Chapter 15
Assume that there are 300 producers of Gala apples and that MC = AC = $0.40 per pound. In a competitive market, price will be driven down to marginal cost. Let's assume that when P = MC, each apple grower produces 2 million pounds of apples for a total market production of 600 million pounds. Now imagine that the apple growers form a cartel and each agrees to cut production to 1 million pounds, which drives the price up to $0.70 per pound. If a single apple grower broke from the cartel and produced an extra million pounds of apples, how much additional profit (approximately) would this apple grower make?
$300,000 At a price of $0.70 per pound each pound of apples earns $0.30 in profit. If a single apple grower were to increase his output by 1 million pounds, this would increase profit by approximately $300,000, a doubling of profit! Note that the increase in profit is approximate because the increase in apple output will push the price down a little bit—ignore the latter complication because the increase in output is only 1/300th of total output. To do an exact calculation, try the demand curve P = $1 - 0.000000001 × Q.
Assess the validity of the following statements. I. Cartels in which all the industry leaders went to the same schools and live in the same neighborhood are easier to sustain than cartels in which the industry leaders don't really know or trust one another. II. It would be more difficult to sustain a cartel in an industry in which it's easy for a firm to sell a little extra product without anyone knowing than in an industry in which all sales are public and visible.
Both I and II are true. Statement I is true because if leaders know one another, they will be more likely to enter into a cartel and to keep to the cartel production scheme. They do this because they find it more likely that those they know will do the same. In addition, there is the potential to become a social outcast if you violate the cartel agreement. As Adam Smith said in the Wealth of Nations, "People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices." Statement II is true because being about to sell in secret makes "cheating" more attractive to producers. This is likely due to the fact that a producer selling extra product in secret is less likely to have fellow members exact retribution.
Usually, we think of cheating as a bad thing. But in this chapter, cheating turns out to be a very good thing in some important cases. Who gets the benefit when a cartel collapses through cheating: consumers or producers? In other words, does cheating increase consumer surplus, producer surplus, or both?
Consumer surplus. Cheating often lowers prices and increases quantity purchased by consumers, which increases consumer surplus, not producer surplus.
Firms in a cartel each have an incentive individually to lower the prices they charge. Another way that one firm can cheat on a cartel is to offer a higher-quality product to consumers. Suppose there were a government regulation that standardized the quality of a good. How would this regulation tend to affect cartels?
It would strengthen cartels. This type of regulation reduces the ability of cartel members to cheat, making the cartel easier to enforce.
Firms in a cartel each have an incentive individually to lower the prices they charge. Suppose there were a government regulation that set minimum prices. How would this regulation tend to affect cartels?
It would strengthen cartels. This type of regulation reduces the ability of cartel members to cheat, making the cartel easier to enforce.
In many college towns, rumors abound that the nearby gas stations collude to keep prices high. Assess the validity of the following statements regarding where you might expect this conspiracy against the public to work best? I. This type of plan will work better in towns with dozens of gas stations than it will in towns with fewer than 10. II. This type of plan will work better in towns where the city council has many environmental and zoning regulations that make it hard to open new gas stations than it will in towns where there is a lot of open land for development. III. This type of plan will work better in towns where all the gas stations are equally busy than it will in towns where half the gas stations are always busy and half tend to be empty.
Only II and III are true. Statement I is not true because having more gas stations will make it more difficult to hold this cartel together because there are more members that need to be monitored. Statement II is true because additional regulations will make entry harder, making it easier to hold the cartel together. Statement III is also true because if some stations are half empty, then those stations will be tempted to win customers by charging a little less. Cheating is more tempting for them. If all the gas stations are equally busy, there won't be a core group that is looking to cheat.
Assess the validity of the following statements: I. It will be easier to sustain a cartel in an industry in which it's easy for new firms to enter than in an industry in which the same firms stick around for decades. II. It will be easier to sustain a cartel when the government makes it legal for all the firms to agree on prices than when the government makes it illegal for all firms in an industry to agree on prices.
Only II is true. Statement II is true because laws against agreeing on price make sustaining a cartel more difficult because now cartel members must be willing to take the risk of being caught and sent to jail. The threat of jail time generally makes people less willing to keep the cartel going. Statement I is not true because new entrants actually make sustaining a cartel more difficult. These new entrants are constantly raising the quantity and lowering the market price.
Assume that there are 300 producers of Gala apples and that MC = AC = $0.40 per pound. In a competitive market, price will be driven down to marginal cost. Let's assume that when P = MC, each apple grower produces 2 million pounds of apples for a total market production of 600 million pounds. Now imagine that the apple growers form a cartel and each agrees to cut production to 1 million pounds, which drives the price up to $0.70 per pound. Calculate profit per pound and total industry profit if the apple growers behave as if they were a monopoly, producing 300 million pounds
Profit per pound is $0.30 and industry profit is $90 million. Correct. At a price of $0.70 per pound each pound of apples earns $0.30 in profit ($0.70 - $0.40). The industry as a whole produces 300 million pounds for a total industry profit of $90 million = $0.30 × 300 million. You should note that this is a decidedly better situation for the industry as a whole than competition would be. Under competition, the total industry profits are $0.
Your professor probably grades on a curve, implicitly if not explicitly. This means that you and your classmates could each agree to study half as much, and you would all earn the same grade you would have earned without the agreement. What do you think would happen if you tried to enact this agreement? Why? Which model in this chapter is most similar to this conspiracy?
The agreement will fall apart because people will cheat and study more to try to gain an advantage. This is similar to the prisoner's dilemma. Correct. The agreement would fall apart because of cheating, because it is difficult to verify how much your classmates are studying, especially if you have a large number of classmates. In addition, each classmate has an incentive to study more than the agreed-upon amount in order to try to get a better grade than he otherwise might. This is similar to a prisoner's dilemma, where cheating is the logical choice, but in the end makes everyone worse off.
What is the formula for monopoly profit?
[P(monopoly) - Average cost] × Q(monopoly) Correct. The monopoly profit is the profit per unit times the number of units sold by the monopoly.
In the late fifteenth century, Europe consumed about 2 million pounds of pepper per year. At this time, Venice (ruled by a small, tightly knit group of merchants) was the major player in the pepper trade. But after Portuguese explorer Vasco de Gama blazed a path around Africa into the Indian Ocean in 1498, Venice found itself competing with Portugal's trade route. By the middle of the sixteenth century, Europeans consumed 6 to 7 million pounds, much of it obtained through Lisbon. After de Gama's success, the price of pepper fell. Based on this information, which of the following best explains the decline of Venice's influence on the world pepper trade?
competition from new entrants to the market Vasco de Gama allowed Portugal to enter the pepper market, increasing the competition for the Venetian pepper cartel.
