Economics of Managerial Decisions 1st

Edition Blair Solutions Manual

Visit to download the full and correct content document: https://testbankdeal.com/dow
nload/economics-of-managerial-decisions-1st-edition-blair-solutions-manual/
Chapter 8
Game Theory and Oligopoly

Chapter Summary and Learning Objectives

8.1 Identify the elements of game theory and explain the Nash equilibrium, a prisoners’
dilemma game, a dominated strategy, and the advantages of a repeated game.
This section establishes the fundamentals of game theory before considering equilibria
in both one-time and repeated games.

8.2 Describe how to determine the equilibrium in games with more than one Nash
equilibrium and in games with no pure-strategy Nash equilibrium.
We discuss games where players have more than two options from which to select, as
well as games where the Nash equilibrium involves a mixed strategy. The procedure for
determining the optimal probabilities for each event is explained.

8.3 Explain the importance of backward induction and credible commitments in sequential
games.
Sequential games are presented, and backward induction is used to determine the Nash
equilibrium. A manager may be able to change this outcome through credible
commitments, established by verifiable action.

8.4 Apply game theory to help make better managerial decisions.

Managers can use game theory to help avoid the end-period problem in repeated games,
to establish credible in sequential and repeated games, and to determine whether the
situation calls for predictability or not.

Chapter Outline

Introduction
A. Summary: The interdependent nature of firms in oligopoly markets necessitates a
strategic way of approaching decision-making. Game theory allows decision-makers to
think through implications of the decisions they make, and possible responses by
others, to determine the optimal strategy.
B. Key Terms
i. Game theory: A mode of analysis used to study decision making in situations with
mutual interdependence and strategic behavior.

Copyright © 2019 Pearson Education, Inc.

109
Rush Managerial Economics, 1e

8.1 Basic Game Theory and Games

Learning Objective 8.1: Identify the elements of game theory and explain the Nash
equilibrium, a prisoners’ dilemma game, a dominated strategy, and the advantages of a
repeated game.
A. Summary: The basics of game theory are established: players, rules, strategies, and
payoffs. A sample game of two soda companies deciding on high or low prices is used to
create a payoff matrix and find the Nash equilibrium, which is then shown to not be the
best joint payoff for both companies. When firms are engaged in repeated games, they
may use trigger strategies or tit-for-tat strategy to encourage higher profits, although
the end period problem may make it difficult to ensure cooperation. When a decision
involves more than two options, finding and eliminating dominated strategies may
make it easier to determine the Nash equilibrium.
B. Key Terms:
i. Game: An interaction between players in which the players follow rules, use
strategies, and receive a payoff at the end.
ii. Strategy: A complete contingency plan consisting of the actions a player may take,
which might depend on the other players’ actions.
iii. Payoff matrix: A table showing how each player’s profit depends on the
combination of the player’s strategy and the rival’s strategy.
iv. Nash equilibrium: The outcome in which each player’s strategy is best for that
player, taking as given the other player’s strategy; at a Nash equilibrium, no one
player can unilaterally improve his or her payoff by playing another strategy.
v. Dominant strategy: A strategy that is always better for the player than any
alternative strategy regardless of the opponent’s actions.
vi. Pure strategy: A strategy that identifies the specific action the player will select in
every possible circumstance.
vii. Cooperative equilibrium: An outcome in which the players coordinate their
actions in order to increase their payoffs.
viii. Repeated game: A game played more than once.
ix. Trigger strategy: A strategy in a repeated game in which a player starts by
cooperating and continues until the rival fails to cooperate, which “triggers”
punishment by switching to noncooperation.
x. Tit-for-tat strategy: A strategy in a repeated game in which the players start by
cooperating in the first round and then copy the rival’s previous period strategy.
xi. End-period problem: The problem created by the absence of any incentive to
cooperate in the last period of a repeated game because there is no possibility of
punishment in the future.
xii. Dominated strategy: A strategy with outcomes that are always inferior to those of
another strategy.
C. Teaching Tip: Prices and advertising are common decisions used in explaining game
theory in a business context, as they are here. Consider using a different decision for
soda companies: whether to start a flavor of soda, or a new line of flavored waters.
Students will quickly realize that the two large soda companies seem to offer the same
options (regular, diet, cherry, diet with lime, etc.) instead of each offering different
flavors and truly adding variety to the soda market. Game theory will help them realize
why this is a Nash equilibrium that is likely suboptimal for both the companies and their
consumers.

