Final answer:
When two firms form a cartel, they aim to maximize industry profits as if they were a monopoly, leading to a higher price, lower quantity, and potentially larger combined profits than in competitive markets.
Step-by-step explanation:
When two firms collude to form a cartel, they work together to maximize total industry profits as though they are a single monopoly. This implies they will agree on the total quantity of output to produce and then divide this output between them in a way that maximizes profits. The cartel will charge a monopoly price, which is higher than the competitive market price, and supply a monopoly quantity, which is lower than the competitive market quantity.
However, in reality, each firm in the cartel may have an incentive to expand output beyond the agreed amount to increase profits, leading to a classic prisoner's dilemma situation. If both firms reason in this way and increase their output, the industry moves towards a more competitive environment, known as cutthroat competition. The price drops, total industry quantity increases, and collective profits may decrease as a result.
If the cartel breaks up, the firms may aggressively compete by cutting prices and increasing output, which further erodes collective profits. Comparing equilibrium outcomes, the price and profits are higher and the output is lower under cartelization than under cutthroat competition. Conversely, under cutthroat competition, the industry quantity is higher and the price is lower, which often results in lower total profits.
If the cartel dissolves, firms may engage in cutthroat competition, increasing the industry quantity and reducing the price and collective profits. Overall, cartelization yields higher profits but is unstable due to the temptation for individual firms to cheat for short-term gains.