OPEC does abide by the Law of Supply!

For those of you who buy the whole OPEC is an effective cartel and they work together at restricting output and raising prices. Even though nothing has changed in the past 20 years for them to become less effective to more effective. This from the Financial Times:

“Opec last month pushed its production to the highest level in its 48-year history even as demand was slipping in the US and Europe, the International Energy Agency (IEA) said on Tuesday.

The combination of surplus supply and weaker demand has pushed oil prices to $113.50 a barrel, down 24 per cent in the past month and the lowest level since late April.”

Of course, the people that wrote this article believe the cartel works and that they agreed to do this to lower prices. I am sure that is partly true, but what would any producer do if the demand increases? The producer would increase supply to meet the demand. They want to do this for two reasons and this will also explain why cartels do not work in free-markets.

First, cartels do not work because there is not a good enforcement mechanism. This is especially true for an international organization. As there is no international justice system to enforce this and people are more spread out. If Nigeria decides to produce a little more than it was allowed to, it will. They have an incentive to do so because they are undercutting the other producers. Then they sell more of their oil and make more money. Since the demand has been staying high then the profits made from undercutting other producers are even higher. Each country will follow until we get back down to the market price.

Second, even if you believe that cartels do work this still holds true. If the price of oil continues to stay high, it increases the profits of those who innovate away or to more efficient energy solutions. For example, in the seventies when gas prices were high the race car industry invent more efficient fuel injected engines. This caused less gas to go to waste when burning the fuel. Since places like Saudi Arabia have only one real commodity, they don’t want to look down 20 years and see no jobs for themselves.

The law of supply states that as price goes up producers will produce more to meet demand. This is all that is happening. What you see in the news is OPEC pretending to “give us” more of a supply when they are just abiding by the market.

The rest of the article can be found here.



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