Sunday, February 17, 2013

On Cartels and OPEC.

Cartels are illegal in the United States. They are occasionally in the news, most notably when reference is made to the Organization for the Petroleum Exporting Countries ("OPEC"). OPEC is a classic cartel, which is a formal arrangement of competitors intending to limit competition and/or effect that limitation. Cartelization can occur on an informal basis, such as with the Mexican drug trade. The tamest form of informal cartelization is "oligopolistic pricing," which is when a market only has a few competitors who never intend to cartelize, but essentially do so based on market conditions.

The gasoline industry in the United States is an example of an oligopoly. There are only a few competitors, and their pricing is almost always in concert. The price of gasoline fluctuates rather widely, based on the price of crude oil. Irrespective of the price of crude oil, the formula for the price at which gasoline is sold to consumers remains constant. So, the price fluctuation in gasoline in the United States is affected by the price of crude oil and OPEC's restriction of output.

There is debate whether oligopolistic pricing should be legal or illegal, because not much competition exists in markets with oligopolies. Any lowering of the price by one competitor causes others to meet that price. Any temporary advantage gained by the company who lowered its price is negated when its competitors lower their prices. For instance, if two gasoline stations are across the street from each other, and they both start with a price of $4.00 per gallon for unleaded gasoline, one cannot lower its price to $3.90 per gallon because the other station would clearly do so, putting both stations in a worse position than keeping their prices at $4.00 per gallon.

Hence, profits of the oligopoly are diminished when one company tries to lower its price. The difference between oligopolies and informal cartels is basically academic. Consumers are harmed by both, and oligopolies engage in tacit cartelization. They just do not split profits like classic cartels.

So why is OPEC allowed to operate as a cartel when its effects are felt in the price of gasoline in the United States? In 1981, the Court of Appeals for the Ninth Circuit heard this issue. In district court, the Central District of California concluded that it lacked subject matter jurisdiction over OPEC and could not hear the case. The Ninth Circuit decided the case on different grounds on appeal. The Ninth Circuit concluded that The Act of State Doctrine precluded the court from declaring OPEC's activities illegal.

The Act of State Doctrine provides that a U.S. court will not adjudicate a politically sensitive dispute which would require the court to judge the legality of the sovereign act of a foreign state. International Association of Machinists and Aerospace Workers v. The Organization of Petroleum Exporting Countries, 649 F. 2d 1354 (1981), cert. denied, 454 U.S. 1163 (1982). OPEC is made up of 12 member countries, so the court reasoned that it was not going to infringe on their decision to cartelize. Id.

OPEC's members are primarily in the Middle East and North Africa. They restrict the output of crude oil in order to stabilize prices and keep them higher than they would be in a free market. OPEC's days are numbered however, because two essential characteristics of a cartel are an ability to control output and a lack of alternatives (called "inelasticity of demand").

If OPEC did not restrict output and control prices, then its member countries would compete with each other, making less than they do in OPEC. Clearly, consumers are harmed, because higher pricing finds its way to them at fuel pumps.

OPEC will either adapt or die when alternative energy becomes readily available, or enough oil reserves are opened in non-OPEC countries that allow for free market competition between OPEC and the new entrant into the market. Current inelasticity of demand and the ability to control output allow OPEC to operate in such a way as to harm consumers across the globe. Within 20-40 years that will not be the case. I think it is extraordinarily unlikely that OPEC will find a way to adapt to a competitive market.

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