Course - Managerial Economics

IIM BANGALORE

PROBLEM SET 7
TOPIC: Game Theory and Oligopoly

Multiple-Choice Questions\Conceptual Questions

1. According to the Cournot model, a firm will

a) assume that rival firms will keep their production constant.

b) produce the quantity where marginal revenue equals marginal cost.
c) respond to changes in production by rival firms by adjusting its production.
d) All of the above are correct.

Cournot model is a static quantity competition model. Own firm production qty will depend
on other firm production qty (Option C is correct). Firms will still use MR = MC to decide
optimal output (Option B is correct). And the best response qty curves are estimated by
assuming/fixing the other firms qty (So option A Is correct)

2. According to the Bertrand model, a firm will assume that rival firms will

a) keep their rates of production constant.

b) keep their prices constant.
c) match price cuts but not price increases
d) match price increases but not price cuts.

Bertrand model is a static price competition model. It doesn’t assume Other firms keep their
qty constant (Option A is wrong) but assumes other firms keep their prices constant (Fixing
the other firms price to estimate our firms best response price function. (Option B)

3. Which of the following is a form of non-price competition.

a) Advertising
b) Quality of service
c) Product quality
d) All of the above are forms of nonprice competition

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 All of these are ways in which firms can compete other than prices. Competing on
prices will lead to Bertrand trap (no profits). So firm can consider these alternative
ways too

4. Which of the following is an example of strategic behaviour?

a) A firm builds excess capacity to discourage the entry of competitors.

b) A firm adopts the pricing behaviour of a dominant firm under the assumption
that other firms will do likewise.
c) Firms in an industry increase advertising expenditures to avoid losing market
share.
d) All of the above are examples of strategic behaviour.

All of these are examples of strategic behaviour (pricing decision, advertising decision,
production decision) as behaviour/decision of one firm influences decision of other
participants and so a firm must consider other’s actions while choosing its own best strategy.

5. Which of the following circumstances in an industry will result in a Nash equilibrium?

a) All firms have a dominant strategy and each firm chooses its dominant
strategy
b) All firms have a dominant strategy, but only some choose to follow it.
c) All firms have a dominant strategy, and none choose it.
d) None of the above is correct

For Nash equilibrium, we assume that firms are rational (and maximize payoffs). So if they
have a dominant strategy they will choose it.

Only when this happens will the likely outcome be the Nash equilibrium outcome.

6. Which of the following describes a Nash equilibrium?

a) A firm chooses its dominant strategy, if one exists.

b) Every competing firm in an industry chooses a strategy that is optimal given
the choices of every other firm.
c) Market price results in neither a surplus nor a shortage.

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 d) All firms in an industry are earning zero economic profits.

C, D are wrong. The Nash equilibrium point depends on the payoffs of the particular game.

A Nash equilibrium is an outcome where no player can an unilaterally change its strategy in
a way that improves its payoff. This means that for each firm, its decision is the most
optimal (best response) given the other firms action. So option B is right.

7. A prisoners' dilemma is a game with all of the following characteristics except one.
Which one is not present in a prisoners' dilemma?

a) Players cooperate in arriving at their strategies.

b) Both players have a dominant strategy.
c) Both players would be better off if neither chose their dominant strategy.
d) The payoff from a strategy depends on the choice made by the other player.

In Prisoners’ dilemma, both players have a dominant strategy (CONFESS). Option B is

present.
If both players didn’t play their dominant strategy, ( IF BOTH REMAIN SILENT), they both get
away with the least jail time. So Option C is present
The payoff depends on the choice of the other player’s action. See the Prisoners dilemma
payoff. If you CONFESS or REMAIN SILENT, your jail time depends on what the other person
choose. So OPTION D is present.

The Nash equilibrium is (CONFESS, CONFESS). The players don’t cooperate. They individually
choose their dominant strategy that is personally best for them. So A is absent.

8. An oligopolist differs from a perfect competitor in that

a) there is cut throat competition in perfect competition but little competition in

oligopoly because firms have significant market power.
b) firms in an oligopoly do not produce homogeneous products while firms in
perfect competition do.
c) the market demand curve for a perfectly competitive industry is perfectly
elastic but it is downward-sloping in an oligopolistic industry.
d) there are no entry barriers in perfect competition but there are entry barriers
in oligopoly

Oligopoly is an extension of monopoly. In monopoly, only 1 player and there are entry for
other players. In perf competition, there are many firms and there is no barrier to entry.