Copyright © 2019 Pearson Education, Inc.

110
 Chapter 8: Game Theory and Oligopoly

8.2 Advanced Games

Learning Objective 8.2: Describe how to determine the equilibrium in games with more
than one Nash equilibrium and in games with no pure-strategy Nash equilibrium.
A. Summary: This section focuses on the potential for multiple Nash equilibria, including a
mixed-strategy equilibrium. When there are multiple possible equilibria, which one will
occur cannot be predicted. In this case, there is an opportunity for one of the players to
potentially influence the outcome so that the Nash equilibrium that benefits them is the
one in which the market settles. In some cases, a mixed-strategy equilibrium is the best
option, as anything other than this may be used by the opponent against you. Payoffs
under each possible scenario can be used to calculate the optimal mixed strategy, and an
in-depth solution and explanation is provided here. The solution highlights the
importance of considering not just the consequences of your actions, but how your
competitor will respond to your actions.
B. Key Terms:
i. Mixed strategy: A strategy in which a player randomly chooses among different
pure strategies according to predetermined probabilities
ii. Mixed-strategy Nash equilibrium: The outcome in which each player’s mixed
strategy is the best strategy for that player, taking as given the other player’s mixed
strategy.
C. Teaching Tip: Rock-paper-scissors is a great example of a mixed-strategy equilibrium.
If you do not randomize completely and select each 1/3 of the time, an attentive
competitor can learn your patterns and win more frequently than you. If your
competitor chooses rock 40% of the time, then your strategy should be to choose paper
40% of the time and you will win more often than not.

8.3 Sequential Games

Learning Objective 8.3: Explain the importance of backward induction and credible
commitments in sequential games.
A. Summary: In some cases, the situation is best described as a sequential game, where one
player moves first and another follows, rather than both moving simultaneously. The
entry game, where a potential entrant decides whether to enter a market and the
incumbent firm determines whether to respond with low prices or high prices, shows
how backward induction can be used to solve for the Nash equilibrium. A different
outcome may be possible if credibility can be established, perhaps by advertising or
investment in capacity. Commitment comes at a cost, and may not be credible; even if it
is, it may be more expensive to establish credibility to deter entry than to simply allow
entry to occur.
B. Key Terms:
i. Sequential game: A game in which the players make decisions one after the other
ii. Entry game: A game in which one player decides whether to enter the market and
the second player responds to the first player’s entry decision.
iii. Game tree: A diagram illustrating the players’ sequential choices and the ultimate
payoffs that result from the choices.
iv. Decision node: A point in a game tree at which a player makes a decision.
C. Teaching Tip: Emphasize that multi-market or multi-period contact provides
numerous opportunities for the incumbent firm to establish credibility. In a one-time
game, it may not make sense to deter entry. But if the potential for entry in 50 locations
over the next 2 years exists, fighting entry in the first few may help to reduce those 50
locations. At any one point in time, the action may seem to reduce profits, but if it
prevents future entry by other competitors, it may be worth it.

Copyright © 2019 Pearson Education, Inc.

