Cartel Formation with Endogenous Capacity and Demand Uncertainty

This article provides a framework for the analysis of cartel formation. It models the strategic interaction among firms who invest into production capacity, sell a near-homogeneous good, and are subject to unexpected demand shocks with persistence. The firms either compete or collude in prices. The model shows that a reduction of demand may promote collusion despite lowering collusive profits. This is the case when capacities are durable and a perceptible decline in demand creates excess capacities that make competition more intense. One finds unstable cartels especially for low discount rates as these lead the firms to choose asymmetric capacities.