fall in price and, therefore, the greater the decline in the cartel’s total profit.
This observation underscores the major problem cartels face: Cartels are inher-
ently unstable.The reason lies in the basic conflict between behavior that max-
imizes the collective profits of the cartel and self-interested behavior by
individual cartel members.
To see this, return to the cartel’s optimal price and output, PMand QM, in
Figure 8.3. Suppose the cartel agrees to set total output at QMand assigns pro-
duction quotas to members. The self-interest of each member is to overproduce
its quota. The member can sell this additional output by cutting price very
slightly. (Remember that one member’s additional output is small enough to
put little downward pressure on price.) What effect does this added output
have on the member’s profit? Figure 8.3 shows that the cartel price is well above
marginal cost. Thus, even allowing for a slightly discounted selling price, sell-
ing the extra output is very profitable. Each member has an incentive to cheat
on its agreed-upon output quota. But if all members overproduce, this behav-
ior is self-defeating. If all members increase output (say, by 10 to 15 percent),
flooding the market with extra output will have a significant downward effect
on price. The total output of the cartel will be far greater than QM, price will
fall below PM, and the cartel’s profit inevitably must drop. Thus, overproduc-
tion is a constant threat to the cartel’s existence.^5 In the presence of wholesale
cheating, the cartel may fall apart.The 11 member nations of OPEC meet twice a year to discuss the cartel’s tar-
get price for crude oil and to allot members’ production quotas. Like a con-
tinuing drama with many acts, the OPEC negotiations center on (1) an
assessment of the world demand for oil, (2) the appropriate limit on total
OPEC supply, and (3) the division of this supply among cartel members.
Over the last 15 years, OPEC has had a mixed record in limiting its supply
and maintaining high oil prices.^6 Until mid-2001, OPEC was largely successful
in negotiating lower total output levels for the cartel and, therefore, main-
taining high crude oil prices. OPEC successively cut its total output quota from
26 million to 24.2 million barrels per day (mbd), members largely honored
their individual quotas, and prices rose to above $40 per barrel. However, with
the worldwide economic slowdown in 2002 and greatly increased supply by
nonmember Russia, OPEC faced the prospect of soft and falling oil prices. With
OPEC members exceeding their quotas by an estimated 1 million total barrels
per day, oil prices fell below $20 per barrel.330 Chapter 8 MonopolyBusiness Behavior:
The OPEC Cartel(^5) A related problem is that an oil producer is typically better off being outside the cartel, where it
can take advantage of a high, cartel-maintained price without limiting its own output. Many oil
producers, including Mexico, Malaysia, Gabon, Norway, Russia, and Egypt, support OPEC’s ini-
tiatives while refusing membership.
(^6) This synopsis is based on industry reports, OPEC’s official communications, and on F. Norris,
“Two Directions for the Prices of Oil and Natural Gas,” The New York Times, February 26, 2011,
p. B3; and “Oil Pressure Rising,” The Economist, February 26, 2011, pp. 79–80.
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