111
Rush Managerial Economics, 1e

8.4 A
Learning Objective 8.4: Apply game theory to help make better managerial decisions.
A. Summary: Most games managers will face are repeated games, as they are engaged with
competitors continually. The end-period problem is relevant here, so managers need to
create ways to create a broader game, including the possibility of a period beyond the
last one. For example, letters of recommendation prevent the end-period problem of an
employee leaving from resulting in significantly decreased performance. Similarly, the
potential for a new contract in the future can be used to ensure optimal performance by
both parties near the end of the existing contract. Credibility is important in advanced
games; announcements are likely more credible when they regard interests that are
closely aligned with a competitor. Managers should also consider whether predictability
is an asset or a liability, as the situation dictates. In sequential games like bargaining,
commitment and credibility are key to achieving the best possible outcome. While one
may think that all information about a firm should be kept as private as possible, in
some cases announcing plans publicly can help prevent potential entrants from entering
a market, or a competitor from engaging in an action that will eventually reduce your
profits.
B. Teaching Tip: Apple often announces how many of its new iPhone or iPad it is going to
be producing, or how many it expects to sell. Why would they give that information to
its competitors, like Samsung? To establish credibility, which may be used later to
dissuade Samsung from producing more output or trying to compete on a new product.

Extra Example:
You are the manager of a large retailer, with only a few competitors.
A. Explain how game theory can be used to help you decide whether to have large
discounts on turkeys near Thanksgiving or not.
B. You overhear an employee of your main competitor mention that the company is
considering launching a new program at their stores. Customers simply enter their
phone number upon checking out and, once they purchase at least $500 in goods during
a calendar month, they receive a coupon worth 25% off up to $200 in goods in the
following month. First, use game theory to determine whether you should offer
something similar. Next, consider how your pricing might change if you do offer the
plan.
C. Suppose you both institute similar plans as described in the previous question. You find
that your sales are not really increasing much, but now you’re giving away $50 worth of
merchandise nearly every month, and your profits are down 4%. It will not bankrupt
you by any means, but you would rather abandon the program in favor of a simpler
plan: customers who join the membership club type in their phone number upon
checkout and receive 2% off their bill. This will save you money but customers do not
have to spend $500 each month to receive it. Should you announce your plans to change
over to this new policy publicly at the beginning of the next calendar year? Do you think
your competitor will respond similarly? What would you do if it kept its original plan in
place?
D. DISCUSSION: Section 8.4 concludes with an important point regarding predictability.
Discuss a few different choices for which it would be useful to be unpredictable, and
other choices for which it would be useful to be predictable.

Copyright © 2019 Pearson Education, Inc.

112
 Chapter 8: Game Theory and Oligopoly

Solution to Extra Example:

A. In this case, it is likely that offering large discounts on turkeys is a dominant strategy. If
your competitor already offers large discounts, you need to also offer large discounts to
avoid losing your customers. If your competitor is not already offering large discounts,
you should offer the discount to steal its customers. Thus, you should discount your
turkeys. (Fun fact: despite the fact that turkey is in highest demand in Thanksgiving, its
price is far lowest every November, and the spread of price over cost is also smallest, so
this is not just about supply; the likely reason is managers making the same decision
you just examined. (Source: USDA).
B. If they offer the plan and you do not, you will likely see many of your customers
purchasing (at least the first) $500 each month at their store. They have essentially
made the cost of switching from their store to yours higher. If you do not offer the plan,
you will likely lose customers. If you do offer the plan, you will keep your customers and
could perhaps drive more sales, but you will also incur a cost each month as customers
redeem their coupons. If there are no additional sales, you stand to lose as much as $50
every month, which could represent a drop in revenues of 6.7% ($50/$750). If you do
not offer it, you likely stand to lose much more, so you should probably offer it. Now that
you both have the plan in place, your pricing is likely to change. You will likely be able to
raise prices a bit, certainly later in the month – anyone who has already spent $400
needs to spend the remaining $100 at your store, even if your prices are a bit higher.
This can help offset the potential 6.7% drop in revenues due to the coupons.
C. Announcing this plan change before actually putting it in place has several benefits.
First, if consumers are unhappy with the change, they will let you know and you will
have time to back out. Second, if your competitor is also experiencing the same drop in
profit that you are (since neither of you are really stealing each other’s customers), it
may announce a similar change of plans. If it is not experiencing a decrease in profit, it is
likely to keep its original plan in place and potentially take some of your customers. You
may want to either keep your original plan also (to prevent your customers from
leaving), or to change the discount from 2% to something higher to keep your
customers.
D. (Note: There are many possible ways to answer this question.)
Predictability is important in establishing credibility. Announcing what you are going to
do, and actually doing it, gives one credibility when it comes to future decisions. This
can be useful in engaging in actions that will prevent competitors from taking other
actions – like increasing the size of one of your stores to prevent your competitor from
opening up a location nearby. Unpredictability can be beneficial in implementing a
mixed-strategy equilibrium. If customers know that every Tuesday you have a
particular product on sale, they will simply wait until Tuesday to purchase it, resulting
in lower sales the rest of the week. But if you randomly put items on sale throughout the
week, they need to visit more often to make sure they do not miss out on a flash deal.
Thus, unpredictability can be useful in driving sales through increased store visits.

