Question

Question 16: In a Cournot market, use the Best Response Functions for firms one and two to explain why collusion (i.e., the market output being equal to the monopoly level) is so hard to maintain.

Answer 1

Cournot Model firms can effectively collude with each other and set a higher price. It would fetch them higher prices. Thus, profits would rise further. Although profits are higher in collusion form, the cheating by the one firm might increase profits of cheater further. Thus, there is a strong incentive for both firms to get involved in cheating for increasing profits.

Following are reaction curves :

(-c)/2 (a -c)/3 Firm 2 (a-c)/3 (a-c)/2

In the above diagram, both firms collude and set output at M point. But after cheating one firm increases its output and both tend to think in a similar fashion. Eventually, there is a fall in price and a rise in output. both end up getting lesser profit.