Which of the following best explains why it is difficult to maintain lasting collusive agreements? aThere is an unavoidable conflict in that a collusive agreement can increase the profits of some, but not all, firms in the industry. bEach firm realizes that its profits would increase if it were the only firm to violate the collusive agreement by increasing its production slightly. cThere is little potential for gain from collusion unless there is a large number of consumers in the market. dEach firm in the industry views itself as facing a vertical demand curve, even though the market demand curve is downward sloping.
Question
Which of the following best explains why it is difficult to maintain lasting collusive agreements? aThere is an unavoidable conflict in that a collusive agreement can increase the profits of some, but not all, firms in the industry. bEach firm realizes that its profits would increase if it were the only firm to violate the collusive agreement by increasing its production slightly. cThere is little potential for gain from collusion unless there is a large number of consumers in the market. dEach firm in the industry views itself as facing a vertical demand curve, even though the market demand curve is downward sloping.
Solution
The best explanation for why it is difficult to maintain lasting collusive agreements is option b: Each firm realizes that its profits would increase if it were the only firm to violate the collusive agreement by increasing its production slightly.
Here's why:
Collusion involves firms coming together to make decisions about output and price. This often involves reducing output and increasing price to increase profits. However, each firm has an incentive to cheat on this agreement. If all other firms are keeping their output low, one firm can increase its output slightly to take advantage of the high prices. This would increase that firm's profits.
However, if all firms think this way and increase their output, the result is a return to competition, lower prices, and lower profits. This inherent incentive to cheat makes it difficult to maintain lasting collusive agreements.
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