Is OPEC a (successful) cartel?

The Organization of the Petroleum Exporting Countries (OPEC) was founded in Baghdad in 1960 by Iran, Iraq, Kuwait, Saudi Arabia and Venezuela. Nowadays the international organisation counts 14 Members.

OPEC’s mission is:

  • to coordinate and unify the petroleum policies of its Member Countries and
  • ensure the stabilization of oil markets in order to secure an efficient, economic and regular supply of petroleum to consumers, a steady income to producers and a fair return on capital for those investing in the petroleum industry.

It seems pretty obvious that OPEC is acting as a cartel. Indeed, the general perception is that OPEC has been able to control the prices and the production of the oil industry. Nonetheless, no competition authority has gone after the organisation so far, to my knowledge. Similarly, I could not find any record of a successful civil law suit.

Is the long, undisturbed life of OPEC only the consequence of politics and pragmatism? Has OPEC been able to continue exist because of faulty rules of procedure or due to the impossibility to apply antitrust legislation to such an international organisation?

But most importantly, has the market finally adjusted itself to prevent OPEC from exercising market power and behave anticompetitively?

Indeed, there are evidence showing that OPEC was never really in control of the market because its Members did not respected the cartel’s decisions [here]. In any case, due to changed conditions of the oil industry, some commentators are arguing that OPEC is no longer able to exercise a decisive influence on the oil’s price.

A successful cartel

A cartel is a group of similar, independent companies which join together to fix prices, to limit production or to share markets or customers between them [here].

Economics tells us that firms have always the incentive to cheat. However, under certain conditions, cooperation can be sustained as the Nash equilibrium.

Sustainable collusion occurs when:

  1. Market players repeatedly interact;
  2. The cheating by one player can be (easily) detected by the other cartellists;
  3. There is a high enough discount factor;
  4. The threat of retaliation is credible; and
  5. Coordination is feasible.

If we simplified to the extreme, likelihood of collusion increases if there are (i) few market players (ii) producing an homogeneous good, (iii) having a similar cost structure, (iv) the spare capacity necessary to retaliate, (v) enjoying a collectively high market share, (vi) in a transparent market (vii) with significant barriers to entry and expansion.

Is OPEC still a successful cartel?

The OPEC’s mission screams to the world that the organisation is acting to distort free competition in the oil industry. No secrecy, no rooms filled with smoke, everything is done under the sun.

Even assuming that the procedural obstacles to start an antitrust case against OPEC can be overcome (e.g. international immunity, cross-border jurisdictions, the need to qualify as an “undertaking” according to EU law), are there the elements to find an antitrust infringements? In other words: is OPEC a successful cartel? Can OPEC really hinder competition in the market?

When it comes to Article 101 TFEU, the anticompetitive conduct must have an appreciable effect on the EU market. Hence, even in case of infringement by object, the undertaking should be allowed to prove that its conduct had no such appreciable effect on the market.

The debate on “restriction by object” and “restriction by effect” is far from being settled. I will limit myself in stating that any cartel that does not enjoy a significant market power would be shooting itself in the foot by trying to restrict competition. [The “by object/effect” issue is excellently discussed here, specifically in relation to OPEC].

OPEC’s Members own 3/4 of the world’s oil reserve. They produce 40% of the global demand and  their exports represent about 60% of international traded oil.

The numbers above seem to hint that OPEC has some substantive market. However, many have started to doubt that OPEC can still effectively control oil’s price. Indeed, OPEC seemed unable to prevent the 2008 price race, despite the fact it increased its production quotas to the highest level in history.

In the past few years few events have contributed to erode OPEC’s power. The development of substitutes of oil products play now a competitive constraint on OPEC’s ability to increase prices. If the cost of a barrel goes too high, the switch to other energy sources will become more convenient, attracting further investments; shale oil prices are constraining OPEC’s ability/willingness to increase prices, for example [here]. Non-OPEC countries also influence OPEC’s strategy. Russia is now the biggest oil producer, as well as the number 1 energy producer [here]. Russia, as much as Saudi Arabia, depends on oil exports for a great  portion of their budget revenues. The two countries put energy issues at the heart of their foreign policy and use oil (and in Russia’s case, natural gas) as tools to achieve political objectives [here]. Russia’s increased production kept under control OPEC’s behaviour, even in the face of a high demand [here].

