Question

The payoff matrix represents hypothetical profits that could be earned by two milk sellers who have formed a cartel. Each seller must decide whether or not to cheat on the production quotas in the cartel agreement. Use the payoff matrix to answer the questions.

Answer 1

Firms in a cartel set quantity where MR equals MC and choose the price from the demand curve at this quantity, maximizing profits. If the cartel dissolves, competition increases, driving prices down and quantity up, reducing profits. Comparing both scenarios, a cartel yields higher prices and profits but a lower quantity than cutthroat competition.

Step-by-step explanation:

When firms collude to form a cartel, they act as if they are a single monopolist. The cartel sets the quantity of goods to produce at the level where marginal revenue (MR) equals marginal cost (MC), which allows them to maximize total profits. The price is determined by the demand curve at this profit-maximizing quantity. The profit for the cartel is the difference between the total revenue and total costs, which is positive and substantial when the marginal cost curve is horizontal assuming fixed costs are zero.

If the cartel breaks up and the firms enter into cutthroat competition, they might engage in price wars which would lead to a higher industry quantity and a lower price compared to the monopolistic pricing of the cartel. The collective profits would be eroded, possibly to zero, due to the intense competition.

In comparing the two scenarios, the equilibrium price and quantity under the cartel are higher and lower, respectively, than under cutthroat competition. The profits earned by the firms in a cartel are much larger compared to the significantly lower or possibly zero profits in the scenario of vigorous competition.

Answer 2

The question discusses a hypothetical cartel scenario between two milk sellers in an oligopoly, analyzing the difference in outcomes when they collude versus when they compete. A cartel typically leads to higher prices and profits by restricting output, akin to a monopoly. In contrast, intense competition after the cartel's dissolution leads to lower prices, higher output, and potentially no profits.

Step-by-step explanation:

The question is about two firms forming a cartel within an oligopolistic market structure and analyzing their pricing, output, and profit strategies. By colluding, the firms are acting like a monopoly, making collective decisions to maximize profits.

a. Cartel Outcomes

If the firms form a cartel, they will attempt to act like a monopoly by setting the quantity where marginal revenue (MR) equals marginal cost (MC). They will then charge a price on the demand curve just above that quantity. If we assume zero fixed costs and a horizontal MC curve (implying that average cost equals MC), the cartel's profits will be positive and are graphically equal to the area of the rectangle formed by the monopoly quantity and the difference between monopoly price and average cost.

b. Cutthroat Competition Outcomes

In a scenario where the cartel breaks up and intense price competition ensues, the firms would compete by lowering prices and increasing output, likely leading to an industry output higher than the monopoly quantity at a lower price. The collective profits of all firms in this scenario are reduced, potentially to zero.

c. Comparison of Equilibrium Outcomes

Comparing the cartel and cutthroat competition outcomes, we can see that the cartel can set higher prices and earn larger profits by restricting output compared to the situation where firms compete aggressively on price, where market quantity increases, price decreases, and profits diminish.