Yesterday, French economist Jean Tirole won the Nobel Prize in Economics for his work in understanding imperfect markets such as monopolies or oligopolies. Personally, Tirole has been a huge influence in how I view the world. His graduate-level textbook on Industrial Organization remains, to me, the standard in the field, even though it is getting a bit long in the tooth.
Here is what Tirole’s textbook says about a little something we like to call predatory pricing (quoting Joskow and Klevorick):
“Predatory pricing behavior involves a reduction of price in the short run so as to drive competing firms out of the market or to discourage entry of new firms in an effort to gain larger profits via higher prices in the long run than would have been earned if the price reduction had not occurred.”
As it happens, this is incredibly relevant to Venezuela right now. Yesterday, several news organizations talked about how Saudi Arabia is leading a push toward lower oil prices in the near future.
The Saudis, the largest oil exporters in the world, are giants in the world’s oil markets by virtue not just of their size and the level of their reserves but because of their enormous spare capacity. Basically, the Saudis can turn their oil pumps on and off in a way that makes a large difference in the oil markets, and only they have the capacity to do this.
What do the stories say about what’s going on? In a nugget, the Saudis are worried about the long-term prospects in the market if oil remains expensive. The growth in shale oil production worries them, particularly in the US, which has now become the world’s top oil producer. There is also some concern that higher oil prices can spur investment in off-shore fields such as the one off the coast of Rio de Janeiro. All of this threatens the kingdom’s dominance of world oil markets.
The message they are sending? “People should get used to low oil prices for a while.” By flooding the market, the Saudis are pushing prices down and making new entrants think twice before deciding whether to stay or not.
Is their behavior an example of predatory pricing? Who knows? As Tirole puts it, “although predatory behavior can be demonstrated within an abstract model, deriving empirical tests for antitrust analysis is difficult indeed.” What seems like predatory pricing to one person may seem like the obvious reaction to a new entrant in the market – lower prices driven by greater competition.
However, the smell test indicates that this is indeed predatory behavior on the part of our OPEC partners. That is why Kuwait and Saudi Arabia are so far ignoring Venezuela’s desperate pleas for an emergency meeting of OPEC to stem a drop in prices that threatens the very existence of the Bolivarian regime. One Kuwaiti minister was quoted as saying “I haven’t heard of any call for an emergency meeting,” the equivalent in oil circles of turning off your cell phone to avoid uncomfortable calls.
Can predatory pricing work? There is no consensus on this among economists. As Tirole puts it, “the predator tries to convey bad news to its rivals about their profitability in its market. The predation does not affect the rivals’ real prospects, only the perception of these prospects. Under rational expectations, predation may or may not succeed in driving (or keeping) rivals out of the market.”
In other words, shale oil may well ride out the Saudi storm, in which case we would probably see low oil prices for a good long time.
If they are indeed doing this, the Saudis are sacrificing short-term profits for long-term gains. If these actions precipitate the fall of the Maduro regime and the substitution for a more inclusive, democratic government, then we could also say these moves are inadvertently causing short-term pain for the sake of a better future.
I know it’s cold comfort, but keep that in mind next time you realize that your salary is not enough to buy all that you need. The Saudis are waking us up from the populist daze Venezuelans have been living in. Waking up usually sucks, but it’s something you simply need to do.