© 2005 Thomson
CChapter 12hapter 12
Price and Output Price and Output Determination Under Determination Under
OligopolyOligopoly
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Gottheil - Principles of Economics, 4e
Economic PrinciplesEconomic Principles
The concentration ratio and the Herfindahl-Hirschman Index (HHI)
Balanced and unbalanced oligopoly
Horizontal, vertical and conglomerate mergers
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Gottheil - Principles of Economics, 4e
Economic PrinciplesEconomic Principles
Cartels
Game theory
Price leadership
Kinked demand
Brand multiplication
Price discrimination
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Gottheil - Principles of Economics, 4e
Concentration RatiosConcentration Ratios
For a vast number of US manufacturing industries, the competition among firms in the industry is essentially competition among the few—oligopoly.
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Gottheil - Principles of Economics, 4e
Concentration RatiosConcentration Ratios
An industry may consist of many firms, but if only a few of the many dominate the industry, then the industry is oligopolistic.
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Gottheil - Principles of Economics, 4e
Concentration RatiosConcentration Ratios
Concentration ratio
• A measure of market power. It is the ratio of total sales of the leading firms in an industry (usually four) to the industry’s total sales.
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Gottheil - Principles of Economics, 4e
Concentration RatiosConcentration Ratios
A criterion for determining whether an industry is an oligopoly:• If the leading four firms in an industry account for 40 percent or more of total industry sales, then an industry is likely to be an oligopoly.
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Gottheil - Principles of Economics, 4e
Concentration RatiosConcentration Ratios
Herfindahl-Hirschman index
• A measure of industry concentration, calculated as the sum of the squares of the market shares held by each of the firms in the industry.
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Gottheil - Principles of Economics, 4e
EXHIBIT 1 CONCENTRATION RATIOS—PERCENTAGE OF TOTAL INDUSTRY SALES PRODUCED BY THE LEADING FOUR FIRMS, AND HHI
Source: U.S. Bureau of the Census, 1997 Concentration Ratios in Manufacturing, 2001.
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Gottheil - Principles of Economics, 4e
Exhibit 1: Concentration Exhibit 1: Concentration Ratios— Percentage of Ratios— Percentage of
Total Industry Sales Total Industry Sales Produced by the Leading Produced by the Leading
Four Firms, and HHIFour Firms, and HHIHow many industries in Exhibit 1 have market shares greater than 50 percent at the four-firm level?• 12 of the 15 industries.
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Gottheil - Principles of Economics, 4e
EXHIBIT 2 DISTRIBUTION OF MANUFACTURING INDUSTRIES BY FOUR-FIRM SALES CONCENTRATION
Source: F. M. Scherer and David Ross, Industrial Market Structure and Economic Performance, Third Edition, Copyright © 1990 by Houghton Mifflin Company, Adapted with permission. Data refer to 1982.
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Gottheil - Principles of Economics, 4e
Exhibit 2: Distribution of Exhibit 2: Distribution of Manufacturing Industries by Manufacturing Industries by
Four-Firm Sales Four-Firm Sales ConcentrationConcentration
How many industries had four-firms controlling 40-59 percent of the industry sales in 1982? • 120 out of 448 total industries had four firms controlling 40-59 percent of the total industry sales.
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Gottheil - Principles of Economics, 4e
Oligopoly and Oligopoly and Concentration RatiosConcentration Ratios
Contrary to many people’s intuition, there is no convincing evidence that the share of industry sales controlled by the four leading firms in the US manufacturing economy is growing.
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EXHIBIT 3 PERCENTAGE OF TOTAL INDUSTRIAL SALES PRODUCED BY INDUSTRIES WITH FOUR-FIRM SALES CONCENTRATION RATIOS OF 50 PERCENT OR MORE: 1895–1982
Source: F. M. Scherer and David Ross, Industrial Market Structure and Economic Performance, Third Edition, Copyright © 1990 by Houghton Mifflin Company, Adapted with permission.
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Gottheil - Principles of Economics, 4e
Exhibit 3: Percentage of Total Exhibit 3: Percentage of Total Industrial Sales Produced by Industrial Sales Produced by
Industries with Four-Firm Industries with Four-Firm Sales Concentration Ratios of Sales Concentration Ratios of
50 Percent or More: 1895-50 Percent or More: 1895-19821982What is the trend in the percentage
of industrial sales produced by the largest four firms since 1963? • There is a downward trend in the percentage of industrial sales by the largest four firms from 1963 to 1982.
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Gottheil - Principles of Economics, 4e
Oligopoly and Oligopoly and Concentration RatiosConcentration Ratios
Market power
• A firm’s ability to select and control market price and output.