In oligopoly, there are a few players and there are barriers to entry preventing the entry of
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additional players. So option D is correct

Option A is wrong. There can still be extreme competition and price war in oligopoly
(Bertrand trap)

Option B is wrong. Oligopoly firms can produce identical or different types of goods.

The market demand curve is downward sloping for both perf comp and oligopoly (law of
demand)

9. All of the following are characteristics of game theory except

a) rules that determine what actions are allowable.

b) payoffs that are the results of the interaction among players' strategies.
c) strategies that players employ to attain their objectives.
d) independence among players

Game theory has all the components – rules, actions/strategies and the payoff for these
strategies.

Game theory does not have independence among players. The payoffs/consequences for 1
player not only depends on his own actions but also action of the other players. Strategic
interdependence is there.

Numerical Questions

10. For each of the following games:

a) Find the dominant strategies (if any)

b) Find the Nash equilibria (if any).

Dominant Strategy = A strategy X is dominant for a player if whatever the strategy the
opponent plays, X is the best action for our player. So you need to check each action for
each player.

For player 1, you need to check what’s his best action if player 2 plays LEFT. And what is
her best action if player 2 plays RIGHT. If it’s the same in both cases, then that action is a
dominant strategy for player 1. Because irrespective of what player 2 does, player 1
benefits by doing that action.

To find Nash equilibria points, mark the cells that contain Player 1’s best response to each
of Player 2s actions. Do the same for player 2 – Mark the cells that contain Player’2s best
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response to each of player 1’s actions. If there is/are common cells, that are marked for
both players, then those are Nash Equilibria.

There are no dominant strategies for Player 1 and 2. If player 2 plays Left, player 1 prefers
Down, while if player 2 plays Right, player 1 prefers Up. A similar symmetric argument holds
for player 2.

There are two Nash equilibria – (Up,Right) and (Down,Left).

II.

Playing Up is a dominant strategy for player 1. Player 1 chooses Up when Player 2 chooses
Left. And chooses Up when Player 2 chooses Right.

There is no dominant strategy for player 2. Player 2 chooses Left when player 1 plays Up,
and chooses Right when player 1 plays Down.

There is one Nash equilibrium - (Up, Left).

III.

There are no dominant strategies for 1 and 2. Player 1 chooses Up when player 2 plays
Right, and chooses Down when player 2 chooses Left. Player 2 chooses Right if Player 1
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plays Down and chooses Left when Player 1 plays Up.
There are no Nash equilibria.
11. Consider the game Rock, Paper, Scissors. Both players simultaneously choose one of
the three options Rock, Paper or Scissors. A player who plays R will beat another player
who has chosen S (“rock crushes scissors”) but will lose to one who has played P
(“paper covers rock”); a play of P will lose to a play of S (“scissors cut paper”). Assume
that the payoffs are the following: when a player wins, the payoff is 1 and when she
loses the payoff is -1. If both players choose the same item and there is a tie, each get
0 points.

a) Let δ = −1. Find the dominant strategies (if any) and Nash equilibria (if any).

Player 1’s Best Response is ROCK if player 2 plays Scissors

Player 1’s Best Response is Scissors if player 2 plays PAPER

Player 1’s Best Response is PAPER if player 2 plays ROCK.

Same can be said for Player 2.

Hence there are no dominant strategies for Player 1 and Player 2.

There is no nash equilibria.

[NOTE : That’s the whole point of rock-paper-scissors. If there were a dominant strategy
that always wins, everyone would play that action only, and Rock-Paper-Scissors would
cease to be a game!]

b) For which values of δ (Scissors, Rock) becomes a Nash equilibrium?

For (Scissors, Rock )to be Nash equilibrium,

CONDITION 1 : Rock has to be Player 2’s best response IF Player 1 plays scissor (This is
already TRUE)
AND
CONDITION 2 : Scissor has to be Player 1’s best response IF Player 2 plays rock.

