ECO101 Solved Problems Games and Oligopoly Solutions

University of Toronto ECO101: Principles of Microeconomics
Department of Economics Robert Gazzale, PhD
Solved Problems: Games and Oligopoly

Version With Solutions
1. Assume the smartphone market is a duopoly between Samsung and Apple. (You may assume
the Cournot assumptions hold.) Given the recent acrimony between the two firms,1 we can
safely conclude that the firms are not currently colluding. If Samsung and Apple did start
colluding, what would be the effects on:
(a) producer surplus;

(b) consumer surplus;
(c) total surplus; and
(d) deadweight loss.
Suggested Solution: The colluding firms would cut back production and increase prices.
(We know this because non-colluding duopolists produce more than a corresponding mo-
nopolist.) As collusion would bring the firms closer to monopoly quantity, it must increase
producer surplus.
As we have higher prices and fewer units sold, consumer surplus must decrease.
We know that total surplus must decrease (i.e., the gain in producer surplus must be less
than the loss in consumer surplus). We know this because the decreased competition between
the firms moves us away from Qeffic towards Qm .
As total surplus has decreased, deadweight loss must increase by definition.
2. Assume the smartphone market is a duopoly between Samsung and Apple. (You may assume
the Cournot assumptions hold.) Explain why antitrust authorities would not allow a merger
between Apple’s smartphone division and Samsung’s smartphone division.
Suggested Solution: As indicated in question 1, the move from duopoly to monopoly
increases deadweight loss.
3. Assume the following market:
M W T P (Q) = 160 − Q
T C(qi ) = 40qi .
That is, each firm’s total cost of production is equal to forty times the quantity it produces,
with market quantity Q the sum of each firm’s production.
(a) For each firm, what is the marginal cost of production?

Suggested Solution: 40.
(b) What is total quantity transacted if this market were perfectly competitive?
Suggested Solution: Regardless of the number of firms, the market supply curve is
perfectly elastic at P = 40 (i.e., the marginal cost of production). Therefore, 120 units
are transacted.
1
http://en.wikipedia.org/wiki/Apple_Inc._v._Samsung_Electronics_Co.,_Ltd.
20171106: Page 1 Games and Oligopoly: Problems: Solutions

(c) Assume a Cournot duopoly. Show that each firm producing one-half of the perfectly
competitive outcome cannot be a Nash equilibrium of the one-shot interaction. (In
particular, use price and quantity effects to show that if a firm reduces output by one
unit, it increases profits.)
Suggested Solution: So in the proposed equilibrium, each firm produces 60, and the
market price is 40. (As marginal cost of each unit is zero, total profits are zero.)
If I reduce output to 59 and you continue to produce 60, 119 units are transacted, and the
market price is therefore P (Q) = M W T P (Q) = 160 − 119 = 41. Quantity effect: Sell
one less unit meaning you miss out on $40 on revenue. Price effect: You have caused
the market price to increase by $1. As you continue to sell 59 units and each of your
customers now must pay you $1 more as a result of your decision to decrease production
by 1 unit, this is $59 in extra revenue. Marginal revenue=QE+PE=-$40+$59=$19.
In total, reducing your output by 1 unit has increased your revenues by $19 and reduced
your costs by $40 and thus increased your profits by $59. Each firm producing 60 cannot
be a Nash equilibrium as either firm could increase profits by choosing an alternative
action.
Alternatively, we can see this directly. As argued above, with each firm producing 60,
each firm’s profits are zero. What are my profits if I produce q1 = 59 and you produce
q2 = 60?
π1 (q1 , q2 ) = P (q1 + q2 ) × q1 − C(q1 )

= 41 × 59 − 40 × 59
= 59
4. Assume a homogeneous good (i.e., no product differentiation). Per-period market demand is

given by M W T P (Q) = 200 − 2Q.
(a) Consider increasing market production from 24 to 25 units. What is the quantity effect?
Suggested Solution: To sell 25 units, the market price must be 200 − 2 ∗ 25 = 150.
150 is the quantity effect: the amount that goes into your pocket from selling the 25th
unit.
(b) Assume a monopoly. What is the marginal revenue from selling the 25th unit? (Hint:
You will first need to find the price effect.)
Suggested Solution: When the quantity was 24, the price was 200 − 2 ∗ 24 = 152.
The price effect is the $2 discount you give 24 customers, or -$48. Marginal revenue =
150-48=102.
(c) Assume a duopoly, where each of 2 firms is selling 12 units. What is the marginal revenue
from one firm increasing production by 1 unit? (Hint: You will first need to find the
price effect.)
150-24=126.
(d) Assume a triopoly, where each of 3 firms is selling 8 units. What is the marginal revenue
from one firm increasing production by 1 unit? (Hint: You will first need to find the
price effect.)

