Such agreement are illegal and are undertaken in

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Such agreement are illegal and are undertaken in secret. Firms in a collusive agreement operate a cartel.The firms in a cartel can pursue two strategies: oComplyoCheatA firm that complies carries out its agreement. A firm that cheats breaks the agreement to its own benefit and to the cost of the other firm.There are four possible combinations of actions for the firms: oBoth firms complyoBoth firms cheatoFirm A complies and Firm B cheatsoFirm B complies and Firm A cheats. Colluding to Maximize Profits: The only thing that firms in duopoly must do beyond what a monopoly does is to agree on how much of the total output each of them will produce. The profit is the cartel’s marginal cost equal to its marginal revenue. The industry marginal cost curve is the sum of MC curves of the two firms.The two firms are the same size at each level of marginal cost, so the industry output is twice the output of one firm. To maximize industry profit, the firms in the duopoly agree to restrict output to the rate that makes the industry marginal cost and marginal revenue equal. Each firm agrees to produce around half the market demand and to share economic profit. When each firm produces half the market demand, the price is greater than the firm’s average total cost so they are gaining a profit. The price is also greater than the firm’s marginal cost, so if one firm cheats and increased output, its profit would increase.One Firm Cheats on a Collusive Agreement:
Suppose firm A convinces firm B that demand has decreased so to sell its 2,000 output they must decrease price from 8,000 to 7,500 per unit. Firm B must match its price, so they lower the price and incur a loss of 500 per unit. Firm A increases its output to 3,000 units. Industry output increases to 5,000 and the price falls.For the complier ATC now exceeds the price, for the cheat, the price exceeds ATC. The complier incurs an economic loss. The cheat increases its profit. One firm cheats on the collusive agreement, the industry output becomes larger than the monopoly output and the industry price is lower than the monopoly price. The total economic profit made by the industry is also smaller than the monopoly’s economic profit.Both Firms Cheat:If both firms cheat and increase their output to 3,000 units price lowers to 6,000 per unit. Industry output becomes 6,000 units, the price falls. The market operates at the point at which the market demand curve intersects the industry marginal cost curve. Each firm has lowered cost and increased output as much as it can without incurring an economic loss. Both firms then make zero economic profit—the same as in perfect competition. The Payoff Matrix: The strategies and payoffs are summarized in the form of the game’s payoff matrix.

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