Chapter 4: World Oil Market: Monopoly, Dominant Firms, and OPEC Notes

Chapter 4: World Oil Market: Monopoly, Dominant Firms, and OPEC

Introduction

• The history of monopolies and dominant firms in the energy sector is closely linked to global industrialization, especially in the oil industry.

• John D. Rockefeller is a key figure in the creation of energy monopolies, shaping the modern understanding of monopoly power in global markets during the late 19th and early 20th centuries.

The Rise of John D. Rockefeller and Standard Oil

• John D. Rockefeller founded Standard Oil in 1870.

• Standard Oil became the most dominant oil company in the United States and a significant monopoly in modern history.

• Rockefeller's business approach was innovative and aggressive, serving as a prime example of how a monopoly controls a market to maximize profits.

Strategic Practices of Rockefeller's Standard Oil

1. Horizontal Integration

• Rockefeller purchased smaller oil companies to bring them under Standard Oil's control, known as horizontal integration.

• This allowed Standard Oil to control the majority of the U.S. oil refining industry.

• By eliminating competition, Rockefeller could dictate market terms, lower costs, and improve efficiency.

• Standard Oil became the dominant supplier of refined petroleum products in the U.S., owning about 90% of the market by the 1880s.

• This dominance allowed Standard Oil to set prices at will, driving out competition and earning extraordinary profits.

2. Vertical Integration

• Rockefeller implemented vertical integration, controlling crude oil extraction, pipeline distribution, and retail through controlled shipping and storage.

• By owning every step in the oil production process, Standard Oil ensured maximum efficiency and cost control.

• Vertical integration created barriers to entry for potential competitors.

3. Price Manipulation and Predatory Pricing

• Rockefeller engaged in predatory pricing to eliminate competitors, temporarily lowering prices to unsustainable levels in specific regions.

• Smaller companies, unable to compete with the low prices, were forced to sell out to Standard Oil, increasing Rockefeller’s market share.

• Once competitors were eliminated, Standard Oil would raise prices to recoup losses and maintain high profit margins.

4. Railroad Rebates and Strategic Partnerships

• Rockefeller secured rebates from railroads, crucial for transporting crude oil and finished products.

• These rebates significantly lowered Standard Oil’s transportation costs compared to competitors.

• In exchange, Rockefeller guaranteed the railroads a steady stream of business, enhancing his leverage in negotiations and market dominance.

• Rebate: Paying back an amount of money to someone after they have paid too much.

1. Monopoly

• A monopoly occurs when a single firm dominates the entire market, with no close substitutes for its product.

• This firm has significant control over the price and quantity of the good or service provided.

Pricing Policies:

• Price Maker: The monopolist can set the price for its product due to being the sole supplier.

• Profit Maximization: The monopolist sets the price where marginal cost (MC) equals marginal revenue (MR), maximizing profit by restricting output to raise prices.

• Price Discrimination: Monopolies can engage in price discrimination, charging different prices to different consumers to maximize profits.

Profit:

• Supernormal Profits: Monopolies can earn long-run supernormal (or monopoly) profits because barriers to entry prevent new competitors.

• Potential for Inefficiency: The monopolist's ability to set prices higher than in a competitive market results in deadweight loss, representing a loss of consumer welfare.

2. Dominant Firm Model

• In a dominant firm market structure, one large firm has significant market power but operates with other smaller competitors.

• The dominant firm typically sets the price and controls the majority of the market share, while smaller firms follow its pricing decisions.

Pricing Policies:

• Price Leadership: The dominant firm often acts as a price leader, setting a price that smaller (fringe) firms accept.

• Market Power: The dominant firm can influence the market price by adjusting its output levels, typically setting output where $MC = MR$ to maximize profits.

Profit:

• Supernormal Profits: Like monopolies, dominant firms can also earn supernormal profits, but to a lesser extent.

• Competition from smaller firms can prevent the dominant firm from exercising complete monopoly pricing.

• Market Share Control: The dominant firm maximizes profits by controlling output and ensuring fringe firms do not offer significantly lower prices.

3. OPEC (Organization of Petroleum Exporting Countries)

• OPEC is a cartel of oil-producing countries that collaborate to control oil production and pricing.

• OPEC's role is often compared to a monopoly, but it consists of multiple entities (countries) that collaborate rather than a single firm.

