3. Breakdown of a cartel agreement Consider a town in which only two residents,

Question

3. Breakdown of a cartel agreement

Consider a town in which only two residents, Eric and Ginny, own wells that produce water safe for drinking. Eric and Ginny can pump and sell as much water as they want at no cost. For them, total revenue equals profit. The following table shows the town's demand schedule for water.

Suppose Eric and Ginny form a cartel and behave as a monopolist. The profit-maximizing price is_____per gallon, and the total output is_____gallons. As part of their cartel agreement, Eric and Ginny agree to split production equally. Therefore, Eric's profit is_____, and Ginny's profit is_______.

Suppose that Eric and Ginny have been successfully operating as a cartel. They each charge the monopoly price and sell half of the monopoly quantity. Then one night before going to sleep, Eric says to himself, "Ginny and I aren't the best of friends anyway. If I increase my production to 45 gallons more than the cartel amount, I can increase my profit even though her profit goes down. I will do that starting tomorrow."

After Eric implements his new plan, the price of water _____ to______per gallon. Given Ginny and Eric's production levels, Eric's profit becomes____ and Ginny's profit becomes_______.

Because Eric has deviated from the cartel agreement and increased his output of water to 45 gallons more than the cartel amount, Ginny decides that she will also increase her production to 45 gallons more than the cartel amount.

After Ginny increases her production, Eric's profit becomes_____, Ginny's profit becomes______, and total profit (the sum of the profits of Eric and Ginny) is now._____

True or False: Based on the fact that both Eric and Ginny increased production from the initial cartel quantity, you know that the output effect was smaller than the price effect at that quantity.

True

False

Eric and Ginny have each cheated on their cartel agreement and increased production by 45 gallons more than the cartel amount. However, they both realize that if they continue to increase output beyond this amount, they'll each suffer a decrease in profit. (To see this for yourself, consider Eric's profit when he produces 90 gallons more than the cartel amount compared to his profit when he produces 45 gallons more than the cartel amount.)

Neither Eric nor Ginny has an incentive to increase output further, nor does either have an incentive to decrease output. This outcome is an example of______ .

Price Quantity Demanded Total Revenue (Dollars per gallon) (Gallons of water) (Dollars) 6.00 0 0 5.50 45 $247.50 5.00 90 $450.00 4.50 135 $607.50 4.00 180 $720.00 3.50 225 $787.50 3.00 270 $810.00 2.50 315 $787.50 2.00 360 $720.00 1.50 405 $607.50 1.00 450 $450.00 0.50 495 $247.50 0 540 0

Explanation / Answer

1) $ 3 is the optimal because because profit is maximized at this price

2) Total output = 270 units i.e. 135 each

3) Eric's profit = Total profit / 2 = 810/2 = $ 405

4) Ginny's profit = 810/2 = 405

5) Decreases to $ 2.50

6) Eric's profit = (135 + 45) x $ 2.50 = $ 450

7) Ginny's profit = 135 x 2.50 = $ 337.5

8) Eric's profit when Ginny also increases its output by 45 units = 180 x 2 = $ 360

9) Ginny's profit = 180 x 2 = $ 360

10) Total profit = 360 + 360 = $ 720

11) False

12) Tit-for-tat strategy

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