Currently Paper is P1’s best response to rock with a payoff of +1. If scissor needs to be his
best response, then payoff should be more than +1. So δ >1

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 12. Suppose that the food truck Cheesy Burgers (denoted by C) has the monopoly of
burgers in the MIT campus and its cost function is given by C(Q)=2Q. The food truck
studied the demand for burgers at MIT and found out that the inverse demand
function can be written as P(Q) = 38 − 2Q.
a) What is the socially efficient output level 𝑄!and the optimal price 𝑃!? What
would the firm’s profits be? (Hint: At socially efficient output level there is no
deadweight loss)

Question says Socially efficient output, No deadweight Loss. This happens in

Perfect competition like circumstances.

Note: The scenario here is not a Perf comp. but the question is asking what will
happen at socially efficient output level. So we solve it as if it were perf-comp
circumstances, because that’s when the output is socially efficient (No
Deadweight loss)

Condition for profit maximizing output in perf. Comp is P = MR = MC. (See

Tutorial 5 for more examples)
P = MR = 38 – 2Q (As firms are price takers in perf. Competition)
MC = d(TC)/dQ = d(2Q)/dQ = 2
Equating MR = MC, we get 38 – 2Q = 2. Q = 18 units.
Substituting Q = 18 units back in demand function, we get P =2$
Profits = P*Q – 2Q = 36-36 = 0. (Long term profits in perf. Comp is zero as
market pushes price down to MR = MC levels)

b) Solve for the equilibrium quantity Qm produced by the monopolist and the
equilibrium price Pm What are the firm’s profits?

If firm is behaving like a monopoly,

Profit Maximizing output occurs at,
MR = MC (See Tutorial 5 for more examples).

MC = d(2Q)/dQ = 2

To find MR, we find total revenue and differentiate it w.r.t to Q to get MR.

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 2
Total Revenue = P*Q = (38 -2Q)*Q = 38Q – 2Q
MR = d(TR)/dQ = 38 – 4Q

Equating MR = MC
38 – 4Q = 2 ; Q = 9 units.

We find P by subbing Q = 9 back into the Inverse Demand Function.

P = 38 -2*9 = 20$

Profits = Total Revenue – Total Costs

TR = 20*9
TC = 2*9 (From total cost function TC = 2Q given in the question)

Profit = 162$

c) Suppose that Greasy Burgers (denoted by G), with the same cost function above, sees that
Cheesy Burgers is making a lot of money and enters the market. Both firms compete as in the
Cournot model. Solve for each firm’s equilibrium quantity (𝑞𝐶𝑁 , 𝑞𝐺𝑁 ), the equilibrium price 𝑃𝑑𝑁 ,
each firms’ profits and total profits.

Scenario here is Oligopoly with identical products + Cournot Model

Let Qcheesy and QGreasy be the quantity produced by the 2 firms.

Market Demand function is P = 38 – 2Q = 38 – 2Qcheesy - 2QGreasy

MC for both firms = 2 (because TC = 2Q)

Each firm will make output decisions by MR = MC and finding optimal Q.

For Cheesy Burgers

TRCheesu = P*Q = (38 – 2Q,cheesy – 2Q,greasy)* Qcheesy

MRCheesy = d(TR)/dQcheesy = 38 – 4QCheesy – 2Qgreasy

By equating MR = MC we get, 38 – 4QCheesy – 2Qgreasy = 2

Qcheesy = 9 – ( Qgreasy/2) (This is the best response function for Cheesy. Because for every
output qty of Greasy, you know the optimal output qty you have to produce for peak profits
using this equation)

Similarly, doing this for Greasy Burgers

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Qgreasy = 9 – ( Qcheesy/2) (It will be a mirror of the earlier equation as MC was the same for both
firms and the MR functions are mirror of each other)

The Nash equilibrium point is the intersection point of the two best response functions. We
can find this point by solving the 2 equations for the 2 unknowns.

Substituting value of Qgreasy from the second equation into the first equation, we can solve
for QCheesy.

QNcheesy = 9 – (9-(QNcheesy/2))/2

= 9 – 4.5 + QNcheesy/4
Qncheesy = 6 units

Subbing Qncheesy into the second equation, we find Qngreasy to be 6 units as well.
Total Qty = 6 + 6 = 12 units.

