Unions are against globalization. To listen to them, unions are a force for good for all workers (rather than just the workers who pay the union its dues). But to watch them, you can see that they’re in favor of cartelization. They don’t mind other people
competing against them, as long as those people are hobbled by the same pay rate, protections, and benefits as the union members have. In other words, they’re not allowed to use a lower cost of living, or a lower regard for their own safety, or a longer work week as a competitive advantage.
Sigh. Unions! Still selfish, after all these years.
Recently, the Organization of Petroleum Exporting Countries (OPEC) celebrated its 50th anniversary (link). The organization was founded in 1960 with the purpose of regulating world’s oil prices and controlling the supplies of oil. Currently, OPEC controls 80 percent of world’s proven oil reserves and its 12 member states oil production capacity accounts for 40 percent of world’s total oil production.
OPEC’s oil production and the world economy
Source: The Economist (link
As a profit-maximizing monopolist, OPEC is faced with a downward sloping demand curve and upward sloping marginal cost curve which represents the market supply curve of the orgaization’s 12 member states. As a profit-maximizing agent, OPEC countries equate marginal cost of production and marginal revenue from oil supplies and thus extract the entire consumer surplus from oil importing countries such as the United States, Japan and the European Union. There are several plausible explanation of OPEC’s monopoly power in the world oil market. First, oil is a good with no close substitutes. Thus, the price elasticity of oil demand curve is significantly price inelastic. The average empirical estimate of the world price elasticity of demand for oil is -0.4, suggesting that a 10 percent increase in the price of oil would, on average, reduce the market demand for oil by 4 percent, ceteris paribus.
The relationship between the total revenue of the monopolist and the elasticity of demand suggests that the unit elasticity of demand is the revenue-maximizing point elasticity of demand for the monopoly firm such as OPEC. As the graph shows, OPEC’s price spikes occured mostly during external shocks such as the 1973 oil shocks, Arab-Israeli war and the recent financial crisis. The spikes in the world price of oil reflected the pure logic of OPEC’s cartel. By pushing the price upward, OPEC countries realized that, in the short run, the price elasticity of demand for oil is even more inelastic, thus reducing the consumer surplus of oil importing countries while expanding the producer surplus of OPEC member states.
The strategic behavior of OPEC mostly depends on the nature of external shocks affecting the production capacity and reserves of world’s oil supplies. During political conflicts, the short-run demand for oil spiked and, therefore, the price elasticity of demand for oil decreased, increasing OPEC’s short run producer surplus. Thereupon, OPEC member states set oil production quotas which exactly reflected the organization’s intention to extract the entire consumer surplus from oil importing countries. Also, during the pre-2008 economic boom, the economic growth in emerging markets further inflated the world price of oil since the OPEC’s short run production capacity outpaced the quotas set by the organization. But during the recent financial crisis, the short-run response of OPEC has been the reduction of per barrel oil price as an strategic step towards maintain the stability of market demand for oil. During the recent crisis, personal consumption and incomes have fallen substantially and therefore, assuming the positive income elasticity of demand for oil, the world demand for oil decreased considerably. The change in the aggregate consumption of oil has led to relatively more price elastic demand for oil. Partly, the increase in the price elasticity of oil is explained by the technological innovation and market access to long-run substitutes of oil such as fuel-efficient and electric vehicles and electric cars.
The technological development of fuel-efficient vehicles has decreased the monopoly power of OPEC by increasing the price elasticity of demand for oil due to the availibility of closer substitutes. In the follow-up of the financial crisis, the OPEC set the per barrel price of oil at $75. Given the downward sloping market demand curve, the short-run oil consumption increased and OPEC thus raised the relative price of oil’s substitutes since it acknowledged the switching costs of changing the consumption of durable goods which complement the consumption of oil. What OPEC did is that it attempted to establish the short-run price elasticity of oil close to unity and, thereby, effectively increase the total revenue of the organization’s member states. However, if in the long run, the market demand for oil was elastic, the net effect of increasing the price of oil, would incidentally fall on the burden of OPEC producers. Therefore, relatively price inelastic demand and price elastic oil supply is the main source of OPEC’s monopoly power in the world oil market.
The rationale behind the cartelled market organization of oil supply is the stability of demand for oil across the world. Could OPEC’s monopoly power, in effect, be broken if one country would set asymmetric prices on the global oil market. The desire of OPEC member states to fully collude in the cartel is the well-known phenomena from industrial organization known as the trigger strategy. According to trigger strategy, a member of the cartel is likely to divert from the cartel’s strategy only if long-term gains outpace short-term losses of acting in accordance with the cartel’s strategic behavior. In purely theoretical terms, if Nash equlibrium exists in the long-term benefits of cooperation, the diversion from cartel’s strategic behavior, will not be feasible.
