Questioning the Nash Equilibrium in Oil Production?
Original Link:
http://seekingalpha.com/article/3985265-nash-equilibrium-explains-opec-efforts-cut-oil-production as accessed on September 16, 2016
As a business student with a keen interest in strategy, I have always heard about the macroeconomic impacts of oil prices and wanted to dive deeper into the key factor controlling these prices – the interaction of several players who produce oil in an attempt to make the most rational choices (that give them the highest payoff). In class, we have worked with games and scenarios with limited variables and more often than not very clearly defined strategies, this notion was challenged when we learnt about mixed strategies and I believe that understanding the way in which a Nash equilibrium is reached when dealing with oil production is a very interesting topic.
To begin with, reaching a Nash equilibrium involves the assumption that players make rational choices to maximize their payoff, however, I found that this assumption fails at times, especially when looking at the case of a drop in the price of oil in recent times due to overproduction (led by one significant player). It was interesting to understand the reasons behind the violation of this assumption – why would the players choose to move away from the Nash equilibrium and make themselves worse off? On reading further, I understood that the OPEC allowed individual players to collaborate and coordinate their actions as compared to other non-OPEC producers and this meant that the setup of the game would now include many more complex steps that would translate to a binary choice between ‘Cut Production,’ or ‘Don Not Cut Production.’ This can be summarized in the following matrix.
However, unlike the Prisoner’s dilemma – we see that players can actually communicate and coordinate with each other – leading to the formation of the OPEC for example. However, it is important to understand the importance of the aforementioned external variables that make the above game more similar to the original prisoner’s dilemma discussed in class. Factor such as Political mistrust and hidden rivalry can reduce the original coordination and having very differing oil production environments in different countries can also accentuate the situation – leading to a situation that closely resembles the original Prisoner’s dilemma. Personally, I would be excited by the prospect of learning more about this topic and the interaction with different sources of energy such as the rise of independent producers, especially so in the USA. It is intriguing to understand the way in which substitutability factors into the game as any Nash equilibrium obtained within oil production would illicit a response in the supply and demand for shale gas.