Nash Equilibrium and the Global Oil Market
Source:
Perminov, Artem. “How Nash Equilibrium Explains OPEC Efforts To Cut Oil Production.” Seeking Alpha, Seeking Alpha, 29 June 2016, https://seekingalpha.com/article/3985265-nash-equilibrium-explains-opec-efforts-cut-oil-production
The linked article discusses how Game Theory and the concept of Nash Equilibrium can be used to intuitively understand the dynamics of the global oil market. The article first takes a look at a Prisoner’s Dilemma scenario, very similar to the one we saw in class, with the following payoff matrix:
For this Payoff matrix, the Nash Equilibrium is Alternative 4, i.e. both prisoners betray (or confess) each other, as it is the one where neither of them can hope to reduce their punishment. The author points out that this alternative is not, however, the best possible choice for the prisoners. If each prisoner had chosen to not betray, they would have chosen Alternative 1 and each been sentenced one year in prison. However the Prisoners would never choose this alternative as it is assumed that they do not communicate with each other in any way or they do not collude / agree upon a course of action mutually.
For this reason, after some research, I learned that the concept of Nash Equilibrium can often not be applied to justify real-world decision making in economics, as policy makers and representatives from concerned nations or organisations make policy decisions in the presence of each other, consult each other, or at least are aware of the decisions their counterparts make.
The article, however, counters this view, by proposing that Game Theory and Nash Equilibrium can be used to intuitively understand the dynamics of the global oil market. The author talks about how the OPEC was unable to negotiate cutting oil production among its members. The author illustrates this scenario using a simplified model, and presents a payoff matrix of two hypothetical oil exporting countries, Oilland and United Oil Emirates (UOE) facing an oil price and export revenue slump and want to increase monetary gains. They can choose to either choose to maintain oil production or cut it in order to increase prices. An increase in oil prices will benefit both countries only if both choose to cut oil production. If only one country cuts production, the other will use this opportunity to seize the former’s market share. The payoff matrix the article presents is as follows:
The article notes that this matrix is very similar to the Prisoner’s Dilemma. Hence, the Nash Equilibrium is when neither country cuts production, and neither country increases its revenue from oil exports. This alternative, rather surprisingly, was the reality of the oil market in 2016, where the OPEC was unable to negotiate oil production cuts among members. This begs the question: if participants in this matrix have the opportunity to cooperate with each other, why do they both not agree to cut production and reach alternative 1, thus making them both better off than if they reach alternative 4?
In 1973, the Israeli-Arab conflict served as a political impetus for countries to cooperate with each other, and ensure they took decisions in agreement with each other which would make each party better off. Now, however, the oil market has become very complex and dynamic, that has made oil exporting companies take decisions in isolation, and thus making the network akin to the Prisoner’s Dilemma, and allowing Nash Equilibrium to rationalize sense of decision making.
Some reasons for oil exports isolating themselves include, according to the author:
- Political mistrust and Rivalry: Saudi Arabia and Iran are two OPEC member with a history of mistrust, and have no reason to believe that either will follow on any mutually agreed decisions regarding oil production, as both expect that if one were to cut production, the other would take advantage resulting in either Alternative 2 or 3.
- Completely different oil production environment: Different countries are comfortable with different oil prices, and hence it is difficult to reach a consensus on cutting oil production, as it likely to disadvantage a country who desires higher oil prices to be reached.
Hence, any efforts taken by the OPEC are unlikely to be fruitful, as oil exports are becoming increasingly isolated in decision-making, with the large-scale ‘game’ that is the global oil market has become pretty similar in morphology to the Classic Prisoner’s Dilemma.