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Oligopoly and Oligopoly and Concentration RatiosConcentration Ratios
Unbalanced oligopoly
• An oligopoly in which the sales of the leading firms are distributed unevenly among them.
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Gottheil - Principles of Economics, 4e
Oligopoly and Oligopoly and Concentration RatiosConcentration Ratios
Balanced oligopoly
• An oligopoly in which the sales of the leading firms are distributed fairly evenly among them.
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EXHIBIT 4 BALANCED AND UNBALANCED OLIGOPOLY
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Exhibit 4: Balanced Exhibit 4: Balanced and Unbalanced and Unbalanced
OligopolyOligopoly1. What percentage of their industry’s total sales do the leading four firms in Industry A and B control? • The leading four firms in both industry A and B control 80 percent of their industry’s sales.
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Exhibit 4: Balanced Exhibit 4: Balanced and Unbalanced and Unbalanced
OligopolyOligopoly2. Why is industry B considered an unbalanced oligopoly? • The largest firm in industry B controls 50 percent of the industry’s sales. It’s market share is greater than the other three leading industries combined and more than four times greater than the next largest firm’s sales share.
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Oligopoly and Oligopoly and Concentration Ratios Concentration Ratios
• The dominance of oligopolies in industry is not unique to the U.S.
• The concentration ratios for U.S. industries are similar to other modern industrialized economies.
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EXHIBIT 5 PRODUCTION CONCENTRATION RATIOS IN JAPANESE MANUFACTURING INDUSTRIES BY LEADING AND FIVE LEADING FIRMS
Source: Nippon, A Charted Survey of Japan, 1994/95, Yano, I., ed., The Tsuneta Yano Memorial Society, p. 162.
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Exhibit 5: Production Exhibit 5: Production Concentration RatiosConcentration Ratios
in Japanese Manufacturing in Japanese Manufacturing IndustriesIndustries
by Leading and Five Leading by Leading and Five Leading FirmsFirmsIn how many Japanese industries
do the five leading firms have greater than a 90 percent production concentration ratio? • Four industries—beer, nylon, glass, and tires and tubes—are controlled by the five leading firms at a concentration of 90 percent or greater.
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Concentrating the Concentrating the ConcentrationConcentration
An oligopoly can build market power in two ways:• Reinvesting its profit and painstakingly expanding its production capacity.
• Merging with and/or acquiring other firms.
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Concentrating the Concentrating the ConcentrationConcentration
There are three reasons why firms merge:1. To exercise greater market control.
2. To increase control over the supplies of their inputs or the buyers of their goods.
3. To expand and diversify their asset holdings.
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Gottheil - Principles of Economics, 4e
Concentrating the Concentrating the ConcentrationConcentration
There are three types of mergers:
1. Horizontal merger
2. Vertical merger
3. Conglomerate merger
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EXHIBIT 6 A CENTURY OF HIGH MERGER ACTIVITY
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Exhibit 6: A Century of Exhibit 6: A Century of High Merger ActivityHigh Merger Activity
Complete this sentence: On the whole, the number of mergers per year in the U.S. has ____ between 1890 and 1990.i. Increased
ii. Remained the same
iii. Decreased
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Exhibit 6: A Century of Exhibit 6: A Century of High Merger ActivityHigh Merger Activity
Complete this sentence: On the whole, the number of mergers per year in the U.S. has ____ between 1890 and 1990.i. Increased
ii. Remained the same
iii. Decreased
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Gottheil - Principles of Economics, 4e
Concentrating the Concentrating the ConcentrationConcentration
Horizontal merger
• A merger between firms producing the same good in the same industry.
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Concentrating the Concentrating the ConcentrationConcentration
A number of high-profile horizontal mergers occurred in the 1990s.• Boeing and McDonnell Douglas in the aircraft industry.
• Staples and Office Depot in the office supply industry.
• Union Pacific and Southern Pacific Rail in the railroad industry.
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Gottheil - Principles of Economics, 4e
Concentrating the Concentrating the ConcentrationConcentration
Vertical merger
• A merger between firms that have a supplier-purchaser relationship.
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Concentrating the Concentrating the ConcentrationConcentration
An example of vertical merging is that of Anheuser-Busch.
The firm has acquired malt plants, yeast plants, a corn-processing plant, beer can factories, and a railway that ships freight by rail and truck.
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Concentrating the Concentrating the ConcentrationConcentration
Conglomerate merger
• A merger between firms in unrelated industries.
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Gottheil - Principles of Economics, 4e
Concentrating the Concentrating the ConcentrationConcentration
The conglomerate merger is the most common type of merger.
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Concentrating the Concentrating the ConcentrationConcentration
• One reason for conglomerate mergers is the desire to diversify operations.