Pricing Policies:

• Collusion to Set Prices: OPEC members collaborate to restrict output and control oil prices by setting production quotas for each member country.

• The goal is to limit supply in order to raise and stabilize prices on the global market.

• Price Rigidity: OPEC countries are often accused of engaging in price fixing to maintain profitability for member nations.

• Cartel Behavior: Each OPEC member faces incentives to cheat on production quotas, leading to instability in the cartel.

Profit:

• Joint Profit Maximization: OPEC seeks to maximize collective profits by controlling the global supply of oil.

• The price is typically set higher than in a competitive market, leading to supernormal profits for member countries.

• Market Power: OPEC has significant power to influence global oil prices, although this ability has diminished over time due to non-OPEC oil production and geopolitical tensions.

• Economic and Political Goals: Profit maximization for OPEC involves strategic geopolitical considerations, with members sometimes prioritizing political objectives over pure economic profit.

Summary

• Monopoly: Single firm controls the market; prices are set above marginal cost, leading to deadweight loss and supernormal profits.

• Dominant Firm: One firm sets the price, with smaller firms following; profits are large but reduced by fringe competitors.

• OPEC: Cartel of oil-producing countries cooperates to limit supply and increase prices, maximizing collective profits but facing instability due to individual incentives to cheat.

Market Structure Examples

• Monopolies like Gazprom can fully control pricing in energy markets, leading to high profits but also inefficiencies.

• Dominant firms like ExxonMobil wield significant influence over pricing but must contend with competition and market dynamics.

• OPEC operates as a cartel to control oil prices globally, facing challenges in maintaining unity and adapting to external pressures.

Monopolist's Profits

The monopolist's profits $\pi$ are total revenues minus total costs:
$\pi = P(Q)Q - TC(Q)$
To maximize profits, take the first derivative of the profit function with respect to output (Q) and set it equal to zero. Using the product rule for derivatives, the first-order condition for profit maximization is:
$\frac{d \pi}{dQ} = P + \frac{dP}{dQ} \times Q - \frac{dTC}{dQ} = 0$
The term $P + (dP/dQ) \times Q$ represents marginal revenue (MR). Here, $P$ is the demand curve (average price at each quantity), and $dP/dQ$ is the slope of the demand curve (reduction in price required to sell an extra unit of output).
The third term, $dTC/dQ$, is the marginal cost (MC). A profit-maximizing monopolist produces where marginal revenue equals marginal cost:
$MR = MC$
This condition ensures that the additional revenue from selling one more unit equals the additional cost of producing that unit.
The profit function is:
$\pi = P(Q)Q - TC(Q)$
The first-order condition for profit maximization is:
$\frac{d \pi}{dQ} = P + \frac{dP}{dQ}Q - \frac{dTC}{dQ} = 0$
Which can be interpreted as marginal revenue (MR) equals marginal cost (MC), giving the second-order condition as follows:
\frac{dMR}{dQ} - \frac{dMC}{dQ} < 0
Indicating that the slope of MR is less than the slope of MC.

Monopoly Producer

Figure 7-2 illustrates a monopoly producer where:

• $AC$ = average cost

• $D$ = demand

• $MC$ = marginal cost

• $MR$ = marginal revenue

Here, $MR$ crosses $MC$ at $Q<em>m$. Producing less than $Q</em>m$ means marginal revenue is greater than marginal cost, making it profitable to produce more. After $Q<em>m$, marginal cost exceeds marginal revenue, decreasing profits. The price at $Q</em>m$ is $P<em>m$, read from the demand curve. Producer surplus (often called profits) is the area $(P</em>m - AC<em>m)Q</em>m$. Excess surplus above Ricardian rents is called monopoly profit.

Calculation

Given the inverse demand function $P = 100 - 0.4Q$ and total cost function $TC = 0.15Q^2 + 75$, we can calculate the profit-maximizing quantity and price for a monopolist.

The total revenue (TR) is $TR = P \times Q = (100 - 0.4Q)Q = 100Q - 0.4Q^2$
Marginal revenue (MR) is the derivative of TR with respect to Q:
$MR = \frac{dTR}{dQ} = 100 - 0.8Q$
Marginal cost (MC) is the derivative of TC with respect to Q:
$MC = \frac{dTC}{dQ} = 0.3Q$
To maximize profit, set $MR = MC$:
$100 - 0.8Q = 0.3Q$
$100 = 1.1Q$
$Q = \frac{100}{1.1} \approx 90.909 \text{ barrels}$
Substitute $Q$ back into the inverse demand function to find the price:
$P = 100 - 0.4(90.909) = 100 - 36.3636 \approx 63.636$
Thus, to maximize profit, the monopolist should produce approximately 90.909 barrels and sell them at a price of approximately $63.636.

