Question

1) Suppose that all five of the producers of readymix cement in the Denver area have entered into a cartel agreement, so that they are producing and pricing at the profit-maximizing monopoly level. a. How would a firm’s managers “cheat” on this agreement? b. Given that the four other competitors’ reactions are not instantaneous, can cheating be profitable?

2) In a small town, the managers of the three janitorial service firms have tacitly agreed to charge $150 per week for cleaning a standard-sized office. Each firm services 200 offices. The marginal cost and average total cost of cleaning an office are both $130. a. What is each firm’s economic profit? b. Suppose that a new office opens. Its owners tell the managers of one of the janitorial service firms that they will hire the janitorial service—but only if the price is $140 per week. Is this new contract profitable for this firm? If the janitorial service managers sign the contract, how would it affect the tacit collusion among the firms?

Answer 1

A cartel supplies lower quantity and higher price. Each firm in the cartel supplies at a price much above its marginal cost, and quantity less than it would supply under competition. Therefore, firms have an incentive to cheat and sell more quantity, often at lower prices, until their price (marginal revenue) equals marginal cost.

1) Firm's manager would chheat on agreement by selling more than their cartel agreement. If they are not detected they keep extra profits and cheating will be profitable. If four other competitors know about cheating and their reactions are not instantaneous cheating can be profitable in the short-run, however, even if four other competitos react with a delay they can punish the cheater for violating the cartel by lowering price and producing more output and make the cheating firms cheating non-profitable.

2) Each firm's economic profit is ($150-$130)x200 = $20x200 = $4,000 per week.

The new contract $140 is profitable to the firm if it can remain undetected, because it makes a profit of $10 ($140-$130 = $10) from the new firm. The new contract will violate the tacit collusion. If other firms can detect cheating the tacit collusion is likely to break down and lead to competition among firms lowering their prices.