• While horizontal and vertical mergers strengthen the firm’s position within the industry, the fate of the firm rests on the health of the industry.
• Acquiring unrelated firms insures the conglomerate against catastrophe if one industry faces severe problems.
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Concentrating the Concentrating the ConcentrationConcentration
Cartel
• A group of firms that collude to limit competition in a market by negotiating and accepting agreed-upon price and market shares.
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Gottheil - Principles of Economics, 4e
Concentrating the Concentrating the ConcentrationConcentration
Collusion
• The practice of firms to negotiate price and market share decision that limit competition in a market.
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Concentrating the Concentrating the ConcentrationConcentration
Cartels are an example of a merger in which firms don’t have to actually buy each other’s assets, yet they enjoy the benefits of having market power.
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Concentrating the Concentrating the ConcentrationConcentration
• While cartels are illegal in the United States, it is difficult to prove collusion.
• Some cartels are disguised. Agricultural cooperatives in regions of the US behave like cartels.
• Some governments encourage cartels to form in their countries. OPEC is one example.
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Concentrating the Concentrating the ConcentrationConcentration
Many studies support the contention that price and concentration ratios move in the same direction – an increase in one is associated with an increase in the other.
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EXHIBIT 7 RELATIONSHIP BETWEEN THE CONCENTRATION RATIO AND PRICE
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Exhibit 7: Relationship Exhibit 7: Relationship Between the Concentration Between the Concentration
Ratio and PriceRatio and PriceWhere on the curve in Exhibit 7 does the concentration ratio have the strongest effect on price?
• The effect is the strongest in the middle of the S-shaped curve.
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Gottheil - Principles of Economics, 4e
Theories of Oligopoly Theories of Oligopoly PricingPricing
Game theory
• A theory of strategy ascribed to the firms’ behavior in oligopoly. The firms’ behavior is mutually interdependent.
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Gottheil - Principles of Economics, 4e
Theories of Oligopoly Theories of Oligopoly PricingPricing
In monopoly, monopolistic competition and perfect competition, firms react only to the demand and cost structures they face. Prices tend toward equilibrium.
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Theories of Oligopoly Theories of Oligopoly PricingPricing
In oligopoly, firms are continually second guessing how the competition will respond to price decision they make. Prices are subject to fits of change.
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Gottheil - Principles of Economics, 4e
EXHIBIT 8 FIRM PROFIT, GENERATED BY HIGH AND LOW PRICING
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EXHIBIT 9 PAYOFF MATRIX
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Exhibit 9: Firm Profit, Exhibit 9: Firm Profit, Generated by High and Generated by High and
Low PricingLow Pricing
How does total profit change as Dell and Compaq change their prices?• When both firms price high, total profit is 20. When one firm prices high and the other prices low, total profit is 18. When both firms price low, total profit is 12.
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Gottheil - Principles of Economics, 4e
Theories of Oligopoly Theories of Oligopoly PricingPricing
Price leadership
• A firm whose price decisions are tacitly accepted and followed by other firms in the industry. The theory explains pricing in unbalanced oligopolies.
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EXHIBIT 10 PRICE AND OUTPUT UNDER CONDITIONS OF GODFATHER OLIGOPOLY
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Exhibit 10: Price and Output Exhibit 10: Price and Output Under Conditions of Under Conditions of Godfather OligopolyGodfather Oligopoly
How is the price of chocolate determined in Exhibit 9?
• Hershey is the “godfather” in the chocolate business. Hershey produces where its MR = MC. That is, 5 tons of chocolate at $5 per pound. The other firms in the chocolate industry accept the $5 per pound price.
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Gottheil - Principles of Economics, 4e
Theories of Oligopoly Theories of Oligopoly PricingPricing
Kinked demand curve
• The demand curve facing a firm in oligopoly; the curve is more elastic when the firm raises price than when it lowers price.
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EXHIBIT 11 CONSTRUCTING AN OLIGOPOLIST’S DEMAND CURVE
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Exhibit 11: Constructing Exhibit 11: Constructing an Oligopolist’s Demand an Oligopolist’s Demand
CurveCurve1. If Lipton were to raise its price above $0.80 per box, what would its competitors do, according to the curve in panel b?• Lipton’s competitors would not follow suit. Lipton’s demand curve above $0.80 (NK) is relatively elastic.
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Exhibit 11: Exhibit 11: Constructing an Constructing an
Oligopolist’s Demand Oligopolist’s Demand CurveCurve2. If Lipton were to lower its price
below $0.80 per box, then what would its competitors do?• Lipton’s competitors would feel compelled to follow suit. Lipton’s demand curve below $0.80 (YK) is relatively inelastic.
