3.3.

1 Discussion: Game theory and oligopoly - Group 5

1. The following payoff matrix is taken from the video clip. Does each player have a dominant strategy?
If yes, what is their dominant strategy? Briefly explain why. What is equilibrium outcome of this game?
Why is the game called "prisoner's dilemma?"

  Stan

Adrienne Don’t confess Confess

Don’t confess Free, Free 20000, Free

Confess Free, 20000 10000, 10000

Answer:

Yes, each player has a dominant strategy. A dominant strategy is a strategy that results in the
best outcome or highest payoff to a given player no matter what action or choice the other
player makes.

Their dominant strategy is to confess. If one of them confesses and the other doesn’t then only
one of them will have to pay. This will greatly benefit the confessor but it is extremely
detrimental to the other making it their dominant strategy. Their equilibrium outcome should
be if they both confess so they would each pay 10,000.00.

The game is called prisoners dilemma because two individuals acting in their own self-interests
do not produce the optimal outcome.

2. The following payoff matrix is taken from the video clip. Two oligopoly firms are competing to earn
higher revenues and profits. Does each firm have a dominant strategy? If yes, what is their
dominant strategy? Briefly explain why. What is equilibrium outcome of this game? Using the
strategies and payoffs in this game, briefly explain why a cartel or collusion between the firms is not
stable or feasible?

  Firm 2
 Firm 1 Price high Price low

Price high 200, 200 100, 300

Price low 300, 100  80, 80

Answer:

Yes, each of them has a dominant strategy which is if one of the firms can sell low and the other firm is
selling high, then firm who’s selling can get more profits. It is their dominant strategy since it results to
the best outcome regardless of what the other firm’s action will be. If one of the firms kept their prices
high, there’s a chance that the other firm will lower prices and get more revenue/profit share from their
market

Equilibrium outcome will be both firms lowering their prices.

Collusion or Cartel is inherently unstable, because the most efficient firms will be tempted to break
ranks by cutting prices in order to increase market share as with the game above. There is an incentive
to cheat on this implicit agreement by cutting the price and attracting more customers away from the
other firms. Firms in a cooperative agreement are always tempted to break the agreement to do better.

3.5: Assignment. Group 5

1. Answer technical question six on pp. 222-225 of Farnham textbook, 3rd edition:

 Question # 6: The following graph shows the long-run average cost curve for a firm in a perfectly
competitive industry.

Draw a set of short-run cost curves consistent with output QE and use them to explain.

a. Why the only output that a competitive firm will produce in the long run is QE
Answer: The firm will produce at Q E with price PE in the long run for the reason that the
average total cost is the lowest. The firm will make the most profit and has the best
economies of scale.

b. Why it will be a profit-maximizing decision to produce more than QE in the short run if the price
exceeds PE
Answer: A firm may choose to output at QA and QB in short run if there a change in the market.
With these two outputs, the firm may still operate but the profit will not be that exceptional.
The firm must produce the amount that the market dictates, they do not have influence over
price, and should produce where marginal revenue is higher than the marginal cost because
they’re in perfect competition.

2. Answer technical question six and application question five on pp. 257-259 of Farnham textbook, 3rd
edition.
Question # 6: In both Industry C and Industry D, there are only four firms. Each of the four firms in
Industry C has a 25 percent market share. The four firms in Industry B have market shares of 80, 10, 5,
and 5 percent, respectively.

a. Calculate the three- and four-firm concentration ratios for each industry.
Answer: For the industry C, since the market share of each firm is 25, the concentration ratio
for these four largest firm is (25+25+25+25) 100%. The industry is entirely concentrated by the
four largest firm.
Same way computation as for the three largest firm concentration ratio (25+25+25), the
concentration ratio for the four firm in industry C is 75. Industry is very concentrated by these
three largest firm.

For the industry D (B), since the market share of each firm is 80, 10,5,5 respectively. The
concentration ratio for these four largest firm (80+10+5+5) 100%. The industry is entirely
concentrated by the four largest firm.
Same way computation as for the three largest firm concentration ratios (80+10+5), the
concentration ratio for the four firm in industry D (B) is 95. Industry is very concentrated by
these three largest firm.

b. Calculate the Herfindahl-Hirschman Index for each industry.

Answer: The HHI number for industry C is 2500. The market influence of the four firms is
strong.

HHI= 252+252+252+252
HHI=625+625+625+625
HHI=2500

The HHI number for industry D (B) is 6,550. The market influence of the four firms is strong.

HHI= 802+102+52+52
HHI=6400+100+25+25
HHI=6,550

c. Are these industries equally concentrated? Explain your answer.

