Foundation for Teaching Economics | Cartels and Competition

Lesson Description:

Concepts:

Incentives matter
Increases in supply lead to reductions in price
Cartels increase their profits and market prices by restricting
production
Desire for profit undermines cartel agreements

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Materials:

Balance Sheet - 1 per team
Production Decision Cards - 25 to 30 cards per game
Production Decision Worksheet - 1 per student
Demand Forecast (overhead transparency)
Market Demand (actual) (overhead transparencies)
Production Record (1 overhead transparency)
Prizes for $200 companies
Grand prize for most profit

Procedure:

Form 6 companies of 4-6 students. (If necessary, increase the company size, but do not increase the number of companies.) Explain that the companies are all producers of the same commodity, selling their product in the same market. Mention that, while there are certainly others who are capable of entering the market, at this point in time, there are only 6 major companies who do almost 98% of the business, worldwide. The goal of each company is to make as much profit as possible; there will be prizes for all companies earning more than $200 and an additional prize for the company that earns the most profit.
Distribute one Production Decision Card to each company. Explain that the firm must decide how much to produce, given the cost of production, the amount of money they have on hand, and their anticipation of the demand for the product. Remind them that they must pay the costs of production at the time they turn in their production decisions.
Display the Demand Forecast overhead. Explain that the economic research department will provide them with the results of market research before each round, and while there is no guarantee that actual demand will be exactly the same as the forecast, the forecasts have been highly reliable in the past. Distribute the Production Decision Worksheet and use the overhead transparency to guide the class through the problems. (Answers: #4 = $150, #5 = -$35) (Note: Resist the temptation to skip this step. Don't assume that because you have good math students, they'll figure it out. It's the vocabulary of the procedure, not the arithmetic, that they need to practice. Doing the worksheet at the beginning allows students to concentrate on decision-making during the simulation.)
Distribute the balance sheets, and point out that each team has a starting balance of $150. Remind them that the goal is to have the biggest balance at the end of the game, and that they must have at least $200 to earn any prize. (Do NOT tell them how many rounds will be played.) Leave the Demand Forecast transparency on the overhead. Allow companies time to discuss the problem and determine the amount they wish to produce in Round 1. Each team must record the number produced on the Production Decision Card and must subtract the total production cost from their balance sheet. Collect the cards and tally the total production on the Production Record overhead (or on the board).
Display one of the Market Demand overheads (choose randomly) and help the class interpret the graph. Total the production for all companies, and draw a vertical line on the transparency to correspond with the total production. (If the class has had the necessary background, discuss the meaning of a vertical supply curve.) Explain to the class that the intersection of the vertical line and the Market Demand curve indicates the market clearing price, the amount they will be paid for each unit they produced.
Instruct students to enter their revenue (market clearing price X the number of units produced) on their balance sheets. Instruct teams to figure out how much profit they made and to consider strategy for the next round.
Distribute new Production Decision Cards and proceed as in Round 1.
Before beginning Round 3, announce that there will be a trade convention; a common activity in which firms in an industry send representatives to a convention to see new technology, innovations, give awards for industry performance, etc. Each student team may send one representative. (It may not be necessary to belabor this process. Some students may see, in earlier rounds, an advantage to be gained by collaboration. In that case, as Round 3 begins, simply say certainly members of different companies run into each other from time to time, as at trade conventions.)
After the negotiation period, direct representatives to return to their companies. Stop all communication between companies. Distribute the Production Decision Cards and proceed with Round 3.
Use the same procedure for Round 4.
(Note: Teachers must be sensitive to students' reactions in determining how many rounds of the game to play. For example, students should see the advantage of collusion by round 3. If, however, you feel that they are still exploring options in round 2, play a third round without collaboration and set up the caucus before round 4. Similarly, be aware of student response in the rounds after the collaboration. If students do not collude as a result of collaboration, do some debriefing after the payout in that round. Then allow collaboration in the next round. If students agree to restrict supply and all companies uphold the agreement, proceed with another round until a team, discovers the advantage of not restricting supply when all other companies have agreed to do so.)
End the simulation by giving out the prizes for companies with profits over $200 and the grand prize for the company with the most profit. (Profit = final balance - $150 beginning balance)
Debriefing questions might include:
- Which team made the most money? What was your strategy?
- Which team made the least? What was your strategy and why did it fail?
- Why did you want to talk to the other teams/companies?
- Why did you agree to set production levels? What was the impact on the market of such an agreement? What was the impact on your profit?
- How did you decide how much to produce?
- Did agreeing to set production levels work? Why? Why not?
- How did the profit motive, the desire of teams to make profit, act as an incentive? What behaviors did this incentive encourage?
- Looking at all the rounds of the simulation, make a generalization about the relationship between price and level of production (supply)
- How does the creation of a cartel affect consumers - both in terms of product availability and in terms of price?
- Predict what happens - in the short run and in the long run - in markets that do NOT prohibit collusion among producers.
- Evaluate the argument that it doesn't matter if producers try to collude; the system of incentives Will undermine their efforts. (You might want to read excerpts from Adam Smith at this point, or have ready a reading assignment for homework.)
- Predict the impact on the market of rules or laws that prohibit collusion between producers.
- Predict the impact on the market of rules or laws that enforce cooperation among producers - for example: licensing requirements for doctors, teachers, hairdressers, taxicabs; or regulatory agencies etc.

PRODUCTION DECISION WORKSHEET

As you make your production decisions, the following hints and examples may help you increase your profits.

The interaction of market demand and market supply will determine the market clearing price - the price at which the units you produce will sell.
In each round, a forecast of market demand will be displayed on the overhead. Remember that this is only a. forecast, and actual demand may vary from the forecast somewhat.
You will have to make your own forecast, or prediction, of market supply. You will know how many units your own company will produce, but the TOTAL market supply will include not only your own production but also that of the other companies in the room.

Example: If you produce one unit and so do all the other companies, the total supply will be 6 units. According to the demand forecast, if 6 units are produced, the market price would be $125.

Your decision must also take into account your production cost.
Suppose your cost is $25/unit.
total production cost for 1 unit = $25
units sold at market price =1 X $125 = $125 (your total revenue)
total revenue - total cost = your profit
$125 - $25 = $100
Try the following problem:

Suppose your group produces 3 units, total market supply = 1 9 units, and your production cost is $25/unit.

cost of production X #units you produced = your total cost of production

__________ X _________ = ___________________

(units sold) X (price) = your total revenue ______ X ______ = ______

(your total revenue) - (total cost) = your profit ______ X ______ = ______
Try one more example; don't leave out any steps!

Your group produces 7 units; market supply is 42; and cost of production is $25/unit.

What is your profit?

Reminders:

Your production decisions and the production decisions of your competitors determine the market clearing price.
The market clearing price and your production cost will determine how much profit you make.

PRODUCTION
DECISION
CARD

Production Cost
$30

Team # ____________________