An OPEC member country is assigned a production quota in a cartel agreement that sets oil output below the competitive level to support a high price. What incentive does each member individually face?
ATo produce less than their quota, since lower supply increases the cartel price further
BTo produce exactly their quota, since deviating would trigger automatic price collapse
CTo produce more than their quota, since at the high cartel price each additional unit sold is profitable
DTo exit the cartel entirely, since independent producers earn higher profits than cartel members
At the elevated cartel price, the marginal revenue from producing one more unit exceeds marginal cost — so each member has a private incentive to expand output beyond their quota. If all members act on this incentive, total output rises and the cartel price collapses. This is the fundamental instability of cartels: the cooperative outcome is profitable collectively but individually defecting is profitable for each member unilaterally. The cartel only survives if members can monitor and punish cheating, or if some enforcement mechanism exists.
Question 2 Multiple Choice
Two firms sell identical products with the same constant marginal cost and compete by setting prices (Bertrand competition). What is the equilibrium outcome?
ABoth firms split the market equally and price at the monopoly level
BBoth firms price at marginal cost — the same outcome as perfect competition
CFirms coordinate on the Cournot equilibrium price to avoid a price war
DThe larger firm sets price above MC and the smaller firm follows
The Bertrand paradox: if firm A prices above MC, firm B can capture the entire market by undercutting by a penny. Firm A responds by undercutting firm B, and so on until both price at MC. At any price above MC, there is always a profitable deviation — undercut the rival. At MC, neither firm can profitably undercut further (that would mean selling at a loss). The result is the competitive outcome with just two firms, which surprises students who expect oligopoly to sustain prices above MC. This result breaks down with capacity constraints, product differentiation, or switching costs.
Question 3 True / False
In Cournot competition, adding more firms to the market pushes the equilibrium price toward the competitive level, approaching marginal cost as the number of firms grows large.
TTrue
FFalse
Answer: True
In the Cournot model, each firm's reaction function accounts for rivals' output. With n firms, each firm's market share shrinks, and the total output across all firms increases toward the competitive level as n grows. With two Cournot firms, price is between the monopoly price and MC. With three firms, it falls further. In the limit as n → ∞, the Cournot equilibrium converges to perfect competition. This makes Cournot a useful benchmark for thinking about how industry concentration affects market outcomes.
Question 4 True / False
Oligopolies generally tend toward collusion because collective coordination to restrict output and raise prices is the dominant strategy for nearly every firm in the market.
TTrue
FFalse
Answer: False
Collusion is collectively rational but individually unstable — it is not a dominant strategy for each firm. Each member of a cartel has a private incentive to cheat by producing above their quota at the high cartel price. If all members act on this incentive, the cartel collapses. Many oligopolies compete vigorously rather than colluding; oligopoly is not synonymous with collusion. Strategic interdependence means each firm must consider rivals' responses, but those responses can lead to competitive or cooperative equilibria depending on the mode of competition, the ability to monitor behavior, and whether the game is repeated.
Question 5 Short Answer
Why is cartel agreement inherently unstable, and what structural incentive undermines it even when all members prefer the cartel outcome to the competitive one?
Think about your answer, then reveal below.
Model answer: A cartel elevates price above the competitive level by restricting total output. At that high price, each member's marginal revenue from producing an additional unit exceeds their marginal cost — so each member individually gains by secretly expanding output beyond their quota. But if all members act on this incentive, total output rises and the cartel price falls back toward the competitive level, erasing the collective gain. The cartel is a collective action problem: the individually rational choice (cheat) produces the collectively worst outcome (cartel collapse). It persists only when cheating can be detected and punished.
This is the Prisoners' Dilemma structure applied to oligopoly. Each firm prefers the cartel outcome to competition, but each firm also prefers to cheat while others comply — and compliance while being cheated on is the worst outcome. Absent enforcement, the dominant strategy for each firm is to cheat, producing the competitive equilibrium even though all prefer the monopoly outcome.