to entry to keep smaller competitors from entering the market entails delving into a price leadership model.

Start with the following assumptions: The World Market demand for oil is given by P=100-X in which X is the aggregate market quantity of crude oil barrels. This market is served by OPEC, a dominant block, and a set of infinitely many countries with smaller oil reserves which act as price takers. in this simple example, OPEC is comprised of two dominating countries, denoted DC1 and DC2 with smaller efficiencies: constant marginal costs such that: MC_DC1 =MC_DC2 =50. The fringe countries have an aggregate marginal cost that can be expressed by MC_SC =50+X.

A.What does the shape of the inverse market demand tell you about the nature of product differentiation in this market? Does it make sense in the oil market?

B. What does constant marginal costs for the dominant countries tell us about the nature of the production function for oil in those countries? Does it make sense in the oil market? (Tip: Think about the nature of scale of production upon costs and how it relates to oil extraction)

C. Derive the residual demand that OPEC will operate in. (Make sure to incorporate the structiral break in residual demand with its respective output range).

Answer 1

Solutions -

a- as per the given quesion, the market is oligopoly market because there are only two sellers i.e. DC1 and DC2. And they formed cartel in the name of OPEC. Both the firms are selling homogeneous product in the market. There is no product differentiation but there is differentiation in capacity of product. these two sellers plays a major role in market. market demand of goods is genrally inverse, but the product sell by seller in this market is an important resource, so there is no major change in demand in respect of change in price. So there is no sense of change in price and change in demand.

b - it shows the long run production function i.e. returns to scale and constant marginal cost explains that both sellers are selling homogeneous product and this marginal cost indicates the level where producer incurred minimum cost at current level of output.

c - residual demand is 27 % in respect of increase in oil production by 58%.

Thanks