The HHI for both industries expresses that industry D (B) has more concentration and market
influence. Both industries have complete influence spread among for firms. But as per HHI, it
shows that the complete influence is not equally distributed between the four firms. There is
more of an influence operating in industry D (B).
Question # 5: Indicate whether each of the following statements describe a perfectly competitive firm, a
monopolistically competitive firm, and/or a monopolist.

a. A firm is producing at the output where MR equals MC and charges the price according to the
consumers’ willingness to pay.

Answer: Monopolist. Equilibrium state for monopolist is MR = MC and the intersection point
when extended to demand curve, gives price. This price is consumer's willingness to pay for
the quantity.

b. In the long run, a firm is producing at the profit maximizing level of output, where the price is
$13 and the average total cost (ATC) is $10.

Answer: Monopolist. In long run also, a monopolist earns super-normal profits. For this price
has to be more than the average total cost at profit maximizing quantity.

c. A firm is producing at the profit-maximizing level of output, where the price is $14, the ATC is
$10, and the marginal cost (MC) is $7. An increase in output will decrease both the ATC and
the firm’s profit.
Answer: It can be both a monopoly company or monopolistically competitive firm (Short-run).
This is due to their P>ATC & MC, which is the characteristic of both market structures in the
short-run, & monopoly company in the long run. With the increase in quantity, ATC will
decline due to declining AFC but profit will decrease due to reducing prices.

d. A firm is producing at the profit-maximizing level of output where the price is $13 and the ATC is
$15, which causes the firm to exit the market in the long run.
Answer: Perfect competition. In the long run, firms can exit if they incur losses or they enter if
incur super normal profits. In this case, firms are incurring loss. Hence, they will exit in the
long run.
3. Answer technical question eight and application question five on pp. 283-285 of Farnham textbook,
3rd edition.  

Question # 8: The following table shows the demand for Good X, which is only produced by two firms.
These two firms have just formed a cartel. Suppose that the two firms have a constant marginal cost and
an average total cost of $55.

a. What is the cartel’s profit-maximizing output and price?

Answer: The profit-maximizing output will at TP of 5000 with a price of $75 for good X. AT this
output level MC=MR.

Quantity/T Price ($ per

P unit) TR ATC TC MR MC

0 100 - 55 -    

1000 95 95,000 55 55,000 95 55

2000 90 180,000 55 110,000 85 55

3000 85 255,000 55 165,000 75 55

4000 80 320,000 55 220,000 65 55

5000 75 375,000 55 275,000 55 55

6000 70 420,000 55 330,000 45 55

7000 65 455,000 55 385,000 35 55

 b. What are the output and profit for each firm?

Answer: Since both firms have the same marginal cost, each of them will produce 2,500 units
to make up the 5,000-profit maximization output level. Each firm will have a profit of 2,500
(75 – 55) = $50,000.

c. What will happen to the profits of both firms if one of them cheats and increases its output by
1,000 units, while the other doesn’t?

Answer: When one of the firms cheats and increases its output from 2,500 units to 3,500
units, the market quantity increases to 6,000 units and the market price decreases to $70. For
the firm that cheats, its profit will increase from $50,000 to 3,500 ($70–$55) =$52,500.
However, for the firm that doesn’t cheat, its profit will decrease from$50,000 to 2,500 ($70–
$55) = $37,500.

