Practice problem set 5

Managerial Economics
PGP, 2020-2022
Scenario 13.3
Consider the following game:

1) Which of the following is true for the game in Scenario 13.3?

A) Moto's dominant strategy is the CD changer.
B) Moto's dominant strategy is the free maintenance.
C) Zport's dominant strategy is the low-profile tires.
D) Zport's dominant strategy is the sun roof.
E) Neither company has a dominant strategy.
Answer: C
Section: 13.2

2) In the game in Scenario 13.3, the equilibrium outcome:

A) is for Moto to offer a CD changer and Zport to offer low-profile tires.
B) is for Moto to offer a CD changer and Zport to offer a sun roof.
C) is for Moto to offer free maintenance and Zport to offer low-profile tires.
D) is for Moto to offer free maintenance and Zport to offer a sunroof.
E) does not exist in pure strategies.
Answer: A
Section: 13.2

3) Nash equilibria are stable because

A) they involve dominant strategies.
B) they involve constant-sum games.
C) they occur in noncooperative games.
D) once the strategies are chosen, no players have an incentive to negotiate jointly to change
them.
E) once the strategies are chosen, no player has an incentive to deviate unilaterally from
them.
Answer: E
Section: 13.3

Scenario 13.7:
Consider the game below about funding and construction of a dam to protect a 1,000-person
town. Contributions to the Dam Fund, once made, cannot be recovered, and all citizens must
contribute $1,000 to the dam in order for it to be built. The dam, if built, is worth $70,000 to
each citizen.

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4) In the game in Scenario 13.7, the strategy pair that pays
A) $69,000 to each player is the only equilibrium.
B) ($0, -$1000) is the only equilibrium.
C) (-$1000, $0) is the only equilibrium.
D) $0 to each player is the only equilibrium.
E) $69,000 to each player and the strategy pair that pays $0 to each player are equilibria.
Answer: E
Section: 13.3

Scenario 13.11
Consider the game below:

5) What is true about dominant strategies in the game in Scenario 13.11?

A) R1 and C1 are dominant strategies.
B) R1 and C2 are dominant strategies.
C) R2 and C1 are dominant strategies.
D) R2 and C2 are dominant strategies.
E) There are no dominant strategies.
Answer: D
Section: 13.4

6) In the game in Scenario 13.11, equilibrium is

A) R1, C1.
B) R1, C2.
C) R2, C1.
D) R2, C2.
E) a mixed strategy based on all four pure strategies.
Answer: D
Section: 13.4

Scenario 13.9
Consider the following game:

Two firms are situated next to a lake, and it costs each firm $1,500 per period to use filters
that avoid polluting the lake. However, each firm must use the lake's water in production, so
it is also costly to have a polluted lake. The cost to each firm of dealing with water from a

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polluted lake is $1,000 times the number of polluting firms.

8) Refer to Scenario 13.9. If this game is repeated over an infinite or uncertain horizon, the
most likely observed behavior will be that (assume a time discount factor of 0.05)
A) both firms pollute.
B) only Lago pollutes.
C) only Nessie pollutes.
D) neither firm pollutes.
E) the firms alternate polluting in different periods.
Answer: D
Section: 13.3

9) In comparing the Cournot equilibrium with the competitive equilibrium,

A) both profit and output level are higher in Cournot.
B) both profit and output level are higher in the competitive equilibrium.
C) profit is higher, and output level is lower in the competitive equilibrium.
D) profit is higher, and output level is lower in Cournot.
Answer: D
Section: 12.2

10) A ________ shows how much a firm will produce as a function of how much it
thinks its competitors will produce.
A) contract curve
B) demand curve
C) reaction curve
D) Nash equilibrium curve
E) none of the above
Answer: C
Section: 12.2

13) In a Cournot duopoly, we find that Firm 1's reaction function is Q 1 = 50 - 0.5Q2,
and Firm 2's reaction function is Q2 = 75 - 0.75Q1. What is the Cournot equilibrium
outcome in this market?
A) Q1 = 20 and Q2 = 60
B) Q1 = 20 and Q2 = 20
C) Q1 = 60 and Q2 = 60
D) Q1 = 60 and Q2 = 20
Answer: A
Section: 12.2

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Scenario 12.3:
Suppose a stream is discovered whose water has remarkable healing powers. You
decide to bottle the liquid and sell it. The market demand curve is linear and is
given as follows:
P = 30 - Q
The marginal cost to produce this new drink is $3.