Copyright © 2019 Pearson Education, Inc.

113
Rush Managerial Economics, 1e

Answer Key
Here are the solutions to the Questions and Problems that appear at the end of the chapter.

8.1 BASIC GAME THEORY AND GAMES

1.1 The three elements of a game are players (1) rules, (2) using strategies, and (3)
receiving a payoff at the end. In basketball, the players must follow the rules
(players cannot run with the ball, etc.). Teams use strategies, such as foul frequently
late in the game when they are slightly behind. And, the payoff is a victory or loss at
the end of the game.
1.2 a. The payoff matrix is below.

Microsoft
Spend a little Spend a lot
S: $8b S: $2b
Spend a little
M: $6b M: $7b
Sony
S: $9b S: $3b
Spend a lot
M: $1b M: $2b

b. The payoff matrix shows that spending a lot is Sony’s best response to either
strategy chosen by Microsoft. The same is true for Microsoft’s response to Sony.
Therefore, spending a lot on advertising is the dominant strategy for both Sony
and Microsoft.
c. The Nash equilibrium occurs where both Sony and Microsoft play their
dominant strategies: spend a lot on advertising. Neither firm can increase its
profits by unilaterally deviating from this outcome.
1.3 Cheating is a dominant strategy for both firms, so the Nash equilibrium of this game
occurs when both firms choose to cheat. Neither firm has an incentive to unilaterally
deviate from this outcome. This game is a prisoners’ dilemma because both firms
would be better off if both complied with the agreement but each has an incentive to
cheat. For either firm, the highest payoff (and therefore best outcome) is cheating
while the other firm complies.
1.4 a. For both UPS and FedEx, choosing a high price is the dominant strategy. Neither
firm can increase its profit by switching to a low-price strategy. Therefore, the
Nash equilibrium occurs where both firms set a high price.
b. This is not a prisoners’ dilemma game because these firms cannot increase both
their profits through cooperation.
c. Although each firm has the possibility of making a higher profit, each set of
managers realizes that its rival won’t cooperate. Accordingly, the managers are
likely to be satisfied with the Nash equilibrium. Neither firm can be made better
off without another firm losing profits. This outcome is what we might expect if
these firms cooperated.

Copyright © 2019 Pearson Education, Inc.

