PETROLEUM ECONOMICS

2015

Duopoly or Oligopoly
OPEC and producers outside OPEC
The following model will demonstrate how the price
is determined when the market is shared by
a producer acting as a monopolist (OPEC): Leader

a price taker (Producers outside OPEC):

Followers

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PETROLEUM ECONOMICS
2015

Duopoly or Oligopoly
OPEC and producers outside OPEC
The initial graphs are based on the following,

When supply of non-OPEC oil is 0, world demand

must be met by OPEC supply
When all demand is met by non-OPEC oil,
demand for OPEC-oil must be 0. Hence the
OPEC demand curve has been determined.

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PETROLEUM ECONOMICS
2015

Oligopoly
OPEC and producers outside OPEC
Cost
Price

DemandWORLD
Supply NON-OPEC
Demand covered
by non-OPEC alone

Demand covered
by OPEC alone
MCOPEC

Quantity
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PETROLEUM ECONOMICS
2015

Oligopoly
OPEC and producers outside OPEC
Cost
Price

DemandWORLD
Supply NON-OPEC
Demand covered
by non-OPEC alone
This line is called
the OPEC demand curve

Demand covered
by OPEC alone
MCOPEC

Quantity
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PETROLEUM ECONOMICS
2015

Oligopoly
OPEC and producers outside OPEC
The following graphs:
When demand curve for the monopolist has been
determined, his marginal revenue curve can be
drawn.

The quantity offered by the monopolist is

determined by the intersection between the
monopolists supply curve an his marginal
revenue curve

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PETROLEUM ECONOMICS
2015

Oligopoly
OPEC and producers outside OPEC
Cost
Price

Price of oil

DemandWORLD
Supply NON-OPEC

MCOPEC

MC = MR
Marginal revenue OPEC

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Volume of
OPEC oil
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Quantity
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PETROLEUM ECONOMICS
2015

Oligopoly
OPEC and producers outside OPEC
Explaining the curves:
When marginal cost is equal to marginal revenue
and the quantity supplied by OPEC is
correspondingly determined, demand must equal
supply and the price is determined by the OPEC
demand curve.
World demand must correspond to the price set by
OPEC. Since demand must equal supply, world
demand must equal supply from OPEC plus supply
from producers outside OPEC.
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PETROLEUM ECONOMICS
2015

Oligopoly
OPEC and producers outside OPEC
Cost
Price

DemandWORLD
Supply NON-OPEC

Price of oil

Non-OPEC
prod.

OPEC prod.

Total supply =
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MCOPEC

World demand

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Quantity
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PETROLEUM ECONOMICS
2015

Oligopoly
OPEC and producers outside OPEC
Cost
Price

DemandWORLD

Price and quantity must

always be on the demand
curve !

Price of oil

World demand
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Quantity
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PETROLEUM ECONOMICS
2015

Oligopoly
When the Cartel breaks up
Cost
Price

DemandWORLD
Supply NON-OPEC

MCOPEC

Supply when
competitive market

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MCNON-OPEC and MCOPEC are added horisontally

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Quantity
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PETROLEUM ECONOMICS
2015

Oligopoly
When the Cartel breaks up
Cost
Price

DemandWORLD

Supply when
competitive market

q
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Quantity

We have now aSM13

free, competitive market,
and the price has come down

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PETROLEUM ECONOMICS
2015

Monopoly competing with alternative

What happens if a monopolist is threatened by a new
competitor ? (Back-stop threat)
This competitor may be a new process for synthetic oil from coal,
which has high initial costs.

The following graphs will demonstrate that the

monopolist is not forced to lower his price to a level
corresponding to perfect competition
It suffices to lower the price so that the competitor will
not be able to take a share of the market and make a
profit.
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PETROLEUM ECONOMICS
2015

Monopoly Alone
Cost
Price
pMONOPOLY

MCOPEC

* MR
OPEC

Demand
Quantity

qMONOPOLY

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PETROLEUM ECONOMICS
2015

Alternative
E.g. new process for synthetic oil from coal
Cost

Average costALT
pALT.

Quantity
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PETROLEUM ECONOMICS
2015

Monopoly competing with alternative

Cost
Price

The objective is to keep the competitor out

without lowering the price to pALT

pMONOPOLY

MCOPEC

pALT.
* MR
OPEC

Quantity

qMONOPOLY

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PETROLEUM ECONOMICS
2015

Monopoly competing with alternative

Cost
Price

p* is a better price for the monopolist than pALT

The monopolist will then supply the
market with q*

pMONOPOLY
p*
pALT.

