OPEC & Capacity (Part 2)

My last post introduces the concept of spare capacity, which is the ability to produce more at a given time than is demanded. More detail is in order.

A certain amount of spare capacity is desirable, indeed, necessary for the orderly functioning of any production process. Take the U.S. job market, for instance. Although the exact figure is a matter of debate, economists consider a society to be fully employed when the unemployment is in fact greater than zero -- at some level between 3-5% or more (called frictional unemployment, where workers are temporarily between jobs in order to maximize benefit). There is actually a tradeoff between the rate of inflation and the level of unemployment. If an economy experiences a sustained unemployment rate of only 2%, inflation will increase as companies offer higher and higher wages to attract people. Rising wages lead to higher costs and higher prices until workers demand even higher wages, perpetuating the cycle. At some level or "ideal unemployment rate" wages and costs are for the most part balanced and inflation remains under control.

On the flip side, a slowing economy leads consumers and businesses to cut back on purcahses. Decreases in sales lead to cost cutting, which eventually means layoffs. When fewer people are employed, they consume less and the downward spiral continues. The job market and the economy go through this cycle over and over, vascillating between an expanding economy (low unemployment) and a slowing economy (higher unemployment).

Let's take this example to the extreme. Say the U.S. suddenly made a dramatic change to immigration or foreign worker policy, and overnight the workforce increased 10% due to the influx of foreign workers. These workers would accept jobs at a much lower wage than that currently received by incumbant workers. Immediately, wages would fall as workers were fired in favor of the newly available and cheaper labor, or as a result of incumbants accepting lower wages in order to avoid being laid off.

This is a situation analogous to what happened as the mega fields of the Middle East and Venezuela were brought online. If production was not controlled, oil prices would fall as a glut of supply was created. Of course, any single producer would continue to maximize profits by producing as much as they could, so the result was cheap oil. When oil was cheap, there was very little incentive to be efficient consumers. Americans drove large cars with big engines that delivered a lot of power, but not a lot of miles per gallon.

At first, a country experiencing the bonanza of newly obtained oil revenue would just be happy to see the additional money come in. Eventually, however, the mineral owners (in this case, sovereign goverments) become more sophisticated, and realize that this source of funds will not continue forever. The OPEC countries (before they were OPEC) understood that they were selling a diminishing resource for cheap, while paying a higher price for other finished goods--some of them the end products of oil--originating in the oil consuming nations.

The realization that they were selling low and buying high created a desire to take more control of their own destiny and their limited resource. Various political events created a convenient environment for cooperation between the OPEC countries, and eventually they formed an alliance.

The OPEC website (opec.org) states that the organization was created in Bagdad on September 10-14, 1960, by Iran, Iraq, Kuwait, Saudi Arabia, and Venezuela. OPEC's stated objective is to "coordinate...oil production policies in order to stabilise the oil market and to help oil producers [i.e., countries exporting oil] achieve a reasonable rate of return on their investments." In simpler terms, OPEC's objective is to ensure its member countries' oil is not sold at a price tantamount to giving it away.

(Continued in Part 3)