We substitute 12 units into the demand function to find the price.

38 – 2Q = P ; P = 14$

So in oligopoly, Cournot model, the 2 burger joints will sell 6 units each for 14$ each.

Each firms profit = 6*14 – 6*2 = 72

Total Profit = 72 + 72 = 144$

c) Calculate the deadweight loss associated to Monopoly and Cournot

equilibrium.

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In both models, the deadweight Loss is a right angled triangle region.The coordinates of the
triangle are different. (SEE Tutorial 5 for detailed calculation steps for DW Loss)

DW Loss in Monopoly = ½ * Base * Height = ½ * (20-2) * (18-9) = 81$

DW Loss in Oligopoly, Cournot = ½* Base*Height = ½*(14-2)*(18-12) = 36$

13. In class we saw the Cournot competition model for two firms with the same cost func-
tion. Now, we are going to consider asymmetric cost functions. Assume that demand
for a good is given by p = a – b.Q, and that there are 2 firms competing in quantities.
Both have no fixed costs and a constant marginal cost. Firm 1 has a marginal cost c1,
and firm 2 has a marginal cost c2 We have that a > c1 > c2
a) Find the reaction functions of firms 1 and 2 in this market: how does the
optimal quantity produced depend on the quantity produced by the other
firm?

Here it’s still a Cournot Model, Oligopoly. The two firms have a different MC. So when we
do MC = MR to find optimal output, the optimal output for the two firms will be different.
Same steps as previous question with minor modifications.

Let Q1 and Q2 be the quantity produced by the 2 firms.

Market Demand function is P = a – bQ = a – bQ1 – bQ2

For Firm 1,

Optimal output is at MR = MC.

TR1 = P*Q1 = (a – b.Q1 – b. Q2)* Q1

MR1 = a – 2b.Q1 – b Q2 (by differentiating TR w.r.t Q1)

MC = c1 (Given)

Equating MR = MC,

a – 2b.Q1 – bQ2 = c1

Q1 = (a – c1 – bQ2)/2b [This is best response/reaction function of firm 1 as for every output

level of firm 2 we know the optimal output for firm 1 from this function]

Similarly we do MR = MC for firm 2 to get the following,

Q2 = (a – c2 – bQ1)/2b [Reaction function of firm 2]

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From both these functions, we see the relationship to be more the other firms product, the
less our own optimal quantity is. (Inverse relationship)

b) Solve for the quantity produced by each firm and the equilibrium price. Which
firm produces a higher quantity? Give an intuitive reason for this.

Solving for the Q1 and Q2 can be done by using the 2 equations and finding the 2 unknowns.

Subbing Q2 from equation 2 into equation 1, we get

Q1 = (a – c1 – b((a-c2 –bQ1)/2b))/2b

Simplifying we get,

Q1 = (a + c2– 2c1)/3b

And

Q2 = (a + c1 – 2c2)/3b

Now we sub back Q1 and Q2 into the initial market demand function to find the equilibrium
price.

We get P = (a – c1 – c2)/3

Since c1 > c2, from the values for Q1 and Q2, we see Q1 < Q2. This is intuitively true as firms
with higher cost structures will produce lower quantity out of the total market output as it
is less efficient.
c) What will be the equilibrium price and the quantity produced by each firm if
they compete in prices (Bertrand competition)?

Bertrand competition is a price war and we know the Nash equilibrium occurs at P = MC, as
firms will keep cutting each other’s prices till they arrive at P = MC.

However here the two firms have C1 and C2 as their costs (MC) and C1 > C2. So the Nash
equilibrium will occur at P = C1 (or very very slightly less than C1). At this point, Firm 2 will
produce and supply all the qty while firm 1 will produce 0 units. (If P is slightly less than c1, its
unprofitable for firm 1 to produce anything at all)

So if P = C1, we find quantity from the demand function.

P = a – bQ ;

Q = (a – c1)/b ;

Output of Firm 1 = 0 (none of the market output is by firm 1)

Output of Firm 2 = (a – c1)/b (All of the market output is by firm 2)

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