Endogenous Cartel Formation with Free Market Entry and Firm Heterogeneity∗

Why do large firms choose to compete with a cartel rather than to cooperate? Bos and Harrington (2010) explained why small firms do not join in a cartel by introducing heterogeneous firms. But it is still unclear why large firms do not join in a cartel. This paper shows a possibility that only mid-level productive firms benefit from joining a cartel by considering endogenous choices of firm-production capacity. The reason is that low-productive firms cannot compete efficiently for production quota in cartel and staying out can yield them larger profits. Highproductive firms prefer to stay out because building excess capacity in cartel lowers their profits. Additionally, this paper also contributes to the cartel literature by considering an endogenous market entry through incorporating the heterogeneous-firm model into the infinitely repeated game approach. So the results also predict that an increase in demand for output and a decrease in capacity and entry costs induce low-productive firms to enter a cartel. Technology improvements of low-productive independent firms and an increase in price elasticity of output demand entice high-productive firms to join a cartel. JEL classification: L1, L2