Other factors that influence the sustainability of the OPEC’s cartel are the differences in production costs of the OPEC’s members, the different weight that oil’s revenues play in their national economy, and their different policy’s objectives [here].

Moreover, a sustainable cartel needs a credible retaliation mechanisms. While Saudi Arabia, the biggest oil supplier, usually keeps at hand more than 1.5 – 2 million barrels per day of spare capacity for market management [here], the rest of the Members have little room to increase production [here].

If OPEC has no influence on oil’s price, what does?

Normally, prices drop when supply and demand increase and vice versa. But in the oil world, demand and supply are only part of the equation. Elements of geopolitics, environmental concerns as well as the oil’s status as the preferred source of energy complicate the picture [here].

The production costs per barrel depend on technological progress and the characteristics of the resource stock [here], which are independent from OPEC.

In the long-run the two factors that drive oil price are: the global demand and the future supply. The former is directly linked to the constant population growth and the increasing need for oil of emerging countries. The latter is highly uncertain to remain stable given that supplier countries manage their reserve more and more independently from the needs of third parties. There is no concrete reason for them to respond to the needs of importing countries and establish a low price [here]. So even in the absence of OPEC the price is very unlikely to go below costs of production.

Zietlov argued that factors that play a greater influence on the oil’s price than OPEC’s market power are:  the steady increasing of global demand, the temporary supply constraints, the US dollar exchange rate, and the growing importance of resource pragmatism and nationalism.

 

The oil industry might be a perfect example of the need to trust the market to eventually adjust itself. Similarly, the oil’s industry provides an example of how market shares are not always indicative of real market power.

However, if now the market seems to have adjusted to a level playing field, it could also go back to a less competitive scenario. For example, things might change if Russia decides to formally join the organisation, so bounding itself to abide OPEC’s decision and increasing OPEC’s spare capacity, necessary to retaliate [here].

P.s.: In the EU, the Commission would have the option to go after OPEC also for infringement of article 102 TFEU. However, from the above I conclude that in spite of the high market shares, OPEC is not able to behave independently of the other market players, hence its Members should not be found to enjoy collective dominance.

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Open Standards to Boost the Internet of Things

The Internet of Things (IoT) integrates the physical world into a computer-based system to allow objects to collect and exchange data. This inter-networking should bring improved efficiency, accuracy and economic benefits. However, many of the benefits of the IoT will occur only as a result of a widespread approach, sharing of data across the value chain and novel services. The adoption of widely accepted standards is the tool to achieve effective and efficient interoperability. The exclusion of all technologies but one might have an adverse effect on competition. Building the IoT on open standards could be the way to maintain a level playing field and promote innovation.

The IoT can build applications for smart transport, health, education, manufacturing and other sectors. It may support more responsive business models thanks to a more granular and frequent data collection that will allow firms to better assess their customers’ needs. Allowing the IoT to live up to our expectations might entail a shift in our approach to governance. If a blanket approach might not be the best solution, it is also true that no one single company, or government, can solve the issue.

The debate on whether there is the need for IoT specific regulation is ongoing and far from being settled. Some consider that the IoT world can be efficiently and effectively governed by current horizontal legislation, such as privacy, safety, environmental and competition rules. However, as a successful IoT environment demands that different devices interact, it is crucial to enable those products to communicate between each other. Hence, it seems impossible to avoid the adoption of a regulatory framework that will allow for interoperability.

Standardisation is critical in establishing a Single Market for IoT. Standards allow complementary or component products from different manufacturers to be combined or used together. They increase consumer choice, convenience and reduce costs of production. They eliminate fragmentation and will enable the emergence of the IoT ecosystem boosting innovation and reinforcing competition.

