2021/22 Semester 1

BHMH2105 Business Economics

Suggested Answers to Tutorial Questions (topic 8)

Q1.

(a) Yes, the dominant strategy for both wine companies is ‘Advertise’. If Great Wine Co.
advertises, Super Wine Co. will advertise because of higher payoff (5 vs 3). If Great
Wine Co. adopts ‘no advertise’, Super Wine Co. will also advertise to yield higher
payoff (15 vs 11). So, the dominant strategy for Super Wine Co. is ‘Advertise’. It also
applies to Great Wine Co.
(b) The Nash equilibrium is “Great: Advertise; Super: Advertise”. It is because each party
will choose ‘advertise’ given that the other party also chooses ‘advertise’ – there is no
tendency for each party to change.
(c) Prisoners’ Dilemma. The equilibrium is such that the combined profit is the lowest for
two parties. This game seems to illustrate that cooperation is very difficult but that
self-interested competition will lead to lower welfare for all concerned.
(d) If they expect they will be in business for an indefinite period, then they may
cooperate with each other and not advertise because the prospect of greater benefits
from future cooperation will be lost if they don’t cooperate now. This expectation will
constrain the parties not to compete (cheat) now.

Q2.

(a) Both players charging low prices (You: Low Price; Your rival: Low Price) is a unique
Nash equilibrium for a one-shot version of the game.
(b) The cooperative (collusive) outcome can be sustained in the infinitely repeated game
with the following trigger strategy: Cooperate provided no player has ever cheated in
the past. If any player cheats, "punish" the player by choosing the one-shot Nash
equilibrium strategy forever after. In particular, for this game we know

The left-hand side of this equation represents the one-time gain of breaking the
collusive agreement today. The right-hand side represents the present value of what is
given up in the future by cheating today. Since the one-time gain is less than the
present value of what would be given up by cheating, players find it in their interest to
live up to the agreement.

P. 1/2
 2021/22 Semester 1
BHMH2105 Business Economics
Suggested Answers to Tutorial Questions (topic 8)

Q3.

(a) If all sellers are operating near capacity, then it will be more difficult for them to
expand. From another point of view, the marginal cost of expanding their output at
that level will be relatively high; hence, there will be little incentive to exceed the
specified quotas and so they are more likely to follow the cartel agreement. By
contrast, a seller with substantial excess capacity will have more incentive to exceed
its quota and is more likely to violate the cartel agreement.

(b) Two opposite factors here: 1) Sellers with significant sunk costs will be relatively
more willing to cut the price so long as the price covers variable costs in the short run
because initial investments are sunk. Thus, those sellers will produce beyond their
quotas and thus violate the cartel agreement. 2) High sunk cost makes it more risky for
new entrants so this poses a lesser threat to the cartel.

(c) Low entry and exit barriers make it difficult to maintain discipline for cartels because
the threat of potential new entrants is great. For example, if all the sellers in a
perfectly contestable market (no entry barrier, thus high threat of new entry) form a
cartel, they cannot raise the price above the price chargeable in a perfectly competitive
market. It is because the higher price would draw new suppliers into the market,
which would drive the market price back down and even the new entrants join the
cartel but the increase in the number of firms, which will reduce the cartel’s
manageability.

***  ***

P. 2/2