Even though some OPEC member states face asymmetric market demand curves in the short run, the stability of world oil demand embodied in the relatively price inelastic oil demand decrease the feasibility of defection from the cartel’s strategic targets, discounted benefits from the collusion far outpace potential short-term losses.
In tomorrow’s episode of John Stossel’s new show on Fox Business, he will address the question, “Who is Wesley Mouch?” in speaking to the parallels between Atlas Shrugged and contemporary America. As one might expect, in my view it seems as if almost all businessmen (given their predilection towards using government to destroy markets to their own advantage) in one way or another embody the qualities of Wesley Mouch.
One exception who will be on Stossel’s program is John Allison, an executive at BB&T Bank, who staunchly opposed TARP, has repeatedly refused to use the law to plunder the property of others and as one might guess is an ardent Austrian-school libertarian. In a scene reminiscent of the smoke-filled rooms of Atlas Shrugged, Allison divulged at an NYU lecture this past fall that the Feds threatened to go in and audit any bank that wouldn’t take government funds, forcing healthy banks to comply so as to cover for the fact that the government was only propping up a select few sick ones (at the expense of the solvent I might add).
In response to Stossel’s call in the aforehyperlinked column for suggestions for a follow-up show on “crony capitalism,” I posted:
If you want to talk about crony capitalism, it may pay to have Burton Fulsom who wrote “The Myth of the Robber Barons” on the program. I think the key is to delineate between political entrepreneurs and market entrepreneurs, something which he does astutely in that book.
Political entrepreneurs seek to use government decrees to profit, largely by cartelization, monopoly advantages and other barriers to entry, while market entrepreneurs generally seek to win profits in the market by merit – by producing the best product at the cheapest price.
More generally, the Mouch problem lies in the fact that while initially businessmen extol the virtues of little regulation, low barriers to entry and minimal governmental interference generally, once they become successful, out of self-interest they support any and all legislation that will cement their position in the market. They support all of those things anathema to the free market that they had used to their advantage in the first place.
This is akin to the economic plight of America as a whole. While up until the early 20th century (though some libertarians will argue that it was really only up until the time of Lincoln), America functioned under a largely laissez-faire economy, with the wealth and progress generated by this economy, we forgot about the virtues that led to our success and rewarded those tending towards failure. We created a welfare state from the riches of a relatively free state, throwing under the bus the very principles that elevated to us to our position as a great nation.
Can you imaging inventing something new and refusing to patent it? We game theorists are a greedy lot. While not doing anything actually illegal, we show no mercy when it comes to an opportunity to make lots of money. In this latest nefarious article, I am going to demonstrate how it is in your best interests to keep silent about your latest invention when it suits you.
First we must understand a key concept in game theory called a “holdup.” A holdup is a situation where you are able to demand almost any amount of money from a person because they have no choice but to pay you or suffer incredible losses. This isn’t just restricted to extorting money at a petrol bunk. Holdups are frequently seen in businesses.
For example, suppose all the pilots in a particular airline decide that they’re not getting paid enough. All they have to do is to go on a collective strike and ask for a 300% raise. Assuming that there are very few pilots around, such a strike will have a compelling power. The reason is twofold. First of all, being a pilot is a specialized skill. And second, the cost of paying a pilot is minimal compared to the cost of maintaining an airplane. So if the airline stops operating because of the pilot strike, they can hardly save any money by not paying the pilots since their fixed costs on machines, etc., is sky high anyway. The pilots are trying to “holdup” the airline company.
Image Credit: Ismael Olea
In fact, the threat is so real, that certain governments have imposed rules on how long skilled labor such as pilots can go on strike.
Such a strike would not work in McDonald’s for the reasons mentioned. The labor is pretty unskilled, and a strike would hurt McDonald’s much less since McDonald’s would save on employee fees which are pretty high. So if the employees threaten to strike (remember that the more people who strike, the more difficult it is to maintain the strike since a strike is like a cartel), McDonald’s would simply fire them and hire more workers since they are easy to replace. Thus, an attempted “holdup” of McDonald’s would not succeed.
Patent law gives inventors the potential to holdup companies that rely on the patent. Wouldn’t it be nice if I had a patent on the technology used to create integrated circuits (IC)? Every single chip company in the world would pay me money, and I would be a rich man with no worries (financially at least).
But suppose I’m a manufacturing company, and I have several ways to manufacture a particular product. I must check beforehand whether any of the steps involved in a particular method have a patent on them. If they do, then I must either come to an agreement with the patent holder to pay her a reasonable sum of money before I Invest heavily into it or choose another method.
