Question for Critical Thinking 5

Salvatore Chapter 10

3. What is the difference between limit pricing and contestable markets?

Limit pricing is a strategy of an existing form to set the price below average cost to create
a barrier to entry by making it unprofitable for new entrants to enter the market. Contestable
markets have a few firms but with no barriers to entry. However, the threat of entrants forces the
existing forms to price competitively.
8. In what way does OPEC resemble a cartel? How successful is it?
OPEC stands for Organization of the Petroleum Exporting Countries. OPEC oversees
and develops policies for oil-producing countries. OPEC manages the supply of oil in effort to
set the price of oil in the world market. By doing this, fluctuations can be avoided. This protects
countries selling and purchasing the oil. This resembles a cartel because it is a formal agreement
between groups of oil producers in effort to regulate pricing. In the US cartels are illegal;
however OPEC is protected by US trade laws.
1.Find the Herfindahl index for an industry composed of (a) three firms- one with 70% of the
market, and the other two with 20 and 10 percent of the market, respectively, (b) one firm with
50% share of the market and 10 other equal-size firms, (c) 10 equal-size firms.
a) 0.70^2+0.20^2+0.10^2=0.49+0.04+0.01=0.54 or 54%
b) 0.50^2+[(0.05^2)*10]=0.25(0.0025*10)=0.25+0.025=0.275 or 27.5%
c) (0.10^2)*10=0.1*10=0.1 or 10%

Froeb Chapter 10

10-4 Examine the US passenger airline industry using the Five Forces. Is this an attractive
industry? Why or why not?

The Five Forces Model measures the attractiveness of an industry by looking at a few areas
1. Bargaining power of customer: This is a low threat in this industry. There is a large
amount of customers compared to firms. Some customers are loyal to particular firms.
However switching cost is low and customers tend to be flexible in choosing an airline
since they are focusing on flying times, locations, layovers etc.
2. Bargaining power of suppliers: Major suppliers of airline companies are manufacturers.
The major manufacturers are Boeing and Airbus. Although parts for airplanes are
standard it is not easy for airlines to switch manufacturers as there is typically a long term
contract in place.
3. Threat of new entrants: This threat is low. The only threats that would make this high
are low switching costs and no proprietary products. Considering those threats this is still
considered a low threat because existing firms have a large cost advantage and when a
 new companies tries to enter the market it can lower their prices to drive the new
competition out.
4. Threat of substitute products: This is a moderate threat. Alternates to air travel are bus,
car, train and boat. Although flying is the fastest and most convenient way to travel,
there are substitutions which are less costly.
5. Competitive rivalry within the industry: This threat is very high. There is a large number
of competitors in this industry. Many airlines try to differentiate themselves from the
market to gain customers. For example Southwest Airlines is known for their low prices
and free checked bags and Jetblue is known for their amenities.
Overall, the airline industry is not an attractive industry to enter because it is very difficult to
compete with competitors. This industry requires a large amount of capital and will take a
long time to begin making profit.

Salvatore Chapter 11

11. Do the duopolists in a Cournot equilibrium face a prisoners’ dilemma?

Doupolists in Cournot equilibrium do face a prisoner’s dilemma. The text indicates that a
monopoly outcome would be Q=6 and P=$6 for total profit of $36. In the Cournot equilibrium,
each produce 4 units for $4, earning $16 when competing against each other. If they behaved as
a monopolist be each producing 3 units (6 total) they could split the monopoly profit of $18.

12. How did the 1971 law that banned cigarette advertising on television solve the prisoners’
dilemma for cigarette producers?
In 1971 a law was passed to ban cigarette advertising on television to help decrease the
amount of smokers because of health risks. However, this law actually increased the amount of
profits of cigarette companies because they eliminated a large portion of their advertising.
Prior to this law, cigarette manufacturers faced a prisoner’s dilemma around television
advertising. The prisoner’s dilemma is the concept that if a group of individuals seek what’s in
their personal best interest then the outcome for everyone would be worse than if they would
have all worked together. If all manufactures advertise on television each company would see in
an increase in revenue but also see an increase in costs (advertising). And if all decided not to
advertise on television they would not see revenue from advertising, but will see a decrease in
costs. The law established in 1971 solved this dilemma, all companies stopped television
advertising, which they would have not been able to stop doing on their own.
2. From the following payoff matrix, where the payoffs are the profits or losses of the two firsts,
determine (a) whether firm A has a dominant strategy, (b) whether firm B has a dominant
strategy, (c) the optimal strategy for each firm, and (d) the Nash equilibrium, if there is one.
Firm B

Low Price High Price

Low Price (1,1) (3,21)

Firm A
High Price (21,3) (4,2)
Both firms have dominant strategies. The optimal strategy for firm A is to choose hi prices at 4
where firm B is at 2. The optimal strategy for firm B is to choose a high price at 21 where firm
A is 3. The Nash equilibrium for both firms would be to sell at 1.
6. Explain why the payoff matrix problem 1 indicates that firms A and B faces the
prisoner’s dilemma

The payoff matrix shows that firms A and B face a prisoner’s dilemma because when
both firms choose their low price or both choose their high price, the firms are equal.

10. Given the following payoff matrix (a) indicate the best strategy for each firm (b) why is the
entry-deterrent threat by firm A to lower the price credible to B (c) what could firm A do to
make its threat credible without building excess capacity?
a. The best strategy for firm A would be to have a high price at 6 (making firm B not
enter. Firm B’s best strategy would be to enter at 3 versus A’s low price of -1
b. The entry deterrent threat firm A shows its constraining its own behavior in order to
make a threat credible. To make competitive advantage over firm B
c. Firm A has to be committed to carrying it out for the threat to be credible. Firm A
could accept lower profit to make is threat credible.
Froeb Chapter 15
15-4 The following represents the potential outcomes of your first salary negotiation after
graduation: Assuming this is sequential move game with the employer moving first, indicate the
most likely outcome. Does the ability to move first give the employer an advantage? If so, how?
As the employee, is there anything you could do to realize a higher payoff?
The employer having the first move does not mean the employer has an advantage. This
is due to the Nash Equilibrium Concept which means each player is assumed to know the
equilibrium strategies of the other players, and no player has anything to gain by changing their
own strategy. The best option is for the employee is to accept in any salary situation.
To get higher payoffs, the employee could counter the employer’s proposed salary in
hopes that the employer will accept the raised amount or counteroffer in the middle.
15-5 Every year, management and labor renogtiate a new employment contract by sending the
propsals to an arbitrator who chooses the best proposal (effectively gaining one side of the other
1 million). Each side can choose to hire, or not hire, an expensive lawyer (at the cost of
$200,000) who is effective at preparing the proposal in the best light. If neither hires lawyers or
if both hire lawyers, each side can expect to with about half of the time. If only one side hires a
laywer, it can expect to win ¾ of the time.
 a. Diagram this simultaneous move game
b. What is the Nash Equilibrium of the game?
c. Would the sides want to ban lawyers?
Side A

Hire Not Hire Lawyer

Lawyer

Side B Hire Lawyer (50, 50) (75, 0)

Not Hire Lawyer (0, 75) (50, 50)

The Nash equilibrium of the game is both or neither hiring a lawyer. Because of this, both sides
would ban lawyers. If they are working in a cooperative state, banning lawyers would place the
game in an equal state for the outcome and would eliminate prisoner’s dilemma.