Oil - Prisoner's Dilemma as a model for OPEC and Cartel Style Oligopolies

This is a quick economics review for people who are concerned about the price of oil and the mechanics at play behind the scenes in the supply and demand curves.

Oil - a fungible commodity like any other - is always under the scrutiny of economists as a major indicator and influence in the world economy. However, unlike some other commodities, it exhibits a greater degree of scarcity and its output is generally controlled by a small group of countries (The Organization of the Petroleum Exporting Countries or OPEC).

Now many investors and hedge funds feel like oil should intrinsically be valued between $40 to $70 USD per barrel (although it is currently trading below $40). This is disastrous for various reasons. First, it shows how weak the economy's demand for oil is. Also, projects like the oil sands in Alberta get halted because it costs more to get a barrel of oil out of the ground than you can profit from selling it.

The problem that OPEC faces can be described by a common game theory model known as the Prisoner's Dilemma or Cheater's Paradox. Let's have a look at how this works:

The way OPEC works is that they will take orders from their customers. Returning to the group, they will set production quotas for each of their members to satisfy the demand (simple supply and demand curves) at a price point of their choosing. If everyone behaves according to the rules they set, the suppliers (OPEC), with perfect information and control on supply, will profit in a similar manner as a monopoly.

However, the system begins to break down when they start to lose control over the inelastic demand and as well as when their individual suppliers misbehave. Let's look at the first scenario.

The world economy has become so weak (and there has even been suggestions that high fuel prices have causes consumers to jump ship to technologies that are less fuel dependent - the law of substitution) that the demand for fuel has plummeted (some say irreparably, others not). This manifests as the demand curve shifting left or at least becoming less steep and more elastic and weakens OPEC's ability to keep prices up at least in the short term. This deflates the price of oil and makes it harder for individual OPEC member countries (such as Venezuela) to maintain enough cash and net exports to support the GDP which is largely dependent on oil export. What is Venezuela to do?

Now Venezuela is incented to "cheat", to produce more oil than in its OPEC stated quota in order to generate revenue to cover the shortfall from the drop in oil prices. This shifts the supply curve to the right and drops the price further compounding the effect. This is exactly the same model as the well documented game theory model the Cheater's Paradox - where OPEC members are the prisoners, producing additional oil is considered cheating and the reward matrix is expressed as marginal increments in GDP.

This process repeats until the supply stabilizes and the price finds a new home, much lower than is expected (which is exactly the case in the current economic environment).