Game theory perfectly explains why OPEC members are going to cheat

pulse

March 23, 2018 4:43 PM

Oil prices are rising and that means there is less incentive to cooperate with production caps.

OPEC members have a deal to cap production levels until December.
Oil prices are rising.
When prices are higher, there is less incentive to cooperate with production caps.

With oil prices rising, Organization of Petroleum Exporting Countries members are facing a dilemma.

Extending output caps means making more room in the market for non-member competitors, and coordinating a higher amount of output means lowering prices. So they might not do either, and game theory could help explain why.

pumping more than 10 billion barrels a day

For an individual country focused on maximizing revenue, producing as much oil as possible is usually the dominant strategy — what players should do regardless of the actions of other players.

But when everyone amps up production, it puts downward pressure on prices. In game theory, this is an example of the prisoner's dilemma. Because everyone acts out of self-interest, players end up in a worse scenario than if they collaborated.

This is where OPEC collusion comes in. Member countries — Algeria, Angola, Ecuador, Equatorial Guinea, Gabon, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia and the United Arab Emirates — act as a single supplier.

But as prices rise, it creates more incentive for members to cheat and produce more. Because marginal revenue is higher than at lower prices, there is greater payoff from raising output — even in the face of production caps.

At the same time, the opportunity cost of complying also becomes greater.

"Cutting output to counter the effect of rising non-OPEC production would require giving up increasing amounts of market share and revenue," Pugh and Peach added.

pulse