Opec Versus A Large Open Economy: A Stochastic Equilibrium Model

If nothing else, recent experience with oil prices has taught us that: (a) even though large, economies such as the U.S. are, nonetheless, open; and (b) even though "small", OPEC has successfully exploited her market power over oil. Yet, nowhere in the literature is there a model capable of adequately analyzing the macro-effects of OPEC's monopolistic behaviour on a large open economy. This paper provides such a model. The model's main feature is that OPEC is an expected revenue-maximizing cartel who exploits the imperfectly-elastic oil demand curve emerging from the domestic economy's use of imported oil as an intermediate input into the production of manufactures. The system is subject to various stochastic shocks with OPEC's expectation on oil demand and domestic agents' price expectations being "rationally" formed. It is found that, unlike small open economies anticipated macro-policies will not alter domestic employment and GNP. In this regard, the large economy behaves as if it were closed. Moreover, micro-policies designed to reduce reliance on OPEC by encouraging adoption of oil -saving technologies are inflationary and permanently reduce GNP. While unanticipated macro-policies can temporarily alter domestic GNP, their impacts may be perverse depending both upon whether OPEC is a price or a quantity setter and upon The extent to which OPEC's revenues are recycled back to the domestic economy through the capital, rather than the trade, account. Lastly, the above results are shown also to hold when OPEC maximizes expected cartel profits, rather than revenues.