If I’m foolish enough to blindly set up my manufacturing plant in a way that utilized a method that has a patent on it, the patent holder can holdup my firm. They can demand outrageous fees for allowing me to utilize that method since it will cost me millions of dollars to set up a new plant that avoids that step.
But suppose I do the research beforehand and find that no one holds a patent for a particular step, and I build my factory around it. After this, a clever inventor reveals that he has just now got a patent for a particular method that my plant utilizes, and I’m screwed. The crafty inventor had purposely delayed his patent on that technique so that when I did a check, nothing showed up. Now after my plant is complete, he has completed the process and obtained a patent. He is now in a position to hold up my firm.
So if you’re thinking of obtaining a patent, it is worthwhile for you to hold off a little bit and wait till a firm invests heavily into a product or process which utilizes your invention. Then you must strike and obtain a patent and keep holding up the hapless firm! I can well imagine professionals having dozens of unpatented inventions, keeping a keen lookout for an opportunity to pounce on a company that will utilize one of their inventions.
Yes, we game theorists are crafty. Nothing wrong in that, is there?
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There have been concerns that, beyond the rising cost of fuel and feed, a hidden factor may be driving food prices higher: collusion among farmers, food processors, or exporters. Federal prosecutors have opened separate criminal probes into possible price-fixing by major egg producers and California tomato processors. This is the latest in a series of U.S. investigations of alleged collusion in food and agriculture. Prosecutors are already pursuing criminal or civil inquiries in the markets for fertilizer, citrus fruit, cheese, and milk, examining whether suppliers worked in league to manipulate prices.
Under U.S. law, it’s a crime for competitors to collaborate on production or prices. Price-fixing is a criminal violation that can bring stiff fines and sometimes prison terms for executives. In recent years, U.S. antitrust enforcers have aggressively pursued such cases. Although federal law bars competitors from collaborating when setting their prices, Congress has created antitrust exemptions, like the 1922 Capper-Volstead Act, intended to help small farm groups and cooperatives bargain with large food processors. There are also exemptions for exports. Egg and tomato producers say their cooperation is shielded by these exemptions.
Egg prices have increased more than 40% in a year. Fresh-egg farmers acted together through a series of export shipments organized by United Egg Producers, an industry cartel whose 250-plus members include virtually all of the nation’s big egg producers. By removing a small fraction of eggs that would have been bound for U.S. sales and arranging instead for their export, United Egg helped tighten domestic supply and drive up the price of eggs across the country.
Tomatoes are among the big price gainers in the past year despite the salmonella scare. In the tomato industry probe, the prosecutors are trying to determine if dominant processors of tomatoes for canning, ketchup, salsa, and sauces conspired to fix prices. The investigation comes after allegations that a consultant to SK Foods, Inc., a big processor located in Lemoore, California, was working with SK to bribe buyers at six major food companies to pay inflated prices for tomato paste and chili peppers. In wiretaps and raids carried out as part of the bribery probe, investigators found evidence of the wider price-fixing conspiracy.
The big dairy cooperative Dairy Farmers of America is under investigation for alleged manipulation of cheddar cheese futures prices in the Chicago Mercantile Exchange in an attempt to restrict competition.
This is an election year. Farmers are a powerful political voice, and the exemptions aren’t likely to be repealed. But the latest food industry investigations show that antitrust enforcers are increasingly willing to challenge the co-ops they allege have overstepped the spirit of the law. If businesses are going to use narrow exemptions to engage in anti-competitive conduct, the government must take a hard look at that.
In my previous post, you read about Nash equilibriums and the formation of cartels. You also read about how cartels tend to be unstable and susceptible to treachery by its members.
This week we will look at De Beers – one of the most successful cartels ever. In fact, it is so successful that it operates completely behind the scenes and has shifted public opinion to accommodate its internal needs.
Simply put, diamonds are not rare. They are expensive yes, but they exist freely on earth. However, like any other commodity, they do follow the laws of supply and demand. The supply has been artificially constrained so that there is no proliferation of diamonds in the market. Because of this, the prices of diamonds are higher than they would be in a free market.
So why is the cartel put together and led by De Beers stable? One would have thought that according to the laws of game theory, it should have broken apart by a defecting member. There are two reasons for this. First of all, most of the cartel members have major holdings by De Beers themselves. This means that there are even fewer players than it looks. Fewer players makes it less likely that there will be a defection.
Secondly, the real partners of De Beers in the cartel are the Russians. They mine small diamonds from Siberia and channel them through De Beers. The Russians know that if they put their diamonds directly into the market, the prices will drop. And that will be bad for them in the long run.