The endorsement of a particular standard is done at the expense of potentially competing technologies. However, competition in network markets is likely to result in standardisation anyway, as long term coexistence is unlikely given that a small initial advantage is apt to influence consumer expectations regarding the adoption of a specific standard. In markets with network effects, such as the IoT one, the product’s value increases the higher the number of adopters. Consequently, the network’s value increases to future adopters. Consumer expectations are often self-fulfilling and an early lead will turn in a competitive advantage difficult to overcome.

The IoT is expected to improve many aspects of our daily lives. It will influence all major economic sectors, from health to education, from transport to manufacturing. Given the total interconnection between all IoT technology, network effects will strongly influence the competitive features of the market. It seems of excruciating importance to assure that the IoT’s potential is not locked in the hands of few dominant market players.

Amazon, Apple, Google, as well as other companies already offer integrated solutions. SSOs are already working on developing standardised software layers. However, the Garten report predicts that there will not be a dominant ecosystem of platform until 2018.

Many of the existing platforms are based on a proprietary model that locks consumers into specific interface standards. Open standards seem to be preferable to proprietary solutions as they have a positive effects as regard to large scale deployment, widespread adoption and lock-in prevention. Open standards would appear to present a perfect mix of flexible multi-stakeholder arrangements. They ensure an adequate balance between the need to foster private sector innovation and the need to avoid technological lock-in or gridlock. Through the application of the principles of openness, broad consensus, transparency, availability and market-driven adoption, consortia are more likely to develop inclusive technology that more strongly adheres to the principles that are at the basis of some of the best technological innovations of our time, including the free and open Internet. With truly open specifications in place, the pathway to standardisation may also become a more smooth one.

So far the digital ecosystem has proved to be a stimulating and innovative environment, continuously delivering new inventions capable of disrupting our daily routine. For the sake of a successful, competitive and fair IoT market, it is about time for the digital world to deliver a business model that moves away from IP revenues-based models and shift to models that generate income through the delivery of innovative complementary products.

***

Dolmans, M., Standards for Standards, paper for the Joint DOJ/FTC hearings on Competition and Intellectual Property Law and Policy in the Knowledge-Based Economy, Washington DC, 22 May 2002, s4.1(a), available at: http://www.ftc.gov/opp/intellect/020522dolmans.pdf.

Dolmans, M., A Tale of Two Tragedies – A Plea for Open Standards, (2010) available at: http://www.ifosslr.org/ifosslr/article/view/46.

Glander, M., Open Standards, Policy Aspects and Legal Requirements, European Competition Journal Vol.6, Iss. 3, 2010.

Ghosh, R.A., An Economic Basis for Open Standards, (2005), p. 4 available at:
https://www.intgovforum.org/Substantive_1st_IGF/openstandards-IGF.pdf.

Kim, D., Lee, H., and Kwakc, J., Standards as a driving force that influences emerging technological trajectories in the converging world of the Internet and things: An investigation of the M2M/IoT patent network, Research Policy Volume 46, Issue 7, September 2017, pp. 1234-1254.

Regulation (EU) n. 1025/2012 of the European Parliament and of the Council of 25 October 2012 on European standardisation

Organisation for Economic Co-operation and Development, The Internet of Things: seizing the benefits and addressing the challenges, Background report for Ministerial Panel 2.2., Working Party on Communication Infrastructures and Services Policy, 2016, p. 12, available at: http://www.oecd.org/officialdocuments/publicdisplaydocumentpdf/?cote=DSTI/ICCP/CISP(2015)3/FINAL&docLanguage=En.

Is economics helpful when it comes to cartels?

Economics implies that cartels are inherently unstable and so should be short-lived because they price above the Nash equilibrium. However, the evidence is cartels are often long-lived.

