Breakdown of a cartel agreement Consider a town in which only two residents, Bob
ID: 1195479 • Letter: B
Question
Breakdown of a cartel agreement
Consider a town in which only two residents, Bob and Cho, own wells that produce water safe for drinking. Bob and Cho 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
Total Revenue
(Dollars per gallon)
(Gallons of water)
(Dollars)
Suppose Bob and Cho form a cartel and behave as a monopolist. The profit-maximizing __________price isper gallon, and the total output is__________gallons. As part of their cartel agreement, Bob and Cho agree to split production equally. Therefore, Bob's profit is__________, and Cho's profit is____________.
Suppose that Bob and Cho have been successfully operating as a cartel. They each charge the monopoly price and sell half of the monopoly quantity. Then one night before going to sleep, Bob says to himself, "Cho and I aren't the best of friends anyway. If I increase my production to 40 gallons more than the cartel amount, I can increase my profit even though her profit goes down. I will do that starting tomorrow."
After Bob implements his new plan, the price of water ________ to__________per gallon. Given Cho and Bob's production levels, Bob's profit becomes________ and Cho's profit becomes___________.
Because Bob has deviated from the cartel agreement and increased his output of water to 40 gallons more than the cartel amount, Cho decides that she will also increase her production to 40 gallons more than the cartel amount.
After Cho increases her production, Bob's profit becomes__________, Cho's profit becomes_________, and total profit (the sum of the profits of Bob and Cho) is now____________.
True or False: Based on the fact that both Bob and Cho increased production from the initial cartel quantity, you know that the output effect was smaller than the price effect at that quantity.
True
False
Bob and Cho have each cheated on their cartel agreement and increased production by 40 gallons more than the cartel amount. However, they both realize that if they continue to increase output beyond this amount, they'll each suffer a decrease in profit. (To see this for yourself, consider Bob's profit when he produces 80 gallons more than the cartel amount compared to his profit when he produces 40 gallons more than the cartel amount.)
Neither Bob nor Cho has an incentive to further increase output, nor does either have an incentive to decrease output. This outcome is an example of predatory pricing, resale price maintenance, a nash equillibrium, or tying.
Price
Quantity Demanded
Total Revenue
(Dollars per gallon)
(Gallons of water)
(Dollars)
4.20 0 0 3.85 40 $154.00 3.50 80 $280.00 3.15 120 $378.00 2.80 160 $448.00 2.45 200 $490.00 2.10 240 $504.00 1.75 280 $490.00 1.40 320 $448.00 1.05 360 $378.00 0.70 400 $280.00 0.35 440 $154.00 0 480 0Explanation / Answer
Suppose Bob and Cho form a cartel and behave as a monopolist. The profit-maximizing price is $2.10 per gallon, and the total output is 240 gallons. As part of their cartel agreement, Bob and Cho agree to split production equally. Therefore, Bob's profit is $252 and Cho's profit is $252.
After Bob implements his new plan, the price of water decreases to $1.75 per gallon. Given Cho and Bob's production levels, Bob's profit becomes $280 and Cho's profit becomes $210.
After Cho increases her production, Bob's profit becomes $224, Cho's profit becomes $224 and total profit (the sum of the profits of Bob and Cho) is now $448.
Based on the fact that both Bob and Cho increased production from the initial cartel quantity, you know that the output effect was smaller than the price effect at that quantity. True.
Neither Bob nor Cho has an incentive to further increase output, nor does either have an incentive to decrease output. This outcome is an example of nash equilibrium.
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