150-16=134.
(e) Assume a four-firm oligopoly, where each of 4 firms is selling 6 units. What is the
marginal revenue from one firm increasing production by 1 unit? (Hint: You will first
need to find the price effect.)
150-16=138.
(f) Relate the answers to the previous subquestions to the ability to sustain collusion as the
number of firms increases.
Suggested Solution: For any quantity that firms in a market wish to split (Q∗m in
this case), increasing the number of firms increases the incentive of any 1 firm to break
a collusive arrangement and sell 1 more units.
Note that this result, stemming from strategic issues to break a collusive arrangement,
is in addition to the fact that coordination becomes more difficult as we increase the
number of firms in a collusive arrangement.
5. Kermit (player 1, the row player) and his nephew Robin (player 2, the column player) are
playing the following game. Each player has a King, a Queen and a Jack in his hand. Each
player then places one of his cards face down on the table. When both players have played a
card, both cards are revealed, and the payoffs are given by the following payoff matrix where,
for each action combination, Kermit’s payoff is given first. (Thus, if Kermit plays his Queen
and Robin plays his Jack, Kermit earns 7 and Robin earns 3)
K Q J
K 6, 6 2, 4 8, 7
Q 3, 1 8, 4 7, 3
J 5, 5 6, 3 9, 4
(a) True, False, Uncertain: Neither player has a dominant strategy.

Suggested Solution: True. Each player’s optimal action depends on what the other
player does.
(b) Identify any and all Nash Equilibria of this game.
Suggested Solution: The following payoff matrix identifies each player’s best re-
sponses in bold. In a Nash Equilibrium, both players are best responding to the play of
others, therefore {Q,Q} is the only Nash Equilibrium of this game.
K Q J
K 6,6 2, 4 8,7
Q 3, 1 8,4 7, 3
J 5,5 6, 3 9,4
(c) Refer to question 5. Robin decides to burn his Jack. True, False, Uncertain: Assum-
ing that Robin and Kermit will play a Nash Equilibrium, Robin’s payoffs might improve
because he can no longer play his Jack. (Hint: Perhaps there are multiple equilibria
now that Robin has discarded his Jack!)

Suggested Solution: True. The following payoff matrix identifies each player’s best
responses in bold. The two pure-strategy Nash Equilibria are {Q,Q} and {K,K}. Robin
does better in the {K,K} than in the {Q,Q}. As for which equilibrium they will play,
that is an interesting question . . .
K Q
K 6,6 2, 4
Q 3, 1 8,4
J 5,5 6, 3
6. Why do people show up late for parties? Game theory might offer some insights . . .
Rahul and Yan have been invited to Prof. G.’s for dinner. They are asked to arrive at 8:00,
but everyone knows that dinner won’t actually be served until 9:00. Each guest chooses—
without knowing the choice of the other guest—whether to arrive at 8:00 or to arrive at 9:00.
So, each guest chooses 1 of 2 actions, what are the payoffs?
Dinner Prof. G. is actually a reasonably good cook, so each receives a payoff of 10 from
eating Prof. G’s dinner. Of course, a guest gets dinner whether she arrives at 8:00 or
9:00.
From 8:00–9:00 If a guest arrives at 8:00 but the other chooses 9:00, the on-time guest has
to talk to Prof. G. for an hour. Ouch! Subtract 3 from the on-time guest’s payoff.2 If
both guests arrive at 8:00, they get to mingle with each other, which is rather enjoyable.
Add 2 to each guest’s payoff.
(a) Depict the strategic interaction between Rahul and Yan in a payoff matrix.
Suggested Solution: In the payoff matrix, each player’s best responses are in bold.
8:00 9:00
8:00 12,12 7, 10
9:00 10, 7 10,10
(b) Does either player have a dominant strategy? Briefly explain.
Suggested Solution: Nope. A player has a dominant strategy if she wants to play
a certain strategy regardless of what the other player does. In this case, if the other
guest chooses to arrive on time, my best response is to arrive on time. If the other guest
chooses to arrive late, my best response is to arrive late.
(c) What strategy profile maximizes the sum of player payoffs?
Suggested Solution: Each player arriving at 8:00 results in a total payoff of 24, which
is greater than any other action combination.
(d) Identify any and all Nash equilibria of this game.
Suggested Solution: We are looking for strategy profiles (i.e., cells in the payoff
matrix) where each player is best responding to the other’s action. As shown in the
payoff matrix (where best responses are in bold), there are two Nash equilibria. The
first is that each guest chooses to arrive on time. The second is that each guest chooses
to arrive late.
2
Alternative interpretation: the guest sits around doing nothing while Prof. G. frantically tries to make sure dinner
is ready by 9.