When players interact for an infinite number of times, as do firms in real markets, they can escape the short-run Nash equilibrium of the Prisoner Dilemma. In the context of infinite interaction, a collaborative behaviour becomes sustainable depending on the benefits of cheating, the credibility of the punishment’s threat and the discount factor.
“Punishment” refers to the reaction of non-cheating firms to an infringement of the collusive agreement: non-cheaters will move away from the cartel equilibrium towards a more competitive equilibrium, so that the cheater’s profit is reduced. Stability of the cartel is ensured by a punishment mechanism that makes the benefits derived from deviation smaller than the benefits of keeping colluding. An effective punishment mechanism should be strong enough to deter cheating, but also credible. It is in every cartel member’s interest to set the punishment mechanism as high as possible, but credibility follows from each non-cheating firm’s interest to implement it if a breach actually occurs. The punishment mechanism should hurt the cheating firm more than the non-cheating ones; hence, it must correspond to the latter’s profit-maximising behaviour.

Economics’s contribution to anti-cartel enforcement

Ex ante, economics can be used to prevent the formation of cartels by prohibiting mergers that would ease collusion. As tacit and explicit collusion rest on the same economic principles, the criteria used to identify tacit collusion in merger review processes can provide guidance also for the detection of explicit collusion.

Ex post, competition law enforcement can benefit from economic analysis because the latter can provide evidence:

  1. on the plausibility that an industry is/was cartelised, i.e. it can
    a) suggest where to look for a cartel, and
    b) reveal whether, given the characteristics of the market, the cartel
    allegation is credible; and
  2. on the impact that a cartel has had in the market.

Unfortunately economics is unable to establish with certainty whether a market is cartelised: economic models can be employed as screening devices, but further investigation will always be necessary.

Likelihood of collusive behaviours

Economics can help identify markets that are prone to cartelisation and establish whether the cartel allegation is credible given the market’s characteristics. However, economists tend to reject the idea of prosecuting cartels on economic grounds only because patterns of prices under collusion and competition are often similar; moreover, economics cannot distinguish between no collusion and unsuccessful collusion, and it cannot distinguish between tacit and overt collusion.

Structural and behavioural markers represent – complementary – screening tools; they identify suspicious behaviours, but cannot provide hard evidence of collusion. Indeed, they could produce false positives, or negatives, because they cannot distinguish between tacit and express collusion or because market players can evade them. Moreover, not all noncompetitive behaviours infringe competition law.

Estimation of the cartel’s effect on the market

Economics is useful to assess the cartel’s effects on the market. The actual cartel’s impact is of relevance for damages actions, but it can also have a bearing on the size of the fine imposed.

The harm suffered by the direct purchaser of a cartelised product has three elements: (i) the direct effect – the quantity of product purchased multiplied by the increase in price as a result of the cartel; (ii) the output effect – the increase in the purchaser’s selling price that is a likely consequence of its input prices increasing, leads to a reduction in the demand for its products; and (iii) the passing-on effect, which occurs when the direct purchaser raises its selling price in response to the increase in output costs, therefore reducing the harm it suffers

The consequence of a cartel on the market can be estimated by understanding what would have happened absent the wrongful conduct: the claimant’s position during the cartel is compared to the position that he would have been in “but for” the anti competitive behaviour. The difference between the claimant’s profits in the counterfactual world to the one in the cartelised scenario is the amount of compensatory damages due to the claimant. To estimate the counterfactual profit we need to know, or estimate, the following:

  1. the amount of the overcharge;
  2. how much lower would have been the selling price at the lower input costs; and
  3. the level of sales occurred at this lower price.

Direct evidence can be useful to quantify the damage; however, economists have developed different helpful tools to carry out the calculation. Comparator-based methods assume that the counterfactual scenario is representative of the likely non-infringement scenario and that the difference between the infringement data and the data chosen as a comparator is due to the infringement. Cost-based methods estimate the non-infringement price by using some measure of production costs per unit and adding a mark-up for a profit that would have been reasonable in a competitive market. Financial methods compare the counterfactual profitability and the actual profitability of the claimant or the defendant. These approaches can estimate the likely non-infringement scenario but cannot delineate it with certainty and precision.

 

In conclusion, even though economic cannot provide hard core evidence of collusion, it is a useful tool to detect cartels and understand their effects in the market. However, the quality of the answers economics can provide is only as good as the data available and as appropriate as the approach chosen.