114
 Chapter 8: Game Theory and Oligopoly

1.5 a. A low bid is the dominant strategy for both firms. Therefore, both firms will
submit a low bid in the Nash equilibrium outcome. The firms’ managers will be
unhappy with this outcome because they could increase their profits if they
were able to cooperate and each submit a high bid.
b. Both firms choosing a high bid is the cooperative equilibrium. If the companies
repeat this game, they can use a tit-for-tat strategy: cooperate in the first round,
then copy the rival firm’s previous choice in every subsequent period. This
punishes the rival firm for deviating from the cooperative equilibrium, which
gives the rival an incentive to cooperate.
1.6 In a prisoner’s dilemma game, the cooperative equilibrium yields higher profits for
both players, but, compared to the cooperative equilibrium, defecting yields a still-
higher profit to the defector in the period in which it alone cheats. Both the grim
trigger and tit-for-tat strategies punish your rival for choosing to defect. The more
forgiving tit-for-tat strategy allows the punishment to end when your rival
demonstrates a willingness to cooperate. This might sustain cooperation (and the
associated higher profits) for more periods than the grim trigger. The grim strategy,
however, means that a one-time defection yields a persistent punishment. This fact
mans that a (potential) defector must compare the one-period gain against lower
profits during the entire future, which might be enough to sustain cooperation for
more periods than the tit-for-tat strategy.
1.7 The threat of punishment sustains the cooperative equilibrium. Neither player will
attempt to defect if the gains from a single period of defection are lower than the
losses from punishment in future periods. However, if both players know there is a
finite end to the game then they know it is optimal to defect from the cooperative
equilibrium in the final period. The players anticipate this result when selecting a
strategy in the previous period, which thereby removes their incentive to cooperate
in the second-to-last period. The cooperative equilibrium falls apart as this
reasoning runs backward from the last period to the second-to-last period to all
other periods.
For any game with an end-period problem, introducing uncertainty about the end of
the game restores the threat of punishment in future periods. Alternatively, both
players would have an incentive to cooperate if they will interact after the current
game ends.
1.8 A dominated strategy earns less profit than an alternative strategy regardless of the
opponent’s choice of strategy. It is never profit maximizing to choose a dominated
strategy because, by definition, there must exist a different strategy that yields
higher profits.
1.9 Speed is a dominant strategy for Intel because this strategy earns the most profit for
Intel no matter what strategy AMD chooses. AMD knows Intel will choose speed, so
AMD will then maximize its profits by choosing power consumption. These
strategies yield the Nash equilibrium because neither firm can increase its profits by
unilaterally deviating from its selected strategy.

Copyright © 2019 Pearson Education, Inc.

115
Rush Managerial Economics, 1e

8.2 ADVANCED GAMES

2.1 Cheap talk is effective to the extent that players’ interests are aligned. For example,
players should believe their rivals’ cheap talk if the rival’s profit would be lower if
the rival acting counter to the earlier statements. The opposite is also true: players’
cheap talk is ineffective if they have an incentive to act counter to their own
statements.
a. Although both firms would increase their profits with high-price offers, Boeing
could increase its profits even further by undercutting the high-price offers
submitted by Airbus. Boeing’s announcement is unlikely to sway Airbus.
b. The results of your rival’s test drill can be valuable to you because the amount of
oil your rival finds is probably correlated with the amount of oil on your field. If
you choose not to test drill in response to your rival’s announcement, your
competitor would not gain anything by choosing not to drill. Therefore, your
competitor will follow through on this announcement.
c. If you believe your rival’s announcement and build high-end homes, your rival’s
profit and your profit would be less if your competitor reneges on the
announcement to build affordable homes. You should believe this
announcement as your incentives are aligned with your rival’s.
2.2 a. There are two Nash equilibria: (1) Woolworths expands and Coles does not
expand, and (2) Woolworths does not expand while Coles expands. In both
cases, neither firm can increase its profits by unilaterally deviating from the
equilibrium.
b. Even with the announcement would assure that Woolworths’ and Coles’
incentives still diverge. The announcement is cheap talk. For example, if
Woolworths started to expand by building new stores before Coles, Coles would
immediately abandon its announcement and not expand since, with
Woolworths’ expansion, Coles’ profit by not expanding is larger than its profit by
expanding. Because Woolworths knows the announcement is merely cheap talk,
it does not change the equilibrium.
2.3 a. No, there is no pure-strategy Nash equilibrium. For any outcome in the payoff
matrix, at least one firm can increase its profits by unilaterally changing its
strategy.
b. Yes, there is a mixed strategy Nash equilibrium. Suppose MTN will choose a high
price strategy with probability r. Then Tigo’s expected profit from choosing a
high price is:
Tigo
Pro ithigh = r × 20 billion + (1 – r) × 30 billion.
Tigo’s expected profit from choosing a low price is:
Tigo
Pro itlow = r × 25 billion + (1 – r) × 10 billion.
MTN will choose r such that Tigo’s expected profit from choosing a high price
equals Tigo’s expected profit from choosing a low price:
Tigo Tigo
Pro ithigh = Pro itlow ,
r × 20 billion + (1 – r) × 30 billion = r × 25 billion + (1 – r) × 10 billion.
Solve this equation for r:
20
r= = 0.80.
25

