Question

3. Breakdown of a cartel agreement Consider a town in which only two residents, Clancy and Eileen, own wells that produce water safe for drinking. Clancy and Eileen 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) 3.60 0 0 3.30 30 $99.00 3.00 60 $180.00 2.70 90 $243.00 2.40 120 $288.00 2.10 150 $315.00 1.80 180 $324.00 1.50 210 $315.00 1.20 240 $288.00 0.90 270 $243.00 0.60 300 $180.00 0.30 330 $99.00 0 360 0 Suppose Clancy and Eileen form a cartel and behave as a monopolist. The profit-maximizing price isper gallon, and the total output isgallons. As part of their cartel agreement, Clancy and Eileen agree to split production equally. Therefore, Clancy's profit is, and Eileen's profit is. Suppose that Clancy and Eileen 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, Clancy says to himself, "Eileen and I aren't the best of friends anyway. If I increase my production to 30 gallons more than the cartel amount, I can increase my profit even though her profit goes down. I will do that starting tomorrow." After Clancy implements his new plan, the price of water toper gallon. Given Eileen and Clancy's production levels, Clancy's profit becomes and Eileen's profit becomes. Because Clancy has deviated from the cartel agreement and increased his output of water to 30 gallons more than the cartel amount, Eileen decides that she will also increase her production to 30 gallons more than the cartel amount. After Eileen increases her production, Clancy's profit becomes, Eileen's profit becomes, and total profit (the sum of the profits of Clancy and Eileen) is now. True or False: Based on the fact that both Clancy and Eileen increased production from the initial cartel quantity, you know that the output effect was smaller than the price effect at that quantity. True False Note that Clancy and Eileen started by behaving cooperatively. However, once Clancy decided to cheat, Eileen decided to cheat as well. In other words, Eileen's output decisions are based on Clancy's actions. This behavior is an example of .

Answer 1

Price P (Dollars per gallon)	Quantity Q (Gallons of water)	total revenue TR=P*Q (dollars)
3.6	0	0
3.3	30	9.9
3	60	180
2.7	90	243
2.4	120	288
2.1	150	315
1.8	180	324
1.5	210	315
1.2	240	288
0.9	270	243
0.6	300	180
0.3	330	99
0	360	0

Part 1)

Suppose Clancy and Eileen form a cartel and behave as a monopolist. The profit-maximizing price is $ 1.8 per gallon, and the total output is 180 gallons. As part of their cartel agreement, Clancy and Eileen agree to split production equally. Therefore, Clancy's profit is $ 162 , and Eileen's profit is $ 162.

As per the above table, maximum profit is $324 when output is 180 gallons and price charged is $1.8. Since both Clancy and Eileen form a cartel and agree to split production equallly.

Clancy and Eileen can pump and sell as much water as they want at no cost. For them, total revenue equals profit. Therefore, total revenue is also shared equally among them.

Part 2)

Suppose that Clancy and Eileen 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, Clancy says to himself, "Eileen and I aren't the best of friends anyway. If I increase my production to 30 gallons more than the cartel amount, I can increase my profit even though her profit goes down. I will do that starting tomorrow." After Clancy implements his new plan, the price of water falls to $ 1.5 per gallon. Given Eileen and Clancy's production levels, Clancy's profit becomes $ 180 and Eileen's profit becomes $ 135.

As per cartel agreement, both Clancy & Eileen produce 90 gallons of water at price of $1.8 . Now, Clancy deviates from the agreement and produces 30 more gallons more than the cartel output. Clancy produces 120 gallons and Eileen produces the same cartel amount of 90 gallons. Therefore, total output is 210 gallons sold at $1.5. Clancy earns profit of $180 (=1.5*120) and Eileen earns profit of $135 (=1.5*90) Total profit is $ 315 (=180+135)

Part 3)

Because Clancy has deviated from the cartel agreement and increased his output of water to 30 gallons more than the cartel amount, Eileen decides that she will also increase her production to 30 gallons more than the cartel amount. After Eileen increases her production, Clancy's profit becomes $ 144, Eileen's profit becomes $ 144, and total profit (the sum of the profits of Clancy and Eileen) is $ 288 now.

Now, as Clancy increased her output to 120 units, Eileen also increased her output to 120 units. Total output expands to 240 and price falls to $ 1.2. Both , Clancy and Eileen  earn a profit of $ 144 (=1.2*120)

Part 4)

True or False: Based on the fact that both Clancy and Eileen increased production from the initial cartel quantity, you know that the output effect was smaller than the price effect at that quantity. True or False

Correct answer is True

Price effect = after price decrease, each unit is sold at a lower price , decreasing revenue

Quantity effect = after price decrease, more units are sold, increasing the revenue

Quantity effect is smaller than price effect. This also means good produced has inelastic demand.

Part 5)

Note that Clancy and Eileen started by behaving cooperatively. However, once Clancy decided to cheat, Eileen decided to cheat as well. In other words, Eileen's output decisions are based on Clancy's actions. This behavior is an example of tit for tat strategy