Question # 5: The following describes the relationship between two major shipping companies hauling
liquid chemicals:
Documents indicated that two shipping companies, Stolt-Nielsen SA and Odfjell ASA, colluded to divide
up the market for transporting liquid chemicals across the sea. The companies discussed which shipping
business each would bid for, route by route, even exchanging information on bid prices. Stolt officials
also developed tables showing the increase in revenues from cooperation compared to all-out
competition. The companies are unknown to most consumers, but they carry the chemicals that are
used to make a variety of everyday products. Carriers are allowed to cooperate in certain ways. They
may pool their capacity if they both carry chemicals for a given producer on the same route. They may
form joint ventures to bid for a piece of business. However, cooperation to divide markets or set prices
would fall outside these areas. The alleged collusion was in response to the Southeast Asian financial
crisis of 1997, which depressed the volume of shipping, and a glut of new ships that decreased freight
rates. Chemical company mergers also increased the producers’ bargaining power, particularly the
merger between Dow Chemical and Union Carbide in 2001. Each of the shipping companies had
important pieces of business with each of the chemical companies that were merging. After the merger,
either Stolt or Odfjell could be dislodged and price wars could break out. Documents indicated that
officials of the two shipping companies held talks on dividing the pie, reviewing contracts around the
world, trade lane by trade lane. Documents also indicated that the cooperation would keep freight rates
5 to 25 percent higher than otherwise. Stolt officials compared the economic costs of “going to war”
with cooperation. On certain trade lanes, Stolt might benefit from individual action, but lower rates
overall would result if the cooperation was abandoned. Journals of company officials indicated that by
April 2001, both companies were threatening price wars if the agreements could not be maintained. The
journals are also filled with notations such as “no written agreements” or “no paper.” Memos included
the phrase, “Don’t be seen as doing something together.” In September 2006, Stolt was indicted by a
federal grand jury in Philadelphia on charges of price fixing and other illegal cartel activities. Stolt-
Nielsen was initially granted amnesty as part of a Justice Department’s investigation into the chemical-
shipping industry, but department officials revoked it in 2004 after determining the company wasn’t
meeting the terms of the deal. The indictment cited company activity between August 1998 and
November 2002. If convicted, corporate officials could face up to three years of imprisonment, $350,000
individual fines, and $10million in corporate fines.
Explain how the discussion of cartel behavior in this chapter relates to this shipping company case.
Answer: Making a cartel gives an advantage to firms so that they can just about transform the market
into monopoly market. This will give an edge, since multiple firms in the same market have less
impact because they are not directly competing with each other. No firm wants to be outdone by
other another firm, otherwise they will lose out on profit. When firm work collectedly to form a cartel,
they are moving much of the competition that causes them to lose influence. Instead of competing
against each other for the lowest price, the firm come together to manipulatable raise the price.
Organizing a cartel is illegal in most markets for this may lead to the possibility of corruption and
unfairness to consumers. Also, competition keeps firms motivated to make the best quality goods that
they can. This promotes the overall furtherance of a society. With a substantial barrier to entry and all
firms working together, consumers can be stuck with over-priced goods with no close substitutes.
These two firms were engaged in illegal activity by working together to keep the price high.
4. Answer technical question six and application question five on pp. 316-319 of Farnham textbook, 3rd
edition. 
Question # 6: An airline estimates that the price elasticity of demand for business travelers (who travel
on weekdays) is –2, while the price elasticity of demand for vacation travelers (who travel on weekends)
is –5. If the airline price discriminates (and costs are the same), what will be the ratio of weekday to
weekend prices?
Answer: The firm can change their price of services due to the change in price elasticity of demand
during the weekend. Consumers are more flexible with price during the week because the services are
needed much more for business. The firm should price discriminate based on price elasticity of
demand to find the optimal markup. The price elasticity of demand and optimal markup are closely
related when considering how much to price the good to maximize profits. Optimal markup is
equated using price elasticity of demand as negative one divided by the sum of positive one and price
elasticity of demand.
variable m = optimal markup while eP = price elasticity of demand
m = -1/1+eP
= -1/1+(-2)
= -1/-1
= 1 or 100% is the optimal markup. During the week, the firm will markup the price 100% of the cost
production.

m = -1/1+eP
= -1/1+(-5)
= -1/-4
= .25 or 25% is the optimal markup. During the week, the firm will markup the price 25% of the
cost production. The ratio of prices will be 100 to 25 or 4:1
Question # 5: Publishers have traditionally sold textbooks at different prices in different areas of the
world. For example, a textbook that sells for $70 in the United States might sell for $5 in India. Although
the Indian version might be printed on cheaper paper and lack color illustrations, it provides essentially
the same information. Indian customers typically cannot afford to pay the U.S. price.
a. Use the theories of price discrimination presented in this chapter to explain this strategy.

Answer: Consumers in the first market are more flexible with the price of the good and have a
higher income level. Textbooks are a normal good and the demand rises with income level.
The product developed a different version of the textbook with cheaper production costs that
could have less marginal revenue. The higher flexibility and utility the higher optimal markup
in the first market.

This is an example of third-degree price discrimination. The publisher segments the U.S. and
Indian markets because there is a different willingness to pay in each market. The publisher
increases its revenues by charging a lower price in the Indian market, which has more elastic
demand. If the publisher charged the high U.S. price in both markets, it would not be able to
sell in India.

b. If the publisher decides to sell this textbook online, what problems will this present for the
pricing strategy? How might the publisher respond?
c.
Answer: Putting a textbook online will remove the ability offer a much cheaper alternative.
The online version is more easily converted for the second market than making a cheaper
version of the textbook for the second market. The firm will have to price the good at the level
the first market is willing to pay. The consumers in the first market will not pay a higher price
for the exact same good offered to other consumers.

Also, If the publisher is going to sell the textbook online, it will probably have to set a single
price, typically the high U.S. price. This means that it will lose the Indian market. However, if
the publisher differentiates the product by, for example, using rupees in the examples in the
Indian version the two versions of the product can be sold in the two markets at different
prices because they are no longer the same commodity.