3. Breakdown of a cartel agreement Consider a town in which only two residents,

Question

3. Breakdown of a cartel agreement Consider a town in which only two residents, Nick and Rosa, own wells that produce water safe for drinking. Nick and Rosa can pump and sell as much water as they want at no cost. For them, total revenue equals profit. The following table shows the town's demand schedule for water Price Quantity Demanded (Gallons of water) Total Revenue (Dollars) (Dollars per gallon) 6.00 5.50 5.00 4.50 4.00 3.50 3.00 2.50 2.00 1.50 1.00 0.50 0 45 90 135 180 225 270 315 360 405 450 495 540 0 $247.50 $450.00 $607.50 $720.00 $787.50 $810.00 $787.50 $720.00 $607.50 $450.00 $247.50 0

Explanation / Answer

As a monopolist, they will maximize profit when total revenue is at its maximum.

Total revenue is at its maximum corresponding to price of $3 per gallon.

So,

The profit-maximizing price is $3 per gallon, and the total output is 270 gallons. As part of their cartel agreement, Nick and Rosa agree to split production equally. Therefore, Nick's profit is $405, and Rosa's profit is $405.

Now, Nick cheats on the cartel agreement and produces an additional 45 gallons of water.

So,

After Nick implements his new plan, the price of water decreases to $2.50 per gallon. Given Rosa and Nick's production levels, Nick's profit becomes (180 * 2.50) $450 and Rosa's profit becomes (135 * 2.50) $337.50.

Now, Rosa also increases her productivity by 45 gallons in response of cheating by Nick.

So,

After Rosa increases her production, Nick's profit becomes (180 * 2) $360, Rosa's profit becomes (180 * 2) $360, and total profit (the sum of the profit of Nick and Rosa) is now $720.

Cheating by both has increased the total output by 33% from initial cartel quantity while price has fallen by 33% from initial cartel price.

So, impact of output effect is equal to the impact of price effect.

Hence, the given statement is False.

This behavior is an example of tit-for-tat strategy.

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