Economics

Explanations

Revision on Producer Cartels

Geoff Riley

31st March 2012

Here is a planned answer to this Unit 1 question

“Explain how a producer cartel might affect the supply, market price and output levels of a commodity as well as total revenue for producers"

This is an explanation question so no explicit evaluation is needed. The examiners are looking for clear explanations, chains of reasoning and an appropriate use of diagrams to support the answer.

Planned answer:

A producer cartel is an organisation that seeks to use control over the market supply of a commodity to keep prices within a target range to stabilise incomes and profits over time. An example of a producer cartel is OPEC.

The producer cartel needs to tread a fine line – too low a market price for oil and the price they are getting might not be enough to cover the cost of extraction and make enough profit to justify the heavy capital investment. But if world crude prices stay high for too long, demand will fall away because the economic incentives for finding oil substitutes and in conserving the use of oil become increasingly strong.

Consider a situation when a cartel wishes to raise the market price of a commodity such as oil. To do this it will seek to restrict or reduce supply. Ceteris paribus this raises price and lowers the quantity traded. If demand for the commodity is price inelastic (i.e. Ped

< 1) then total revenue for producers will rise. There will be a reduction in

consumer surplus and a rise in producer surplus. My diagram shows that, at the new higher equilibrium price of P2, total revenue for the producer cartel will have risen.

Cartel Supply Diagram

OPEC was founded in 1960 – it controls around 40% of world crude oil output and just over half of world oil exports although it has a larger share of world crude oil reserves. OPEC controls it's own supply through a system of output quotas.

OPEC's mission is to ensure the stabilization of oil markets in order to secure an efficient, profitable and regular supply of petroleum to consumers, a steady income to producers and a fair return on capital to those investing in the petroleum industry.

OPEC production

OPEC Prices and Production

Key Terms

Ceteris paribus: To simplify analysis, economists isolate the relationship between two variables by assuming ceteris paribus - all other influencing factors are held constant

Collusion: Collusion is any explicit or implicit agreement between suppliers in a market to avoid competition. The main aim of this is to reduce market uncertainty and achieve a level of joint profits similar to that which might be achieved by a pure monopolist

Equilibrium: Equilibrium means 'at rest' or 'a state of balance' - i.e. a situation where there is no tendency for change. The concept is used in both microeconomics (e.g. equilibrium prices in a market) and also in macroeconomics (e.g. equilibrium national income)

Inelastic demand: When the price elasticity of demand is less than 1

Market supply: Market supply is the total amount of an item producers are willing and able to sell at different prices, over a given period of time egg one month. Industry, a market supply curve is the horizontal summation of all each individual firm's supply curves.

Geoff Riley

Geoff Riley FRSA has been teaching Economics for over thirty years. He has over twenty years experience as Head of Economics at leading schools. He writes extensively and is a contributor and presenter on CPD conferences in the UK and overseas.

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