***

Ayers, I., How cartels punish: a structural theory of self-enforcing collusion, in Columbia Law Review, 1987, pp. 295-325.

Bishop, S. and Walker, M., The economics of EC competition law: concepts, application and measurement, University Edition, Sweet and Maxwell, 2010.

Friedman, J.W, A non-cooperative equilibrium for supergames, in Review of economic studies, 1971, pp. 1-12.

Harrington, J.E. Jr., Behavioral screening and the detection of cartels, EUI-RSCAS/EU Competition 2006 – Proceedings, 2006

When the market definition/market share approach does not work to assess market power

Traditionally, competition authorities start their assessment by identifying the competitive scene, i.e. the relevant market, which includes the firm’s product and potential substitutes. They then calculate market shares to decide whether the firm(s) under scrutiny has enough market power to benefit from the adoption of an anticompetitive strategy. 

However, when market shares are not a strong indication of market power, market definition is least useful. Difficulties arise in products differentiated markets since market boundaries are problematic to draw; as well as in bidding markets, in markets with networks, and in highly dynamic and innovative market. This is so because competition might be “for the market” rather than “in the market.” Moreover, when market concentration has no strong links to the economic theory by which competition would allegedly be harmed, market definition is also of limited help.

From an economic point of view, the assessment of market power does not always require the identification of the relevant market. Economists prefer to focus on the level of competition in the market and to gather and assess evidence in the way that best sheds light on the competition question at hand. To better serve the purpose of competition law analysis, economists have developed techniques that allow the direct assessment of market power, some of which are discussed below.

Direct evidence of the effects of a firm’s behaviour might better answer the question at hand. Indeed, sometimes it might be enough to establish that the firm’s price is too high compared to its marginal cost, or that its economies of scales are so great that no one can replicate them, and hence compete effectively. Past events in the market, such as recent mergers, the entry, expansion or exit of market players and their effects on prices, are likely to be very informative regarding the potential competitive effects of future occurrences in the market.

Alternatively, market power can be assessed directly by calculating the Lerner Index, which predicts the price-marginal cost margin and reveals the firm’s ability to raise prices above short-run marginal costs. However, in many industries the competitive price is not equal to short-run marginal costs. Moreover, the Lerner Index is not applicable to firms producing multiple products – the majority – and it assumes that the firm is competing according to a static short-run non-cooperative Nash equilibrium – but this will often not be the case.

Another way to identify market power is to observe the way firms and industries react to variation in marginal costs. This can be done, for example, by focusing on the residual demand estimation, which measures the ability of a firm to raise prices by reducing output after taking into account the demand responses of buyers and the supply responses of its competitors. The residual demand curve is the horizontal difference between the market demand curve and the total supply of all other firms. 

As the exercise of market power follows from demand inelasticity, a firm holds market power and can increase prices when buyers do not have good demand substitutes. If demand is not highly elastic, the exercise of market power can be directly observed by looking at the competitive price or competitive industry output. If costs have not changed, the most plausible explanation for any observed variation in the market price is that the demand elasticity has altered while firms were exercising market power.

A fourth technique to assess directly market power relies on the assumption that firms may behave differently when cooperating than when they compete. If data regarding multiple types of behaviours is available, econometricians will assess whether the specific shift in prices can be better explained by two types of behaviours rather than one.

Lastly, the effects that a merger can have in a market can be directly assessed by focusing on consequent price changes rather than increases in market shares. Merger simulations and pricing pressure tests are more suited to assess deals in products differentiated markets than the market definition/market shares approach.

Merger simulation directly calculates how much the price will increase post-merger by first modelling the nature of competition in the pre-merger scene and then combining this data to predict the post-merger scenario. Merger models can play an important role in the assessment of the effects post-merger marginal cost reductions have on prices, but they cannot represent the only basis for a competition authority’s final decision, as they omit important parts of the competitive effects analysis, such as entry, buyer power, product repositioning and changes in the mode of competition post-merger. 