15) Refer to Scenario 12.3. What will be the price of this new drink in the long run if
the industry is a Bertrand duopoly?
A) $3
B) $9
C) $12
D) $13.50
E) none of the above
Answer: A
Section: 12.3

16) Suppose two firms with differentiated products are competing on price. The
reaction curve for Firm 1 is P1 = 4 + 0.5 P2, and the reaction curve for Firm 2 is P 2 = 4
+ 0.5P1. What is the equilibrium price outcome in this market?
A) P1 = P2 = 4
B) P1 = P2 = 6
C) P1 = P2 = 8
D) P1 = 6 and P2 = 8
Answer: C
Section: 12.3

17) The authors cited statistical evidence that the price elasticity of demand for Royal Crown
cola is -2.4, and the price elasticity of demand for Coke is roughly -5.5. Which firm likely
has stronger brand loyalty among customers that provides greater potential for monopoly
power in the cola market?
A) Coke
B) Royal Crown
C) Both firms should have identical monopoly power
D) We do not have enough information to answer this question.
Answer: B
Section: 12.1

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Short answer question

17) The market structure of the local pizza industry is best characterized by monopolistic
competition. One Guy's Pizza is one of the producers in the local market. The demand for
One Guy's Pizza is:
Qd = 225 - 10P  P = 22.5 - 0.1 Qd.
The resulting marginal revenue curve is
MR(Qd) = 22.5 - 0.2 Qd.
One Guy's cost function is:
C(Q) = 0.15Q2  MC(Q) = 0.3Q.
Determine One Guy's profit maximizing level of output and the price charged to customers.
Is this a long-run equilibrium?
Answer: To determine One Guy's optimal output, we set One Guy's marginal revenue equal
to marginal cost. This is 22.5 - 0.2Q = 0.3Q  Q = 45. The market price for One Guy's
Pizza at this level of output is $18. This is not a long-run equilibrium because One Guy's is
earning a positive profit. The positive profit will attract entrants into the local pizza industry.
Section: 12.1

18) Two firms at the St. Louis airport have franchises to carry passengers to and from hotels
in downtown St. Louis. These two firms, Metro Limo and Urban Limo, operate nine
passenger vans. These duopolists cannot compete with price, but they can compete through
advertising. Their payoff matrix is below:

a. Does each firm have a dominant strategy? If so, explain and what that strategy is.
b. What is the Nash equilibrium? Explain where the Nash equilibrium occurs in the payoff
matrix.
Answer:
a.
Metro Limo has no dominant strategy. If United Limo advertises, then Metro does best by
advertising; but if United does not advertise, then Metro should not advertise. United has a
dominant strategy, and it should advertise.

b.
The Nash equilibrium is for both firms to advertise. Each does best, 25 and 15, respectively,
by advertising, given what the other firm does.
Section: 13.3

19) Suppose that the market demand for mountain spring water is given as follows:
P = 1200 - Q
Mountain spring water can be produced at no cost.

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a. What level of output would be produced by each firm in a Cournot duopoly?
What will the price be?
Answer:

The Cournot equilibrium is found by using the reaction curves of the two firms to
solve for levels of output. The reaction curve for firm 1 is found as follows:
R1 = PQ1 = (1,200 - Q)Q1
= 1,200Q1 - (Q1 + Q2)Q1
= 1,200Q1 - Q12 - Q2Q1

The firm's marginal revenue MR1 is just the incremental revenue R1 resulting from
an incremental change in output ΔQ1:
MR1 = ΔR1/ΔQ1 = 1,200 - 2Q1 - Q2

Setting MR1 equal to zero (the firm's marginal cost) and solving for Q 1 yields the
reaction curve for Q1:
Firm 1's Reaction Curve: Q1 = 600 - (1/2)Q2
Going through the same calculations for firm 2 yields:
Firm 2's Reaction Curve: Q2 = 600 - (1/2)Q1
Solving the reaction curves simultaneously for Q1 and Q2 yields: Q1 = Q2 = 400.
Thus the total output is 800 and the price will be $400.

Section: 12.2

20) Hale's One Stop and Auto Service competes with Murray's Gas Mart. The local
demand is:
Qd = 25 - 10P  P = 2.50 - 0.1 Qd. Both firms sell exactly the same quality of gasoline.
Thus, if the firms charge a different price, the lower price firm will capture the entire
market share. If the firms charge the same price, they will split the market share.
The marginal cost functions are both constant at $1.25. If the firms compete by
setting price, what is the market output level? What is the market price level?

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Answer: If the firms compete by setting price, the equilibrium price will be $1.25 per
unit. The market output level will be 12.5 units. If both firms attempt to price above
$1.25, the firm with the lower price will enjoy the entire market share and earn an
economic profit while the higher pricing firm sells no units of output. The higher
price firm will have an incentive to undercut the price of the other firm. This
behavior will continue until both firms charge $1.25. If the firms offer a price below
$1.25, they will lose money and exit the industry or raise prices. Thus, equilibrium
occurs where both firms charge $1.25 per unit.

Section: 12.3