The following table is for two towel companies. They each offer cotton towels that are highly absorbent and fluffy even though they are made from different cottons. Since every household uses towels, these firms believe that there will always be a tomorrow for their product. Both Tom and Cathy have agreed to charge high prices in order to make a more than normal profit. Which of the following is true?
A) in the long run, it is in Cathy's Cotton's best interest to defect from their agreement and charge a lower price.
B) in the long run, it is in Tom's Terrycloth's best interest to defect from their agreement and charge a lower price.
C) there is no incentive for either firm to defect from the agreement
D) the agreement is only rational as long as the interest rate is sufficiently low to make the gains from defecting less than the present value of the of the profit obtained from colluding.
E) none of the above

Question

The following table is for two towel companies. They each offer cotton towels that are highly absorbent and fluffy even though they are made from different cottons. Since every household uses towels, these firms believe that there will always be a tomorrow for their product. Both Tom and Cathy have agreed to charge high prices in order to make a more than normal profit.  Which of the following is true?
A) in the long run, it is in Cathy's Cotton's best interest to defect from their agreement and charge a lower price. 
B) in the long run, it is in Tom's Terrycloth's best interest to defect from their agreement and charge a lower price. 
C) there is no incentive for either firm to defect from the agreement 
D) the agreement is only rational as long as the interest rate is sufficiently low to make the gains from defecting less than the present value of the of the profit obtained from colluding. 
E) none of the above

Quizplus · Accepted Answer

The scenario described fits the conditions of a Prisoner's Dilemma, where both firms would benefit more from defecting and charging lower prices, but if both do so, they would end up worse off than if they had both maintained their high prices. The only reason for them to stick to the agreement is if the interest rate is low enough that the present value of future profits from colluding outweighs the gains from defecting. Therefore, option D is the correct choice.

The Following Table Is for Two Towel Companies