214ECN Managerial Economics

Seminar 3

1. Firms E and F are duopolists. They each have two possible strategies for product
development. The payoff matrix is as follows:

Possible strategies for firm F

Possible strategies for E A B
1 $5 million, $6 million $4 million, $5 million
2 $6 million, $5 million $5 million, $4 million

a. What is Firm E’s optimal strategy?

Strategy 2
b. What is firm F’s optimal strategy?
Strategy A
c. Is this an example of the prisoner’s dilemma?
No
d. Is there a dominant strategy for firm E? Explain
Yes, strategy 2
e. Is there a dominant strategy for firm F? Explain
Yes, Strategy A.

2. While there is a degree of differentiation among general merchandise retailers like

Target and Kmart, weekly newspaper circulars announcing sales provide evidence
that these firms engage in price competition. This suggests that Target and Kmart
simultaneously choose to announce one of two prices for a given product: a regular
price or sale price. Suppose that when one firm announces the sale price and the
other announces the regular price for a particular product, the firm announcing the
sale price attracts 50 million extra customers to earn a profit of $5 billion, compared
to the $3 billion earned by the firm announcing the regular price. When both firms
announce the sale price, the two firms split the market equally (each getting an extra
25 million customers) to earn profits of $1 billion each. When both firms announce
the regular price, each company attracts only its 50 million loyal customers and the
firms each earn $3 billion in profits. If you were in charge of pricing at one of these
firms, would you have a clear-cut pricing strategy? If so, explain why. If not, explain
why not and propose a mechanism that might solve your dilemma. (Hint: unlike Wal-
mart, neither of these two firms guarantees “Everyday low Prices”)

1
Answers:
The normal form game looks like this:

Kmart
Strategy Sale Price Regular Price
Target Sale Price $1, 1 $5, $3
Regular Price $3, $5 $3, $3
Notice that there are two Nash equilibria: (Sale, Regular) and (Regular, Sale) with profits
of ($5, 3) and ($3, $5), respectively. Thus, there is not a clear-cut pricing strategy for either
firm. One mechanism that might solve this problem is to advertise your sales on alternate
weeks. Another mechanism might be to guarantee “everyday low prices” (so that you
effectively commit to always charge the sale price). In this case, your rival’s best response
would be to charge the regular price and your firm would earn profits of $5 million.

3. Suppose Toyota and Honda must decide whether to make a new breed of side-
impact airbags standard equipment on all models. Side-impact airbags raise the price
of each automobile by $500. If both firms make side-impact airbags standard
equipment, each company will earn profits of $1.5 billion. If neither company adopts
the side-impact airbag technology, each company will earn $0.5 billion (due to lost
sales to other automakers) If one company adopts the technology as standard
equipment and the other does not, the adopting company will earn a profit of $2
billion and the other company will lose $1 billion . If you were decision makers at
Honda, would you make side impact airbags standard equipment? Explain.
Answers:
The normal form game looks like this:

Honda
Toyota Strategy Airbags No Airbags
Airbags $1.5, 1.5 $2,-$1
No Airbags -$1, $2 $0.5, $0.5
The dominant strategy, in this case, would be to offer airbags.

4. You are the bargaining coordinator for Sun Car Manufacturers. At present you are
renegotiating the labor contract with the union representative. You are bargaining
over an expected 20 percent increase in earnings over the next three-year contract
period. You are trying to decide whether to offer one-third, one-half, or all of the
increase in earnings to the union. The union rules are such that all contracts must be
voted on. The additional earnings are contingent on getting started on the new
contract next week. If an agreement isn't reached on the first round of negotiations,
the firm will go out of business. The union representative tells you that if you do not
give the union all of the additional profits, the union members will not vote for the

2
agreement.
a. Show the extensive form of this game.
b. What will you offer the union? Why?

a. See Figure below.

b. The bargaining coordinator should offer 33% of the increase to the union. The union claims
it will vote no if you do so, but by doing so, the firm will go bankrupt and the members will lose
their jobs. Obviously, a 6.7 percent pay hike is preferable for the union; the Union's threat is
not credible.

3
5. Suppose the market for computer chips is dominated by two firms: Intel and AMD.
Intel has discovered how to make superior chips and is considering whether or not to
adopt the new technology. Adoption would entail a fixed setup cost of C but would
increase revenues. However, if Intel adopts the new technology, AMD can easily
copy it at a lower setup cost of C/2. If Intel adopts and AMD does not, Intel would
earn $20 in revenues while AMD would earn $0. If Intel adopts and AMD does
likewise, each firm will earn $15 in revenues. If Intel does not adopt the new
technology, it will earn $5 and AMD will earn $2.
a. Write this game in extensive form.
b. Under what conditions (i.e., for what values of C) does AMD have an incentive to
adopt the new technology if Intel introduces it?
c. If C = 12, should Intel adopt the new technology? Explain.

a.

b. AMD's payoff from adopting must exceed its payoff from not adopting. This is true if 15 -
C/2 > 0. Solving for C we find that AMD has an incentive to adopt if Intel adopts whenever C <
30.
c. No. When C = 12, AMD's best strategy is to adopt if Intel Adopts, which means Intel would
earn only 3 by adopting. By not adopting, Intel can earn a payoff of 5; Intel's best option is not
to adopt. This is the only Nash equilibrium, and it is also a subgame perfect Nash equilibrium.

