Question

Consider a duopoly setting with where each firm can choose either to produce at the collusion level QC or at the Non Collusion level QNC . The payoff matrix for the two firms is given above.

Suppose the firms reach an agreement and both firms pledge to produce at QC. Which firm has an incentive to cheat and produce QNC instead (assuming the other firm stays true to the agreement)?

a. Firm A
b. Firm B
c. Neither firm
d. Both firms

Answer 1

Firm B has a stronger incentive to cheat in a duopoly collusion setting, while Firm A is less likely to cheat due to asymmetric incentives and risks, leading to the possibility of both firms maintaining collusion.

Step-by-step explanation:

Considering a duopoly scenario with Firm A and Firm B, where each firm has the option to produce at a collusion level QC or at a non-collusion level QNC, we examine the incentives to cheat on a collusion agreement. Given the dynamics of the duopoly, Firm B has a clear incentive to cheat by producing at QNC, assuming Firm A maintains production at QC. This is because Firm B can potentially double its profits through cheating while Firm A will only realize a marginal increase in profits if it decided to cheat, considering the smaller size of Firm B. Moreover, the risk associated with cheating is greater for Firm B since a 90% loss of gains can occur if Firm A decides to cheat in response. Consequently, this creates a significant deterrent for Firm B to honor the collusion. In contrast, due to the relative sizes of the firms and the limited gain for Firm A, it is less likely that Firm A will cheat. Overall, there is a possibility that both firms can adhere to the collusion due to the asymmetric incentives and risks involved.