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EXHIBIT 12 PRICE RIGIDITY IN OLIGOPOLIES WITH KINKED DEMAND CURVES
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Exhibit 12: Price Rigidity in Exhibit 12: Price Rigidity in Oligopolies with Kinked Oligopolies with Kinked
Demand CurvesDemand CurvesThe marginal revenue curve associated with a kinked demand curve is:i. Continuous
ii. Discontinuous
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Exhibit 12: Price Rigidity in Exhibit 12: Price Rigidity in Oligopolies with Kinked Oligopolies with Kinked
Demand CurvesDemand CurvesThe marginal revenue curve associated with a kinked demand curve is:i. Continuous
ii. Discontinuous
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Exhibit 12: Price Rigidity in Exhibit 12: Price Rigidity in Oligopolies with Kinked Oligopolies with Kinked
Demand CurvesDemand Curves
As long as the MC curve crosses the gap created by the discontinuity in the MR curve, price will remain unchanged, as shown in panel b.
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Gottheil - Principles of Economics, 4e
Exhibit 12: Price Rigidity in Exhibit 12: Price Rigidity in Oligopolies with Kinked Oligopolies with Kinked
Demand CurvesDemand Curves
If the MC curve cuts the MR curve above the gap, output will decrease and price will increase. This scenario is depicted in panel c.
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Brand MultiplicationBrand Multiplication
Brand multiplication
• Variations on essentially one good that a firm produces in order to increase its market share.
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Brand MultiplicationBrand Multiplication
• A firm’s market share =
(number of brands) × (brand market share).
• As the number of brands in the industry increases, market share per brand diminishes.
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Gottheil - Principles of Economics, 4e
Price DiscriminationPrice Discrimination
Price discrimination
• The practice of offering a specific good or service at different prices to different segments of the market.
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Price DiscriminationPrice Discrimination
• Oligopolists sometimes segment the market in order to charge consumers what they are willing to pay for a good or service.
• Differences in airline ticket prices are a good example.
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EXHIBIT 13 DEMAND SCHEDULE FOR A UNITED AIRLINES ROUND-TRIP FLIGHT BETWEEN LOS ANGELES AND NEW YORK
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Exhibit 13: Demand Exhibit 13: Demand Schedule for a United Schedule for a United
Airlines Round-Trip Flight Airlines Round-Trip Flight Between LA and NYBetween LA and NY
If United chose not to segment its market in Exhibit 12, what would be its total revenue?
• The maximum total revenue for United would be achieved at a ticket price of $318 each, for a total of $119,250.
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Gottheil - Principles of Economics, 4e
EXHIBIT 14 DEMAND BY MARKET SEGMENT FOR A UNITED AIRLINES ROUND-TRIP FLIGHT BETWEEN LOS ANGELES AND NEW YORK
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Exhibit 14: Demand by Exhibit 14: Demand by Market Segment for a United Market Segment for a United
Airlines Round-Trip Flight Airlines Round-Trip Flight Between LA and NYBetween LA and NY
What is United’s total revenue when it segments its market into a multiple-fare system?
• United’s total revenue is $210,635. This is an increase of $91,385 over the unsegmented market.
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Price DiscriminationPrice Discrimination
• Price discrimination exists in virtually every market.
• Some differences in price are not clear cases of price discrimination, however.
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Why Oligopolists Why Oligopolists Sometimes Sometimes
DiscriminateDiscriminate• For example, many would argue that upper balcony seats are not the same as front row seats at a concert. If the goods are different, then it is not necessarily price discrimination to charge more for the front row seats.
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Cartel PricingCartel Pricing
• A cartel determines price by acting as if it is a monopoly.
• Price and quantity are determined using the MR = MC rule.
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Gottheil - Principles of Economics, 4e
EXHIBIT 15 CARTEL PRICING AND OUTPUT ALLOCATIONS
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Exhibit 15: Cartel Exhibit 15: Cartel Pricing and Output Pricing and Output
AllocationsAllocationsWhy is there an incentive for cartels to “cheat” and produce greater quantities than they are assigned?
• The price and output decisions made by the cartel are determined by the MR = MC rule.
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Exhibit 15: Cartel Exhibit 15: Cartel Pricing and Output Pricing and Output
AllocationsAllocationsWhy is there an incentive for cartels to “cheat” and produce greater quantities than they are assigned?
• The price and quantity assigned to individual firms within the cartel may not coincide with where the firm would maximize profit using its own MR and MC curves.
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Exhibit 15: Cartel Exhibit 15: Cartel Pricing and Output Pricing and Output
AllocationsAllocationsWhy is there an incentive for cartels to “cheat” and produce greater quantities than they are assigned?• There is an incentive for the firm to try to secretly increase quantity and thereby increase its own profit.