4
6. You are the manager of XYZ Inc. and must decide how much output to produce to
maximize your firm's profit. XYZ and its rival, ABC Corp., produce a good that
consumers view as essentially identical. These two firms make up the entire industry,
so the market price for the good depends on the total amount produced by the two
firms. A survey reveals that the market price of the product depends on total market
output as follows:

XYZ and ABC each use labor, materials, and machines to produce output. XYZ
purchases labor and materials on an as-needed basis; their machines were
purchased three years ago and are being depreciated according to the straight-line
method. XYZ's accounting department has provided the following data about its unit
production costs:

Reports from industry experts suggest that ABC's cost structure is similar to XYZ's
cost structure and that technological constraints require each firm to produce either
100 units or 200 units of output.
a. Briefly explain which costs are relevant for your decision, and why.
b. Write this game in normal form.
c. How many units should XYZ produce: 100 units or 200 units?

a. Direct labor and direct materials, since they are variable costs. Depreciation is a fixed (or
sunk) cost, and is therefore irrelevant to the decision (the firm's fixed costs are $200, since
$200/100 = $2 $200/200 = $1. These later numbers are the ones reported in the table).
b. The payoff matrix (normal form) below shows the relevant contributions to overall profits
(the sunk costs are irrelevant, remember!) for alternative levels of output by the two firms. The
key is to note that if each firm produces 100 units, total market output is 200 units and the
price is $6. XYZ's contributions in this case are ($6 - $5) x 100 = $100. If one firm produces
100 units and the other firm produces 200 units, the market price is $5. In this case, each
firms contributions are zero (the price equals relevant unit costs of $5). If both firms produce
200 units, the market price is $4, and the contributions of each firm are ($4 - 5) x 200 = $ -
200.

5
c. The dominant strategy for XYZ is to produce 100 units -- regardless of what ABC does,
XYZ is better off producing 100 units. Importantly, this is true regardless of whether the game
is simultaneous move or sequential move. The same is true for ABC. Thus, if XYZ plays its
dominant strategy it will contribute $100 towards it's fixed costs of $200. Any other strategy
leads to lower contributions and even greater losses.

7. Indentify the key features of game thoery and evaluate its contribution to our
understanding of business decisions.

Game thoery is a “ paradigam” a set of concepts and the relationship among those concepts.
It provides a means by which situations of interdependance can be analysed, and predictions
made about the outcomes of those situations. For that reason it offers a formal and rigorous
approach to the problems associated with oligopoly. Those problems were previously
approached in a relatively informal way, simly assuming for instance that higher levels of
concentration bring increasing levels of market power and increaseing profit, which is difficult
to justify without further analysis.

Game thoery proceeds by formally stating the conditions that make up the game - the actions
that the players may take, the order in which they take them, and the extent of the knowledge
they have. The game is then examined to see if a Nash equilibrium can be identified - a
situation that is prefered by each player, given what the other has done. The consequneces of
repeating the game and other variations are considered.

This approach has yielded important insights on issues like collusion and entry deterrence,
and the economics of industrial organisation has become dominated by game thoery.
However, it remains problematical in a number of respects. The predicted outcome of a game
can change very dramatically with small changeds in the “protocols” – the rules that
determine the ways in which players move. As the protocols are difficult to observe it can be
almost impossible to decide which type of game is an appropriate model for a particular
situation. Even if the protoclos are known, a game my have many equilibria or none, which
makes it difficult to predict which one will be reached. Further more, the situations examined
involved relatively limited decision and yet they are often made extremely complex. Game
thoery assumes a kind of hyper-reationallity on the prart of players, in the sense that they
calculate the very complex consequences of different moves, and yet common sense often
suggests solutions to a game that the thoery cannot find.

Overall, game thoery has proved its value to academics by offering a means ghtrough which
hitherto intractable issues coulbd be modelled. However, its ability to predict important
economic relationships, like that of a firm’s actions to its environment and its performance,
remain uncertain.

6
8. Use the following extensive-form game to answer the questions below.
a. List the feasible strategies of player 1 and player 2.
b. Identify the Nash equilibria to this game.
c. Find the subgame perfect equilibrium.

Answers:
a. Player 1 has two feasible strategies: A or B. Player 2 has four feasible strategies:
(1) W if A (2) W if B(3) X if A (4) X if B.
b. (60, 120) and (100, 150).
c. (100, 150).
W 60, 120

A 2
X 50, 50
1
d.
B W 0, 0
2

X
100, 150