Total Cost :
$TC = 0.15Q^2 + 75 = 0.15(90.909)^2 + 75 ≈ \text{RM } 1314.667$
Average Cost:
$AC = \frac{TC}{Q} = \frac{0.15Q^2 + 75}{Q}= 0.15Q + \frac{75}{Q}= 0.15(90.909) + \frac{75}{90.909} \approx 13.63635 + .825 ≈ \text{RM } 14.461$

Total Profit
$\pi=TR-TC= P(Q) - AC(Q) = (P-AC)Q = (63.636-14.461)90.909= ≈ \text{RM } 4470.450$
At Q=90.909
$TR = 100 Q -0.4Q^2$
$MR = 100 - 0.8Q = 100 – 0.8(90.909)= 100 – 72.7272 = 27.2728$
$TC = 0.15Q^2 + 75$
$MC = 0.3Q = 0.3(90.909) ≈ 27.2727$
The gray area in Figure 7-3 illustrates this profit.

Monopoly Compared to Competition

Comparing a monopoly to a competitive market depends on the cost curves for additional firms entering the market. If cost curves are the same for each firm and there are no barriers to entry, a monopoly would make excess profits, attracting other firms to enter the industry.

Figure 7-4 illustrates competitive supply in a constant cost industry.

If another firm enters and firms do not collude, the short-run supply curve is the horizontal sum of the marginal cost curves. More firms enter as long as profits exist. In this constant-cost industry, entry and exit of identical firms trace out a horizontal long-run supply curve ($S_1$). Social losses from monopoly power are the area under the demand curve and above the supply curve, between the monopoly output and the competitive output (shaded area in Figure 7-5).

If you have market power, you can optimize profits by exploiting it. A monopoly makes more money because it can pick the price or quantity, unlike in a competitive case where firms accept the market price. A monopoly can pick either price or quantity, but not both; the market dictates the other. A monopolist faces a downward-sloping demand curve and cannot simultaneously have a high price and high sales quantity.

Multiplant Monopoly Model

OPEC decisions involve political bargaining and individual country decisions with various economic and political goals. To maximize total profits, OPEC must consider its combined marginal cost and demand function, accounting for costs in each member country.

Consider a simplified model where OPEC consists of two countries: a lower-cost country and a higher-cost country (Figure 7-11).

Assume $MC<em>1 = 5 + 0.4Q</em>1$ and $MC<em>2 = 11 + 0.8Q</em>2$. The aggregate marginal supply is

MC= 5 + 0.4Q \text{ for MC < 11} To find the quantity for aggregate marginal supply where MC > 11
$5+0.4Q=11$
$0.4Q=6$
$Q=15$
MC=7+0.267Q for MC>11. This is found by first rearranging the marginal cost equation
$Q<em>1=\frac{MC-5}{0.4}$ $Q</em>2=\frac{MC-11}{0.8}$
Since $Q= Q<em>1 + Q</em>2$
Then $Q= \frac{MC-5}{0.4} + \frac{MC-11}{0.8}$
$Q=\frac{2MC-10+MC-11}{0.8}$
$Q=\frac{3MC-21}{0.8}$
$0.8Q=3MC-21$
$3MC=0.8Q+21$
$MC=\frac{0.8Q+21}{3}$
$MC= 7+0.267Q$
Inverse demand equation is
$P = 155.556 - 2.222Q$
Marginal revenue function is
$MR = 155.556 - 4.444Q$
Set $MR = MC$ to find where the aggregate marginal supply intersects the demand.
$155.556 - 4.444Q=7+0.267Q$
Combine like terms
$148.556=4.711Q$
$Q=31.534$
We need to check that we are assessing the portion where both countries are producing. Since $Q$ is greater than 15, both countries are producing. If Q were less than 15, only the low-cost country would be producing, and we would have to use the marginal cost curve to the right of the kink to solve for Q.

We solve for market price by substituting Q into the demand equation as follows:
$P = 155.556-2.222Q = 155.556 - 2.222 \times 31.534 = 85.487$