MCmonop

*
Demand

q*

Quantity

PETROLEUM ECONOMICS
2015

Monopoly competing with alternative

Cost
Price

The alternative production will

then have to come in addition.

pMONOPOLY
p*
pALT.

MCmonop

ACALT

Demand

q*

Quantity
AC: Average cost

PETROLEUM ECONOMICS
2015

Monopoly competing with alternative

Cost
Price

The alternative production will

then have to come in addition.

pMONOPOLY
p*
pALT.

MCmonop

MCALT
ACALT

*
Demand

q*

Quantity

PETROLEUM ECONOMICS
2015

Monopoly competing with alternative

Cost
Price

As the alternative AC curve does not

intersect the demand curve, it suffices
for the monopolist to lower the price to p*

pMONOPOLY
p*
pALT.

MCmonop
ACALT

*
Demand

q*

Quantity

The price p* is higher than pALT , hence it is

better for the monopolist

PETROLEUM ECONOMICS
2015

Monopoly competing with alternative

Cost
Price

As the alternative MC curve does not

intersect the demand curve,
it suffices for OPEC to lower the price to p*

pMONOPOLY
p*
pALT.

MCOPEC
ACALT

*
Demand

q*
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Quantity

and the competitor has no chance of

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getting off the ground

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PETROLEUM ECONOMICS
2015

Long Term Shift in Demand

after Short-term Increase in Price

DemandSHORT-TERM, T
DemandSHORT-TERM, 0
MC after increase

p0,2
pT

MC before increase

p0,1

*
qT

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q0,2
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q0,1

DemandLONG TERM

q
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PETROLEUM ECONOMICS
2015

Long Term Shift in Demand

Price is held constant after increase
DemandSHORT-TERM, T
DemandSHORT-TERM, 0

pT

MC after increase

MC before increase

p0

*
qT

DemandLONG TERM

q0

Should the monopolist increase the price p0 or not?

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PETROLEUM ECONOMICS
2015

Long Term Shift in Demand

Price is held constant after increase
Long term:
= 1.1 => demand is elastic

This means that a price increase will lead

to lower revenues
do not increase the price

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PETROLEUM ECONOMICS
2015

Long Term Shift in Demand

Price is held constant after increase
Short term:
= 0.1 => demand is inelastic
This means that a price increase will lead to higher
revenues

increase the price

So, what is the better decision,
Short term, or
Long term ?
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PETROLEUM ECONOMICS
2015

Long Term Shift in Demand

Demand Curves
1

3:
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q(t) a p(t)

q T pT

q0 p0

is price elasticity

Constant-elastic demand curve

q(t) q (q q )e gt
T

g is called the
substitution effect

Demand will change exponentially after t = 0

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PETROLEUM ECONOMICS
2015

Long Term Shift in Demand

Present Value of Price Increase

PV

INCR

p q(t) e rt dt
T

PV

INCR

p q (q q ).e gt e rt dt
T

PV

INCR

1 rt
1 ( (r g)t)
p q ( )e (q q )(
)e
r
rg
T

PV

1 1
q
p q ( )
r rg r g

INCR

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PETROLEUM ECONOMICS
2015

Long Term Shift in Demand

Present Value of No Price Increase

PV p q e rt dt
0

PV

p0 q0
r

We can now look at PVINCR relative to PV

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PETROLEUM ECONOMICS
2015

Long Term Shift in Demand

PVof Price Increase over PV of No Price Increase
PV
p 1 1
q r
q(
)

PV
p r r g r g q
INCR

PVINCR pT pT
r
r

1
PV
p 0 p0
r g r g

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PETROLEUM ECONOMICS
2015

Long Term Shift in Demand

PVof Price Increase over PV of No Price Increase
PV
PV

INCR

pT p T
r
r

1

p p

r g

r g

The ratio of the present values is determined by the

price increase,
long term price elasticity,
discount rate r
substitution effect g.
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PETROLEUM ECONOMICS
2015

Long Term Shift in Demand

PVof Price Increase over PV of No Price Increase
PV
PV

INCR

pT p T
r
r

1

p p

If PVINCR > PV

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r g

r g

then a price increase is favorable.

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PETROLEUM ECONOMICS
2015

Long Term Shift in Demand

Opt for Price Increase or No Price Increase?

PV

PV
p p

INCR

pT p T -
0

r
r
1

r g r g

For a given price increase, PVINCR /PV will be

determined by and r/(r+g).

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PETROLEUM ECONOMICS
2015

Long Term Shift in Demand

Opt for Price Increase or No Price Increase?

PV

PV
p p

INCR

pT p T -
0

r
r
1

r g r g

It may be favorable to increase the price even if

the long term price elasticity > 1
if the discount rate is high enough
if the substitution rate g is low enough.
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