Copyright © 2019 Pearson Education, Inc.

116
 Chapter 8: Game Theory and Oligopoly

Next, suppose Tigo chooses a high price with probability p. Then MTN’s
expected profit from choosing a high price is:
Pro itMTN
high = p × 50 billion + (1 – p) × 30 billion,
and MTN’s expected profit from choosing a low price is:
Pro itMTN
low = p × 20 billion + (1 – p) × 40 billion,
Tigo will choose p such that MTN’s expected profit from choosing a high price
equals MTN’s expected profit from choosing a low price:
Pro itMTN MTN
high = Pro itlow ,
p × 50 billion + (1 – p) × 30 billion = p × 20 billion + (1 – p) × 40 billion.
Solve this equation for p:
1
p = = 0.25.
4
Thus, the mixed-strategy Nash equilibrium occurs when Tigo chooses a high
price with a probability of 0.25 (25 percent) and MTN chooses a high price with
a probability of 0.80 (80 percent).
2.4 a. No, there is no pure-strategy Nash equilibrium. For any outcome in the payoff
matrix, at least one firm can increase its profits by unilaterally changing its
strategy.
b. Yes, there is a mixed-strategy Nash equilibrium. Suppose Express Scripts (ES)
chooses a high-bid strategy with probability r. Then CVS’s expected profit from
choosing a high bid is
Pro itCVS
high = (r × $2 billion) + [(1 – r) × $0 billion]
and CVS’s expected profit from choosing a low price is
Pro itCVS
low = (r × $1 billion) + [(1 – r) × $2 billion]
Express Scripts will choose r such that CVS’s expected profit from choosing a
high price equals CVS’s expected profit from choosing a low price:
Pro itCVS CVS
high = Pro itlow
(r × $2 billion) + [(1 – r) × $0 billion] = (r × $1 billion) + [(1 – r) × $2 billion]
Solve this equation for r:
2
r = = 0.67
3
So, Express Scripts submits a high bid 67 percent of the time and low bid 33
percent of the time.
Now suppose CVS chooses a high price with probability p. Then Express Scripts’
expected profit from choosing a high price is
Pro itES
high = (p × $4 billion) + [(1 – p) × $3 billion]
and Express Scripts’ expected profit from choosing a low price is
Pro itES
low = (p × $5 billion) + [(1 – p) × $2 billion]
CVS will choose p such that Express Scripts’ expected profit from choosing a
high price equals Express Scripts’ expected profit from choosing a low price:
Pro itES ES
high = Pro itlow ,
(p × $4 billion) + [(1 – p) × $3 billion] = (p × $5 billion) + [(1 – p) × $2 billion}

Copyright © 2019 Pearson Education, Inc.

