It’s rare that we find an article with such a diverse array of topics, but the Financial Post recently published a Bloomberg article that discusses the ongoing problems in the Persian Gulf.
The background to this story is Iran’s continued research into nuclear energy and their production of weapons grade material. In response, the international community has imposed economic sanctions against Iran. These sanctions include restrictions on international payments for Iranian oil exports. Despite the sanctions, Iran continues with its nuclear program and now the US and Europe are planning an oil embargo against Iran. Iran has responded by threatening to close access to the Strait of Hormuz through which all tankers leaving the Persian Gulf must pass.
The first economic issue we have comes from game theory. Is Iran’s threat to close the Straits credible? Whether or not they possess the military capability, the economic damage to Iran itself would be devastating. The government, reportedly, derives 80% of their revenue from oil exports and all that oil must pass through the Strait of Hormuz. The cost of closing the Strait is greater than the benefit and, for this reason, it is unlikely that Iran will follow through on its threat.
Even if they did attempt to restrict shipping, the US has vowed to use their impressive naval power to ensure that oil from the Gulf States continues to flow. Any long term disruption in oil exports could cause oil prices to rise towards $200 per barrel and lead to another global recession. While the US is incurring all of the costs in patrolling the Gulf, China is enjoying the benefits. This second economic issue is known as the ‘free rider’ problem. It occurs when a good or service is produced and the use of it cannot be restricted to only those that pay. Fireworks and sidewalks are other examples of goods that are ‘non-excludable’.
The US and Europe are contemplating a complete embargo against Iranian oil. Meanwhile China is sitting back and anxiously waiting for the embargo to happen.
A monopoly occurs when there is only one seller of a good and most readers are aware that a single seller will increase prices. There is another market condition in which there is only one buyer; a monopsony. If Europe, the US and Japan all refuse to purchase Iranian oil, China would be left as the lone purchaser. A monopolist has significant influence over the price and causes it to rise. A monopsonist can also influence price but causes it to fall. If the embargo goes ahead, China will be able to buy oil cheaper than the rest of the world.
In this article we see the concepts of credible threats, the free rider problem and monopsony. A rational person would recommend that the Iranian government back down, and a rational government would listen. We will continue to watch this story as it unfolds.
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