(e) If you did the previous question correctly, you identified more than one Nash equilibrium.
Put yourself in the shoes of one of the guests. What might you do to increase the
likelihood of the equilibrium giving you the highest payoff.
Suggested Solution: One way to think about this game is that is a game of coordi-
nation. Communication is the obvious solution to a coordination problem. Call Rahul
and say “Hey, Rahul. It’s Yan. I’m planning on being on time, and just want to make
sure you are as well.”
If this game is played repeatedly, an alternative solution is to gain a reputation for being
on time. Each player prefers the outcome where both arrive on time. If Rahul knows
that Yan is one of those people who is always on time, Rahul will be on time. (Likewise,
if Yan has a reputation for always being late, Rahul will choose to show up at 9.) Of
course, you might have to bear some uncomfortable hours alone at parties as you develop
that reputation for being on time . . .
(f) In words, how is this game similar to a Prisoner’s Dilemma? Dow does it differ?
Suggested Solution: First, a little terminology. This game is an example of a Stag
Hunt game (https://en.wikipedia.org/wiki/Stag_hunt).
Both the Prisoner’s Dilemma (PD) and the Stag Hunt (SH) model situations in which
there are gains from cooperation (i.e., both playing “cooperate” maximizes the sum of
payoffs). In situations best modelled as a PD, the cooperative outcome is not a Nash
equilibrium as each player’s dominant strategy is to choose the non-cooperative (defect)
action. In contrast, the SH game highlights an alternate impediment to cooperation:
coordination. In a situation best modelled as a SH game, both the cooperative and non-
cooperative outcomes are equilibria. The problem is that the non-cooperative action is
the safe action. The riskier cooperative action only pays off if the other chooses the
riskier cooperative action as well.
7. Assume a homogeneous good (i.e., no product differentiation). Per-period market demand is

given by Q(P ) = 17 − P3 . Each of N firms has a per-period cost function C(qn ) = 50 + 3.75qn ,
where 50 is a firm’s per-period fixed cost.
(a) What is the marginal cost of producing 1 more unit?

Suggested Solution: $3.75
(b) Assume N = 2 firms, neither is constrained by capacity, and prices need not be in whole
cents. Assuming both firms have paid fixed costs, what is the Bertrand Nash equilibrium
of the one-shot interaction of these 2 firms?
Suggested Solution: Each firm charges a price equal to marginal cost: P = $3.75.
If one firm is charging $3.75, the other firm cannot increase its profits by changing to a
price different than $3.75, therefore each firm charging P = $3.75 is an equilibrium.
If one firm is charging P̂ > $3.75 the other firm ought to charge a price just underneath
P̂ . As both prices cannot be just underneath the other price, there can be no equilibrium
with P > $3.75.
(c) Assume no firm is constrained by capacity, prices need not be in whole cents, but no
firm has yet paid fixed costs. Explain why in equilibrium only 1 firm pays the fixed cost.
(Translation: Both firms entering and paying the fixed cost cannot be an equilibrium
because at least 1 firm could do better by changing her action.)
Suggested Solution: Well if N > 1, P = M C = 3.75. Clearly no firm is covering
fixed costs, so each firm would prefer not to enter. Only with one firm in the market