This brings us to an important point on cartels. The long run. Game theory predicts that if a “Prisoner’s Dilemma“-like game is repeated indefinitely with no end in sight, then the logical outcome, assuming that all participants are intelligent, is cooperation. What this means is that there is a better chance of a member cooperating if the game is repeated continuously.
This happens because if the game is repeated, then all other players will know that the person who defected last time is untrustworthy and can make life hard for them. Also, if it is known beforehand that each party will do in the next game what the other party did in the last game, then it is in each party’s best interests not to renege on the cartel since they will be punished for it in the next game.
Other firms can punish the defector by pricing them out of the market as well. This means that everyone collectively lowers their price temporarily so that the remaining firm is driven out of business. This usually happens to new entrants who are a threat to already established cartels.
Nevertheless, in my opinion, this only means that the cartel will survive longer. When there are a large number of participants, the temptation can be too great for individual members to resist, and cartels are always breaking and reforming again. However, if I’m in a cartel with someone else who I know has defected the last time, I might lose faith in him and decide to defect before he does. So again, the cartel breaks up.
It’s a complex dynamic, and in the long run, it’s all about trust. In fact, this leads us to another interesting idea. Perhaps altruism, self-interest, and honesty are rational strategies and not employed only by the soft-hearted. We’ll discuss that in another blog.
One of the neatest developments in economics is the formulation of game theory. Even though its strategies and recommendations have been known to people throughout history, game theory puts these strategies on a theoretical structure. One of the situations thrown up by game theory is a Nash equilibrium.
Assume that there are competing players in a situation (call it a game). Each player has to choose which strategy to adopt. The outcome of that strategy is going to depend on what other people choose. In such a situation, a Nash equilibrium is formed when each player knows what strategies the other player is going to adopt and will gain nothing by changing his/her choice.
Let us take an example of chess. If you watch a Grandmaster play chess against someone who is well beneath him or her in playing stature, you will probably be surprised that the Grandmaster will take longer to beat the novice than an expert would take, although the expert is still much superior to the novice but far inferior to the Grandmaster.
Grandmaster Chess. Photo by Kryten. Taken from Everystockphoto.com
The reason for this is that when you try and finish off an opponent quickly, you leave gaps in your own defenses. These gaps are not easy to spot, but Grandmasters are in a position to take advantage of them. Therefore, it is in the interests of anyone who is playing a Grandmaster to take their time and not rush. So if there are two Grandmasters playing each other, each knows that the other will adopt the strategy of non-rush and will therefore play non-rush themselves. Because of this, Grandmasters are in the habit of taking their time, securing their defenses, and playing slowly.
However, when the expert plays the novice, he has no problems about tearing the poor novice apart because he knows that the novice can’t take advantage of the weaknesses that he leaves behind while attacking. If the expert were to play the Grandmaster, however, he would be a fool to rush into the attack.
In the case of the two Grandmasters, the Nash equilibrium consists of both players choosing the strategy of non-rush because they know that their opponent will do the same. It would be foolish to attack a Grandmaster hastily because they would be building their own defenses, and if you don’t do the same, you will be left in an untenable position. Therefore, the strategies of two Grandmasters playing each other are stable. Each will not change their own strategy if the other continues to maintain theirs.
In a cartel, a group of players who control the supply of a certain product get together and agree to keep the price of that particular product high. There are two strategies here – high prices and not so high prices. It’s easy to see why all the cartel members benefit in the long run if each follows the strategy of high prices. However, it is unstable because it is not a Nash equilibrium.
This is because of the fact that if one of the cartel members changes their strategy to not so high prices, that person will get all the customers who will no longer buy from the other players since they are following the high prices strategy. This will lead to a dramatic gain of business for the player who changes his strategy to not so high prices. Naturally, this situation can’t last. The moment the other players find out that one of them has changed their strategy, it is no longer in their best interests to adhere to the strategy of high prices. Thus, they change their strategy to not so high prices as well, and the cartel breaks.
OPEC Headquarters in Vienna
Cartels are so unstable precisely because of the threat of betrayal. And the more people that make up the cartel, the more unstable it becomes since there are more chances of any one person changing their strategy.
Cartels like OPEC have stood the test of time because, firstly, there are not too many players. And secondly, they all recognize that they’re here for the long term and that if one of them breaks the cartel by adopting not so high prices, then all others will follow suit, and they will be back to square one with lower prices.
Indeed, the only real reason for any cartel to stay together is if they are in the long run together and realize that united they stand and divided they fall.
Editor’s note: Last year a German watch magazine did an interview with John Nash. Read more about it at Amateur Economist. Thanks to Chris Meisenzahl for the link!