Angola plays its dominant strategy in defecting against OPEC

The Financial Times reported last week (paywalled):

Angola, Africa’s second biggest oil producer, has said it is leaving Opec after disagreements over its production targets, delivering a blow to the oil cartel chaired by Saudi Arabia.

The decision comes after the producer group lowered Angola’s oil output target last month as part of a series of cuts led by Saudi Arabia to help prop up prices.

OPEC is an example of a cartel. Cartels can arise when a market is an oligopoly - a market where there are many buyers, but few sellers. A cartel essentially acts like a monopoly seller - it is able to use market power to extract greater economic rent from the market (in the form of higher profits, arising from higher prices), than the countries would be able to extract if they were competing with each other. The cartel can be maintained because there are few sellers, so it is relatively easy for them to coordinate their actions. In this case, OPEC coordinates to raise prices by restricting production.

However, there is always an incentive for each cartel member to cheat on the cartel agreement, or to leave the cartel entirely (as Angola has done). To see why, we can apply some game theory. Let's say that there are two players - Angola and 'the rest of OPEC'. Each player has two strategies - high production (which leads to lower prices and lower profits for oil producers), or low production (which leads to higher prices and higher profits). If one player has high production and the other low production, the high production player benefits more. However, if both players have high production, both are worse off. These outcomes and payoffs are illustrated in the diagram below (the payoff numbers represent profits, but are just made up to illustrate this example).

To find the Nash equilibrium in this game, we use the 'best response method'. To do this, we track: for each player, for each strategy, what is the best response of the other player. Where both players are selecting a best response, they are doing the best they can, given the choice of the other player (this is the definition of Nash equilibrium). In this game, the best responses are:

1. If the rest of OPEC chooses high production, Angola's best response is to choose high production (since 2 is a better payoff than 0) [we track the best responses with ticks, and not-best-responses with crosses; Note: I'm also tracking which payoffs I am comparing with numbers corresponding to the numbers in this list];
2. If the rest of OPEC chooses low production, Angola's Arabia's best response is to choose high production (since 4 is a better payoff than 3);
3. If Angola chooses high production, the rest of OPEC's best response is to choose high production (since 10 is a better payoff than 9); and
4. If Angola chooses low production, the rest of OPEC's best response is to choose high production (since 15 is a better payoff than 12).

Note that Angola's best response is always to choose high production. This is their dominant strategy. Likewise, the rest of OPEC's best response is always to choose high production, which makes it their dominant strategy as well. The single Nash equilibrium occurs where both players are playing a best response (where there are two ticks), which is where all of OPEC (including Angola) chooses high production.

Notice that both players would be unambiguously better off if they chose low production. However, both will choose high production, which makes them both worse off. This is a prisoners' dilemma game (it's a dilemma because, when both players act in their own best interests, both are made worse off).

That's not the end of this story though, because the simple example above assumes that this is a non-repeated game. A non-repeated game is played once only, after which the two players go their separate ways, never to interact again. Most games in the real world are not like that - they are repeated games. In a repeated game, the outcome may differ from the equilibrium of the non-repeated game, because the players can learn to work together to obtain the best outcome.

And that is what happens when a cartel forms. If all of OPEC (including Angola) works together and agrees to choose low production, both players benefit. That is what they were doing, up until Angola chose to leave OPEC. The problem here is that both players choosing low production is not an equilibrium. If Angola knows that the rest of OPEC is choosing low production, it is better off defecting from the agreement and choosing high production. Angola profits more that way (at least, in the short term).

So essentially, by leaving OPEC (and thereby choosing high production), Angola is simply playing its dominant strategy.

Read more:

• The oil price war is actually just a return to equilibrium