117
Rush Managerial Economics, 1e

Solve this equation for p:

1
p = = 0.50
2
So, CVS submits a high bid 50 percent of the time and a low bid 50 percent of the
time.
Thus, the mixed-strategy Nash equilibrium occurs when CVS chooses a high
price with a probability of 0.50 (50 percent) a low-price with a probability also
of 50 percent, while Express Scripts chooses a high price with a probability of
0.67 (67 percent) and, accordingly, a bid with a low price the other 33 percent of
the time..
2.5 a. No, MasterCard does not have a dominant strategy. MasterCard does not have a
strategy that gives strictly higher profits regardless of Visa’s strategy.
b. The Nash equilibrium occurs where both Visa and MasterCard charge a high fee.
A high fee is Visa’s dominant strategy and MasterCard’s best response to this
strategy is to charge a high fee as well.
c. MasterCard will use a pure strategy. Any mixed strategy that involves setting a
low fee at least part of the time will have a profit that is less than $3 billion for
MasterCard because any “mix” (or probability-weighted average) of $3 billion
and $2 billion must be less than $3 billion.

8.3 SEQUENTIAL GAMES

3.1 a. Backward induction would not be useful in solving this game because you and
your rival are announcing your price at the same time. This is not a sequential
move game.
b. Backward induction can play a role in this situation. The four possible outcomes
are (a developed oil field/pipeline built), (a developed oi field/no pipeline built),
(no developed oil field/pipeline built), and (no developed oil field/no pipeline
built). In fact, this situation can be enriched by noting that different sizes of
pipelines can be built and different numbers of wells can be drilled. You need to
sign a contract to determine the size of the pipeline before you drill. Using a
game tree that shows how your profit and the pipeline company’s profit depend
on the number of wells and the size of the pipeline along with backward
induction allows you to determine the profit-maximizing number of wells you
will drill.
c. Backward induction can play a role in this decision, albeit a fairly obvious one. If
the game tree has the American Cancer Society (ACS) setting the date of its
fundraiser first, the American Diabetes Association (ADA) goes second. The ADA
can use backward induction to insure that it sets its fundraiser on a different
date. Backward induction isn’t particularly useful because any date chosen
yields the same equilibrium result: the ADA picks a different date and both
maximize their funds raised.
3.2 Threats are credible when they are preceded by a costly or irreversible commitment
or when they are in the player’s best interest. If it is possible for a player to renege
on a threat without cost, rivals will not take the threat seriously.

Copyright © 2019 Pearson Education, Inc.

118
 Chapter 8: Game Theory and Oligopoly

3.3 First, we must use backwards induction to determine Firm B’s best response to Firm
A’s strategy. If Firm A sets a high price, Firm B will maximize its profits by setting a
medium price. If Firm A sets a medium price, Firm B also sets a medium price. If
Firm A sets a low price, Firm B also sets a low price. Of the corresponding terminal
nodes, Firm A earns the highest profit at the node where both firms choose a
medium price. Therefore, Firm A will set a medium price and Firm B will respond
with a medium price.
3.4 a. Use backwards induction to determine Microsoft’s optimal amount of
investment. When Microsoft chooses high investment, Electronic Arts responds
with medium investment. When Microsoft chooses medium investment,
Electronic Arts also chooses medium investment. When Microsoft chooses low
investment, Electronic Arts also chooses low investment. Of the corresponding
terminal nodes, Microsoft earns the highest profit at the node where both firms
choose medium investment.
b. Yes, the outcome would differ. Both firms agree to a contract where both firms
choose high investment because this outcome increases both firms’ profits over
the solution in part a. The contract is necessary for this outcome to occur
because otherwise Electronic Arts could increase its profits further by choosing
medium investment.
3.5 a. The following figure shows the game tree.

b. The Nash equilibrium of this game occurs with both firms introducing the new
product. We can find this outcome using backwards induction. When Firm A
chooses to introduce the new product, Firm B makes its largest profit by
introducing it also. In this case, Firm A makes a $2 million profit. If Firm A
chooses to not introduce the product, Firm B makes its largest profit by
introducing it. In this case, Firm A makes $0 of profit. By working backwards, the
managers of Firm A realize that they make the largest profit by introducing the
product ($2 million), after which Firm B will also introduce the product.

