Endogenous Cartel Formation with Heterogeneous Firms∗

In the context of an infinitely repeated capacity-constrained price game, we endogenize the composition of a cartel when firms are heterogeneous in their capacities. When firms are sufficiently patient, there exists a stable cartel involving the largest firms. A firm with sufficiently small capacity is not a member of any stable cartel. When a cartel is not all-inclusive, colluding firms set a price that serves as an umbrella with non-cartel members pricing below it and producing at capacity. Contrary to previous work, our results suggest that the most severe coordinated effects may come from mergers involving moderate-sized firms, rather than the largest or smallest firms. ∗We appreciate the comments of Marc Escrihuela-Villar, Hélder Vasconcelos, participants at the 2009 International Industrial Organization Conference, two anonymous referees, and the editor, David Martimort. The first author acknowledges the hospitality of the Department of Economics of Johns Hopkins University where this research was initiated. The second author recognizes the financial support of the National Science Foundation under grant SES-0516943. And we both thank Viplav Saini for his excellent research assistance.