Question

Consider a cartel in which each firm has identical and constant marginal costs. If the cartel maximizes total industry profits, what does this imply about the division of output between the firms?

Short answer

Firms in a cartel with identical marginal costs will equally divide output to maximize total profits.

Step-by-step solution

Understanding Cartel Behavior

A cartel is a group of firms that collude to maximize their joint profits by restricting output and increasing prices. In this case, we assume each firm in the cartel has identical and constant marginal costs. Thus, they work together to behave as a monopoly aiming to maximize total industry profits.

Cartel as a Monopoly

The cartel aims to produce at the level where their joint marginal revenue equals joint marginal cost to maximize profits, just like a monopolist would do. Since all firms have identical marginal costs, they will coordinate their output to achieve this condition for the entire cartel.

Allocation of Output

Given that each firm has identical and constant marginal costs, they have no cost advantage over each other. Therefore, to maintain fairness and efficiency within the cartel, the output is typically divided equally among the firms in the cartel. This equal division ensures that each firm incurs the same total cost for their share of the output.

Key concepts

Collusion in Economics

Collusion in economics refers to a strategic alliance between competing firms to boost joint profits and gain market power. Often, firms decide to collude as a way to circumvent the competitive pressures of the market, seeking to create a structure similar to that of a monopoly. This cooperation usually involves agreements to restrict output and increase prices, reducing competition among them. It’s important to note that collusion can be illegal in many jurisdictions as it undermines market competition and can lead to higher prices for consumers.

• Firms collaborate to achieve a common goal: maximize total profits.
• Agreements might include pricing, output levels, or territory division.
• Collusion transforms a competitive market into a more controlled environment.

Collusion allows firms to exploit their combined strength, achieving outcomes that individual action in a competitive market wouldn't allow. However, creating a feasible collusion agreement is complex and requires trust among firms not to break the agreement for individual short-term gains.

Monopoly and Cartels

A cartel can be considered a group of firms acting together to mimic the behavior of a monopoly, controlling the market in a way that would be impossible individually. When firms in a cartel work together, they aim to maximize their joint profits by controlling market supply and influencing prices. The cartel, acting as a single monopoly, determines the level of output and price to optimize overall profit.

• Cartels restrict supply to increase prices above competitive levels.
• Joint decision-making replaces competition among individual firms.
• The aim is to enhance collective rather than individual profitability.

By coordinating their strategies, cartel members can benefit from efficiency gains similar to those a monopolist experiences. The agreement to act collectively positions the cartel almost as a single entity, allowing for better control over the market.

Output Division in Cartels

Output division in cartels is a crucial aspect that determines how much each member firm produces. This division ensures that all participating firms share in the total profits derived from collusion. When firms within a cartel have identical and constant marginal costs, as in the initial problem, an equal distribution often becomes the logical choice.

• Equal division maintains fairness among firms, given identical costs.
• Ensures that none of the firms incurs higher costs than others.
• Supports stability within the cartel by minimizing internal disputes.

Equal output distribution also simplifies the cartel's internal logistics, as all members can focus on their predefined share without negotiating for individual advantages. This approach not only sustains harmony among the members but also streamlines efficiency, just as a unified monopoly would aim to operate. Understanding these dynamics helps reveal why such collaborative tactics can pose challenges to free market principles.