Copyright © 2019 Pearson Education, Inc.

119
Rush Managerial Economics, 1e

8.4 MANAGERIAL APPLICATION: GAME THEORY

4.1 We can solve this problem through iterated elimination of dominated strategies.
Low price is a dominated strategy for both AMD and Nvidia. High price is now a
dominated strategy for Nvidia. This leaves Nvidia choosing a medium price. AMD’s
best response is choosing a medium price as well. In the Nash equilibrium, both
AMD and Nvidia choose a medium price.
4.2 You are facing an end-period problem. With the expiration of the contract, the tuna
supplier has no incentive to behave cooperatively. The supplier foresees the end of
your business relationship and may decrease the quality of tuna supplied to you,
make late deliveries, or otherwise make non-cooperative decisions to maximize its
profits at your restaurant’s expense. You can address this by either negotiating or
starting negotiation of a new contract with your tuna supplier.
4.3 You might promise to offer a particular price or level of quality of your product. The
other firm is more likely to believe your promises if you can make a commitment
beforehand. For example, your firm could increase production capacity to lower
your marginal cost. Now your optimal price is lower and the firm will believe your
promises of low prices. If you are promising high quality, you could invest in a new
production technology that improves the quality of your product.
4.4 a.

Rival
High price Low price
Y: $2 million Y: -$1 million
High price R: Large R: Very
You Large
Y: $3 million Y: $0
Low price
R: Loss R: $0

b. Your dominant strategy is setting low prices. The same is true for your rival. In
the Nash equilibrium, both you and your rival set low prices and earn zero
economic profit.
c. In the cooperative equilibrium, you and your rival both set high prices. You
could adopt a trigger strategy such as tit-for-tat to give your rival an incentive to
cooperate.
4.5 If the offense runs any non-random strategy, the defense can predict what play will
be called and move to counter it. The offense is more likely to win a given play if it
keeps the opposing coach guessing. Using a mixed strategy with plays chosen
randomly ensures that the defensive coach cannot predict and counter the plays.
4.6 a. See the accompanying game tree. Backward induction shows that the Nash
equilibrium has your rival developing in Gainesville and you developing in
Ocala. In particular, your rival reasons as follows: If your rival builds in
Gainesville, you will build in Ocala because that gives you the larger profit. With
this outcome, your rival makes a profit of $10 million. On the other hand, if your
rival builds in Ocala, you will build in Gainesville because that gives you the
larger profit. In this case, your rival makes a profit of $5 million. Your rival
realizes that building in Gainesville offers the larger profit, so your rival builds in
Gainesville and you build in Ocala.

Copyright © 2019 Pearson Education, Inc.

120
 Chapter 8: Game Theory and Oligopoly

b. This announcement is not credible. Your rival still gets to submit the first
building plan, so it is still optimal for you to respond by selecting the opposite
town. Your announcement doesn’t change your profit-maximizing decision.
c. Assuming your rival is able to verify the sale, this announcement is a credible
threat. You have irreversibly committed to develop in Gainesville because this is
the only lot you have left. No matter what your rival chooses, you will always
develop the Gainesville lot. Now your rival faces two choices: develop
Gainesville and make a profit of $1 million or develop Ocala and make a profit of
$5 million. In the Nash equilibrium, your rival will build in Ocala and you will
build in Gainesville.
d. The answers in parts b and c are different because you made a credible
commitment in part c. Selling the Ocala lot irreversibly altered the game tree,
removing the terminal node reached in the Nash equilibrium in the parts a and b.
4.7 a. Your threat is not credible. If you follow through on your threat, you will lower
your profits. Your rival knows this and will therefore ignore your threat.
b. Now your threat is credible because you made a commitment. Your profits are
now higher if you cut prices, so your rival will believe your threat.

Copyright © 2019 Pearson Education, Inc.

121