South-Western College Publishing - Economics  
Troubled Waters in Oil Industry
Subject Cartels and Mergers
Topic Oligopoly
Key Words Costs, Emploment, Merger, Producers, OPEC, Output, Prices, Regulators
News Story

Exxon Corp. and Mobil Corp. are considering merging to create the biggest oil company in the world. The rationale is to reduce costs. In spite of new technology which has decreased the costs of extracting oil, and reducing employment and exploration, costs are still too high. A merger would enable duplicate staff to be released. Also, aggressive Mobil, which has significant reserves, would complement conservative Exxon, which is financially sound.

Cost reduction is necessary due to low oil prices. U.S. oil producers need to receive $12 to $15 a barrel in order to break even, and oil prices are now under $12 a barrel. The Organization of Petroleum Exporting Countries (OPEC), whose members produce 40 percent of the world's oil, have been unable to agree on production cutbacks to force price up. They are concerned that non-OPEC producers like Russia would simply increase output. Perhaps they also realize that high prices would only keep high-cost producers, such as those in the U.S., in business.

One disadvantage of the merger is that the two firms have different cultures. Also the merger would undoubtedly attract the attention of regulators - Exxon and Mobil were created when Standard Oil was broken up in 1911.

(Updated January 1, 1999)

Questions

1. a) What is a cartel? What does it do?
  b) Why is the OPEC cartel currently weak? Consider the news story and what you know about the best conditions for effective cartels.
2. a) Draw a diagram of a long-run average cost curve. Mark the minimum efficient size.
  b) According to the news story, Exxon and Mobil currently have average costs that are greater than the minimum. Mark a point at which they might be given their individual sizes.
  c) What economies of scale might arise from the merger? Refer to the news story.
  d) Illustrate what would happen to average cost and output if the two firms were to merge.
3. a) What diseconomies of scale might arise? Again, refer to the news story.
  b) On your diagram, show where the merged company might be if there were diseconomies of scale.

Source Wall Street Journal, "Sinking oil prices prompt merger talks among giants", St. Petersburg Times, November 28, 1998.

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