Output adjusting cartels facing dynamic, convex demand under uncertainty: The case of OPEC

a r t i c l e i n f o JEL classification: D42 Q40 C61 Keywords: Quantity instead of price strategies OPEC Dynamic Stochastic and convex demand Uncertainty This paper analyzes the optimal strategy of a monopoly facing stochastic and dynamic demand and choosing a Cournot-type strategy, more precisely, adjusting its output. This investigation is motivated by the decisions of OPEC to adjust its output and by the again high and volatile oil prices. The oil market characteristics – uncertainty, dynamic and convex demand, and a quantity adjusting cartel – provide in turn an explanation for two different kinds of volatility for oil prices, small and large. Moreover, it makes a difference in such a setting whether OPEC plays in prices (as it did up to 1985) or in quantities (its current policy) and the model implications are compatible with the observed pattern. The numerical example, even accounting for all necessary caveats, suggests that OPEC may not be a perfect cartel but even assuming that OPEC behaves like a duopoly would lead to much larger supplies. This paper studies optimal noncompetitive quantity strategies when the evolution of demand is sluggish and convex and demand and supply are stochastic processes. One objective is to solve the corresponding dynamic stochastic optimization problem. The other objective is to improve our understanding of oil prices, because this investigation is motivated by the Organization of Petroleum Exporting Countries (OPEC), which faces a market with the above characteristics and which pursues a quantity adjustment policy. Of course, the economic importance of oil, the dramatic evolution of oil prices during 2005– 2008 (see BP (2011)), and today's high oil prices provide further reasons. In order to appreciate the surprise and shock caused by the high oil prices during 2008 and by today's levels of above $100/b, it is worth recalling past expert assessments, e.g.: US Department of Energy (2001) and International Energy Agency (2004) were both promising a doubling of Middle East output at $25 per barrel, and Salameh (2004) predicted that prices are unlikely to rise above $50 per barrel; Fischer et al. (2009) reveal continuous underestimations of demand in the EIA's (short term) forecasts. Some characteristics are crucial when modeling cartels in general and OPEC decisions in particular. The first crucial but by and large ignored aspect is that OPEC has stopped posting official crude oil prices at the end of 1985. OPEC's abandonment …