When closeness of competition is the central issue, market shares are not necessarily indicative, while diversion rations directly assess the issue. Diversion rations calculate the percentage of lost volumes that are captured by another product following a unilateral price increase. If combined with margin data, diversion ratio can perform so-called price-pressure tests, which can assess the change in pricing incentives post-merger – and, at instances, the magnitude of the price change. The firm’s net incentive to raise prices after the merger is identified by comparing its incentive to increase prices due to lost competition against the opposing incentive to decrease prices due to cost savings.

In conclusion, depending on the type of behaviour under scrutiny and the available data, it is not always necessary or useful to delineate the relevant market to establish if a firm is able to exercise market power. The choice towards one or the other method should be dictated by the structure of the industry under scrutiny and the legal question at hand, rather than by the certainty that market definition is the best tool available.

***

Baker, J.B. and Bresnahan, T.F., Estimating the residual demand curve facing a single firm, in International Journal of Industrial Organisation 6 (1988), pp. 283-300.
Baker, J.B. and Bresnahan, T.F., Empirical methods of identifying and measuring market power, in Antitrust Law Journal, Vol. 61, No. 1 (Summer 1992), pp. 3-16.

Bishop, S. and Walker, M., The economics of EC competition law: concepts, application and measurement, University Edition, Sweet and Maxwell, 2010

Kamerschen, D.R. and Kohler, J., Residual demand analysis of the ready-to-eat breakfast cereal market, in The Antitrust Bulletin, Winter 1993, pp. 903-942.

Economics and Competition Law

Economics is the study of how society decides what, how and for whom to produce.”

Begg, Fischer and Dornbusch

A lawyer who has not studied economics…is very apt to become a public enemy.

Justice Brandeis (1916)

To abandon economic theory is to abandon the possibility of rational
antitrust law.

Judge Robert Bork (1978)

 


It is undoubted that economics has come to play a crucial role in competition law assessments.

This might represents a natural evolution of the area, as competition policy rests on the economic idea that it is appropriate to limit the exercise of market power in the interest of economic efficiency and welfare. And economics goals are at the heart of modern competition law regimes, i.e. society/consumer welfare.

At the most fundamental level economics is concerned with the implication of a rational choice, hence it is an essential tool for figuring out the effects of legal rules.

Economics studies how markets work, how they allocates goods and services to different consumers. Competition law is concerned with how markets work; its general objective is to ensure that there is competition between market players, and that this competition benefits consumers.

Economics can help understand how markets operate, how firms (will) behave, and whether their behaviour will eventually benefit consumers; it helps answering questions that are central to competition law cases.

But, if on the one hand economics has helped clarify some of the debated issues, on the other hand it might have brought also some non-sense. Why? “[a]lthough economic theory is indispensable to our task, clear-cut answers are often impossible. The complexities of economic life may outrun theoretical tools and empirical knowledge. We often will remain uncertain about the economic results of the particular practice or market structure under examination. Nor can we always predict the consequences of prohibiting some particular behavior. Thus, we shall time and again meet this question: How far must we search for economic truth in a particular case when the economic facts may be obscure at best, when the relevant economic understanding may be controversial or indefinite, and when the statute does not give us a clear-cut value choice?” ( P. Areeda, L. Kaplow and A. Edlin, Antitrust Analysis, Problems, Text and Cases, Aspen
Publishers, 6th Edition, 2004, p. 105)

Glossary of Industrial Organisation Economics and Competition Law – OECD

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Aside

An Introduction to EU Competition Law*

As freak legislation, the antitrust laws stand alone. Nobody knows what it is they forbid.”

Isabel Paterson


  WHAT IS COMPETITION POLICY?

Competition policy deals with the organisation of domestic market economics. It aims to allocate resources in the most efficient way.

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Aside

Dive into Competition Law

THE ORIGINS AND AIMS OF COMPETITION POLICY

People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices. It is impossible indeed to prevent such meetings, by any law which either could be executed, or would be consistent with liberty and justice. But though the law cannot hinder people of the same trade from sometimes assembling together, it ought to do nothing to facilitate such assemblies; much less to render them necessary.”

 A. Smith, Wealth of Nations 

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