UBS: Show and cartel

Cooperation is generally considered a good thing. Unless, of course, the people who are cooperating are really not meant to do so. For example, in a free market producers are meant to compete: this keeps prices down and encourages innovation. When producers start to cooperate in their own interests, the costs to consumers are high: be it the Medellin drug cartel, traders fixing LIBOR, or the Organisation of Petroleum Exporting Countries (OPEC). So it warms the heart of a free market economist to see OPEC apparently falling apart. The very group who were created to restrict supply so as to push up the price are pumping oil with wild abandon. But does this mean that the cartel is actually ineffective?

In the past OPEC quotas have been observed more in the breach than in the rule (chart 1), but this reflects the circumstances. As long as oil prices remained high, breaches of the quota were not a problem for the cartel. Or to put it another way, OPEC was not increasing its (flat) quota to keep pace with global demand. As long as demand was absorbing extra production it was all fine. But then extra production came online from elsewhere: US shale, Russia, even Brazil. All of a sudden it became important for members of OPEC to stop cheating.

Luckily enough, most cartels suffer from the prisoner's dilemma. If everyone agrees to keep production low so as to push up prices, each member of the cartel has an incentive to cheat; increasing production to gain market share and sell more at an elevated price. As this is rational for all of them, they all end up cheating and the cartel falls apart. It takes something to stop them; usually some sort of punishment. In the Medellin cartel it usually took the form of a bullet. In OPEC it is in the form of lower oil prices.

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