EC120 Chapter Notes - Chapter 17: Invisible Hand, Resale Price Maintenance, Price Discrimination
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Consider a town in which only two residents, Antonio and Caroline, own wells that produce water safe for drinking. Antonio and Caroline can pump and sell as much water as they want at no cost. For them, the total revenue equals profit. The following table shows the town's demand schedule for water.
|
Price |
Quantity Demanded |
Total Revenue |
|---|---|---|
|
(Dollars per gallon) |
(Gallons of water) |
(Dollars) |
| 3.60 | 0 | 0 |
| 3.30 | 35 | $115.50 |
| 3.00 | 70 | $210.00 |
| 2.70 | 105 | $283.50 |
| 2.40 | 140 | $336.00 |
| 2.10 | 175 | $367.50 |
| 1.80 | 210 | $378.00 |
| 1.50 | 245 | $367.50 |
| 1.20 | 280 | $336.00 |
| 0.90 | 315 | $283.50 |
| 0.60 | 350 | $210.00 |
| 0.30 | 385 | $115.50 |
| 0 | 420 | 0 |
Suppose Antonio and Caroline form a cartel and behave as a monopolist. The profit-maximizing price is (1) $______ per gallon, and the total output is (2) ___ gallons.
As part of their cartel agreement, Antonio and Caroline agree to split production equally. Therefore, Antonio's profit is (3) $____, and Caroline's profit is (4) $_____.
Suppose that Antonio and Caroline have been successfully operating as a cartel. They each charge the monopoly price and sell half of the monopoly quantity. Then one night before going to sleep, Antonio says to himself, "Caroline and I aren't the best of friends anyway. If I increase my production to 35 gallons more than the cartel amount, I can increase my profit even though her profit goes down. I will do that starting tomorrow."
After Antonio implements his new plan, the price of water (5) (increases/decreases) to (6) $____per gallon. Given Caroline and Antonio's production levels, Antonio's profit becomes (7) $____ and Caroline's profit becomes (8) $______.
Because Antonio has deviated from the cartel agreement and increased his output of water to 35 gallons more than the cartel amount, Caroline decides that she will also increase her production to 35 gallons more than the cartel amount.
After Caroline increases her production, Antonio's profit becomes (9) $_____, Caroline's profit becomes (10) $_____ and total profit (the sum of the profits of Antonio and Caroline) is now (11) $_____
(12) True or False: Based on the fact that both Antonio and Caroline increased production from the initial cartel quantity, you know that the output effect was smaller than the price effect at that quantity.
Note that Antonio and Caroline started by behaving cooperatively. However, once Antonio decided to cheat, Caroline decided to cheat as well. In other words, Caroline's output decisions are based on Antonio's actions.
(13) This behavior is an example of (tying/ a dominant strategy/ a tit-for-tat strategy/ a prisoners' dilemma).
3. Breakdown of a cartel agreement
Consider a town in which only two residents, Gilberto and Juanita, own wells that produce water safe for drinking. Gilberto and Juanita can pump and sell as much water as they want at no cost. For them, total revenue equals profit. The following table shows the town's demand schedule for water.
|
Price |
Quantity Demanded |
Total Revenue |
|---|---|---|
|
(Dollars per gallon) |
(Gallons of water) |
(Dollars) |
|
5.40 |
0 |
0 |
|
4.95 |
25 |
$123.75 |
|
4.50 |
50 |
$225.00 |
|
4.05 |
75 |
$303.75 |
|
3.60 |
100 |
$360.00 |
|
3.15 |
125 |
$393.75 |
|
2.70 |
150 |
$405.00 |
|
2.25 |
175 |
$393.75 |
|
1.80 |
200 |
$360.00 |
|
1.35 |
225 |
$303.75 |
|
0.90 |
250 |
$225.00 |
|
0.45 |
275 |
$123.75 |
|
0 |
300 |
0 |
Suppose Gilberto and Juanita form a cartel and behave as a monopolist. The profit-maximizing price is (1) $______ per gallon, and the total output is (2) ___ gallons.
As part of their cartel agreement, Gilberto and Juanita agree to split production equally. Therefore, Gilberto's profit is (3) $____, and Juanita's profit is (4) $_____.
Suppose that Gilberto and Juanita have been successfully operating as a cartel. They each charge the monopoly price and sell half of the monopoly quantity. Then one night before going to sleep, Gilberto says to himself, "Juanita and I aren't the best of friends anyway. If I increase my production to 25 gallons more than the cartel amount, I can increase my profit even though her profit goes down. I will do that starting tomorrow."
After Gilberto implements his new plan, the price of water (5) (increases/decreases) to (6) $____per gallon. Given Gilberto and Juanita's production levels, Gilberto's profit becomes (7) $____ and Juanita's profit becomes (8) $______.
Because Gilberto has deviated from the cartel agreement and increased his output of water to 25 gallons more than the cartel amount, Juanita decides that she will also increase her production to 25 gallons more than the cartel amount.
After Juanita increases her production, Gilberto's profit becomes (9) $_____, Juanita's profit becomes (10) $_____ and total profit (the sum of the profits of Gilberto and Juanita) is now (11) $_____
(12) True or False: Based on the fact that both Gilberto and Juanita increased production from the initial cartel quantity, you know that the output effect was smaller than the price effect at that quantity.
Gilberto and Juanita have each cheated on their cartel agreement and increased production by 25 gallons more than the cartel amount. However, they both realize that if they continue to increase output beyond this amount, they'll each suffer a decrease in profit. (To see this for yourself, consider Gilberto's profit when he produces 50 gallons more than the cartel amount compared to his profit when he produces 25 gallons more than the cartel amount.)
Neither Gilberto nor Juanita has an incentive to further increase output, nor does either have an incentive to decrease output. This outcome is an example of
(13) (resale price maintenance/ predatory pricing/ tying/ a Nash equilibrium).
