Monopoly Structure
by Carlos
In this article I tried to give you a better understanding of the price setting in a monopoly market using the exit of the United Arab Emirates from the OPEC-Cartel. I sticked to the theoretical economic argumentation I learned in my microeconomic courses.
Monopoly Structure
When visiting Microeconomics classes I never fully understood how and why monopolies only set their supply and not their prices, like polypols would do. The case of the United Arab Emirates (UAE) exiting the Organization of the Petroleum Exporting Countries (OPEC) helped me understand this theoretical argument. Let me explain it to you.
First, we should make sure that we all comprehend what we are talking about. A monopoly describes a company which is the only supplier in a market of a certain product or service. Take for instance the Deutsche Bahn; they are (almost) the only option for us citizens to travel moderate distances in Germany and nearby. The absence of direct competition makes the Deutsche Bahn the monopolist in the train market. A polypol on the other hand refers to a market structure where many different companies operate under high competition. The customer therefore has the choice out of a broader supply.
The key difference here is that the monopoly obviously can charge higher prices than the many companies in the polypol can. But what seems intuitive is in the economic theory not the case! Monopolies do not set prices directly. Instead, they only determine the supply of their products or services. The prices are being formed in the market and therefore are based on the demand by the customers. The monopoly has an incentive to keep the supply artificially low, so the demand is high and the prices rise as more people demand fewer items. By doing this the monopolist has the advantage of increasing his revenue per item sold which makes him more profitable. This is logical so far.
Here is the twist; if prices rise due to a decline in the supply the demand might also go back as not all customers buy the same amount of the good as before. In our example with the Deutsche Bahn the people would then take the car or just stay at home. As you can see there is a trade-off for the monopolist: higher revenue per item versus fewer products sold. The result of this dilemma is based on the willingness of the customers to buy the same amount when prices rise, which is described as the price elasticity of demand. High elasticity means that customers react very sensitively to price changes and would demand much fewer goods. The monopolist needs to consider this effect when changing his supply and is effectively constrained by the elasticity.
Now let us get back to our main case with the UAE exiting the OPEC. The OPEC is an organisation of oil-producing countries mainly in the middle east who work together to keep the amount of oil being sold artificially low. As we now have learned this leads to higher prices per barrel oil and therefore a higher profitability of the producing countries. Due to our low price elasticity of demand we would also pay the higher prices while still demanding the same amount of oil. As we, the energy intensive industries, are highly reliant on the imports of oil, our suppliers have the opportunity of selling us this oil at higher prices and therefore increasing revenue and profit.
The exit of the UAE was a consequence of them being unsatisfied with the constraints on supplying oil. The UAE wants to sell more oil and make more revenue, but on the other hand would dump the price of oil which harms profitability. This is exactly the trade-off we have seen earlier. The UAE has already announced to sell much more oil to the global market, which would support the proposed intention of making more revenue thanks to the high oil price now due to the Iran-War. In addition the UAE wants to take advantage of the fossil-fuel reliant global economy as long as they can.
Hopefully this article helped a little bit with understanding how economic theory works and how it can be applied to real issues. Especially the monopoly structure is hard to comprehend, but maybe the concrete example with the OPEC gives a fresh perspective on profit-maximization of monopolies in this world. Thanks for reading!