Cartel Theory

  • A cartel is a formal price-fixing agreement

Perfect Competition

  • Start by imagining a perfectly competitive market
    • 100 firms exist, each with a single plant and identical production technology (i.e., same costs)
    • This means each firm will produce 1% of total output (i.e., each firm supplies 1/100 of total production)
    • The long-run equilibrium are shown in the figure below (similar to what we did the first week of class)

Mutliplant Monopoly

  • Now suppose a monopolist exists and buys all 100 firms
    • The monopolist can allocate production across plants however they choose
    • Producing at the optimal level and setting price according to market demand leads to a higher price, lower output, and less welfare
    • The monopolist doesn’t start in LR equilibrium because \(MR \neq LMC\)

  • The monopolist will sell off enough plants to decrease marginal cost (short-run supply) until \(MR = MC = LMC\) → This will lead to even more social cost

Cartel Theory

  • A cartel consisting of 100 firms is analytically equivalent to a monopoly that owns 100 plants
    • In the short run, this leads to the same price and output of a multi-plant monopoly
    • The cartel chooses the total amount of the good to provide to the market
    • The cartel agrees on a price to charge
    • By working together, they allocate production in a way that minimizes cost
  • Although the cartel and monopoly outcomes are the same in the short run, they are not the same in the long run
    • In the short-run, firms cannot enter or exit
    • In the long-run, entry can occur and entrants choose to join the cartel. This will continue until profits are driven down to the competitive level, where there is no more entry.
  • The long-run equilibrium of the cartel can be characterized by excess capacity and overinvestment.
    • Only the efficient member of the cartel will produce
    • In order to maintain cooperation, excess profits may have to be shared equally among members