Question

Why might a firm that voluntarily entered into a cartel agreement decide to cheat on (or breach) the agreement?

Short answer

Firms might cheat on a cartel agreement for reasons such as potential for short-term gains, lack of enforcement mechanisms and trust between cartel members, or changing economic conditions that impact profitability.

Step-by-step solution

Understand the Concept of a Cartel

A cartel is a group of independent market participants who collaborate with each other to fix prices, limit supply or thwart competition in order to maximize their profits. Firms might voluntarily enter into such agreements because by cooperating, they can collectively act like a monopolist and achieve higher profits than they would be able to individually.

Discuss the Potential for Short-term Gains

In the short term, a firm might cheat on a cartel agreement in order to increase its own profits. If a firm secretly lowers its prices while other firms keep their prices high, it can snatch a larger market share and earn more profits.

Mention the Lack of Trust and Enforcement Mechanisms

Cartels rely on mutual trust and cooperation. However, because contracts between cartel members to fix prices or limit output are illegal in many jurisdictions, they cannot be legally enforced. Therefore, there is always a temptation to cheat as the breaching firms cannot be penalized legally.

Discuss the Impact of Economic Changes

Changes in the economic environment can also lead firms to cheat. If market conditions change - for instance, if the cost of production rises or there's a drop in consumer demand - maintaining the cartel price may no longer be profitable for some firms, leading them to breach the agreement.

Key concepts

Economic Incentives

Economic incentives play a crucial role in understanding why firms engage in cartel behavior and why they might decide to cheat on such agreements. A cartel enables firms to act like a single monopolist. This helps them secure higher profits by fixing prices or limiting output. However, within this cooperative framework, individual firms can see opportunities for further profit.

Imagine a scenario where all firms in a cartel keep their prices high. If one firm decides to secretly lower its prices, it can potentially capture a larger share of the market. This short-term gain becomes a powerful economic incentive to cheat on the agreement.

Firms face a significant temptation to increase their own revenues by leveraging slight deviations from the established cartel strategy. Understanding these incentives helps explain why maintaining a cartel is so difficult. Economic incentives continually push individual companies to breach agreements for immediate benefits.

Market Dynamics

Market dynamics describe the ever-changing environment that businesses operate in. These changes can impact the stability of cartels, leading firms to behave unpredictably.

One crucial aspect of market dynamics is changes in consumer demand. For example, if there is a sudden drop in consumer interest, firms within a cartel might struggle to sell their goods at fixed high prices. This could encourage them to lower prices, thus breaching the cartel agreement, in order to sell off their stock.

• Supply cost variations: When production costs increase, maintaining a pre-agreed high price can become less attractive.
• Entry of new competitors: New firms entering the market can disrupt the balance, prompting cartel members to cut prices to remain competitive.

Understanding how market dynamics affect cartels can provide insight into why such agreements often fail over time. With ever-shifting supply and demand, it becomes challenging for firms to stick to rigid price or output frameworks.

Trust and Enforcement

Trust is the backbone of any cartel agreement. However, the lack of legal enforcement mechanisms complicates this reliance on mutual trust.

Cartels are often illegal, meaning that the agreements cannot be upheld in court. This absence of legal oversight means that members must rely entirely on trust.

• Lack of enforcement: No legal repercussions for breaches can make agreements fragile.
• High potential for mistrust: A single breach by one member can lead to a breakdown of the entire agreement.

Without a formal system to monitor and enforce adherence, the potential for cheating is high. Each firm's decision to honor the cartel is based on speculative trust, making it easy for any member to be tempted to breach. Understanding the fragility of trust and lack of enforcement highlights why cartels are so prone to collapsing.