Chapter 8: Problem 2

Why might a firm that voluntarily entered into a cartel agreement decide to cheat on (or breach) the agreement?

Short Answer

Expert verified

Firms might cheat on a cartel agreement for reasons such as potential for short-term gains, lack of enforcement mechanisms and trust between cartel members, or changing economic conditions that impact profitability.

Step by step solution

Understand the Concept of a Cartel

A cartel is a group of independent market participants who collaborate with each other to fix prices, limit supply or thwart competition in order to maximize their profits. Firms might voluntarily enter into such agreements because by cooperating, they can collectively act like a monopolist and achieve higher profits than they would be able to individually.

Discuss the Potential for Short-term Gains

In the short term, a firm might cheat on a cartel agreement in order to increase its own profits. If a firm secretly lowers its prices while other firms keep their prices high, it can snatch a larger market share and earn more profits.

Mention the Lack of Trust and Enforcement Mechanisms

Cartels rely on mutual trust and cooperation. However, because contracts between cartel members to fix prices or limit output are illegal in many jurisdictions, they cannot be legally enforced. Therefore, there is always a temptation to cheat as the breaching firms cannot be penalized legally.

Discuss the Impact of Economic Changes

Changes in the economic environment can also lead firms to cheat. If market conditions change - for instance, if the cost of production rises or there's a drop in consumer demand - maintaining the cartel price may no longer be profitable for some firms, leading them to breach the agreement.

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