N = 1 is it the case that no firm in the market prefers to exit and no firm out of the
market prefers to enter. N.B. Constant marginal cost markets are often referred to as
natural monopolies. This question shows that without capacity constraints or product
differentiation, monopoly truly is the natural outcome!
(d) What are the equilibria of this market entry game?
Suggested Solution: There are two equilibria: In the first equilibrium, firm 1 enters
and firm 2 stays out. In the second equilibrium, firm 2 enters and firm 1 stays out.
8. In a weird universe, there are two ECO101 students. Each student has the same costs and
benefits. A student’s payoff from a good grade on a test is 20, from an average grade is 5 and
from a poor grade is 0. Each student chooses a level of studying. If she chooses HI, she pays
a cost of 10, but only pays a cost of 6 if she chooses LO.
Assume grading on a curve. In particular, if each student chooses the same level of studying,
each student earns an average grade on a test. If one student chooses HI and the other
chooses LO, then the student choosing HI earns a good grade on the test while the student
choosing LO earns a poor grade on the test.
(a) Assume each student simultaneously and independently chooses how much to study.
Depict the payoff matrix of this game.
Suggested Solution:
HI LO
HI -5,-5 10,-6
LO -6,10 -1,-1
(b) What is the Nash equilibrium of the game played one time?
Suggested Solution: Both players choose HI. In the following payoff matrix, I have
indicated each players best response by putting the associated payoff in bold.
HI LO
HI -5,-5 10,-6
LO -6,10 -1,-1
(c) Does either player have a dominant strategy? Briefly explain.
Suggested Solution: Each player has a dominant strategy to choose HI. That is,
regardless of whether the other student plays HI or LO, I get higher payoffs by playing
HI.
(d) What strategy profile maximizes the sum of payoffs?
Suggested Solution: In this case, it is either {HI;LO} or {LO;HI}
Totally irrelevant: this is not a classic Prisoners’ Dilemma. In a classic prisoners
dilemma, the “collusive” (or cooperative) action maximizes joint payoffs. This will be
the case when the gains from defection are less than the reduction in payoffs for the
other player.
9. Imagine a world before cell phones. You and a friend have decided to meet at a coffee shop
this afternoon. In discussing your options, you reveal that you prefer Aroma Espresso Bar,
whereas your friend prefers L’Espresso Bar Mercurio. Later, when getting ready to meet your
friend, you realize that while you and your friend discussed the relevant merits of each coffee

bar, you did not actually make a decision! In this world without cellphones, each of you must
simultaneously and independently choose which coffee shop to go to.
What you do know: each person’s payoffs are the sum of two factors. First, a player gets a
payoff of 1 from going to her preferred coffee shop, and 0 from the other. Second, each player
gets a payoff of 2 if both go to the same coffee shop, and a payoff of zero if each goes to a
different coffee shop.
(a) With you as player 1 (the row player), depict the payoff matrix for this game.
Suggested Solution:
A M
A 3,2 1,1
M 0,0 2,3
(b) Identify any and all Nash equilibria for this game.
Suggested Solution:
A M
A 3,2 1,1
M 0,0 2,3
(c) Does either player have a dominant strategy?
Suggested Solution: Nope, the action that is your best response does depend on
what your friend chooses. Looking at player 1 (i.e., you): your best response is to choose
Aroma if your friend chooses Aroma, and to choose Mercurio if your friend chooses
Mercurio. The situation for your friend is the same.
(d) One reason why we rely on game theory to analyze strategic situations is the hope that
game theory will enable us to predict outcomes. So, does game theory enable us to
predict outcomes in this game? Briefly explain.
Suggested Solution: The game in this question is an example of a coordination game.
In this case, game theory is not too helpful. First, there are multiple equilibria. Even
if I restrict my prediction to Nash equilibria, I cannot say whether you and your friend
“coordinate” on Aroma or Mercurio.
Second, I cannot rule out miscoordination. Sure, if you go to Aroma and your friend goes
to Mercurio, this is not an equilibrium. In this case, just because it is not an equilibrium
does not mean it is an implausible outcome. Keeping fixed your friend’s choice, you
will wish you had chosen Mercurio, and keeping fixed your choice of Aroma, your friend
can increase payoffs by choosing Aroma instead of Mercurio. (In the language of game
theory, an outcome where you miscoordinate is rationalizable.) For example, perhaps
you went to Mercurio thinking that you would be nice to your friend and would try
and coordinate on her preferred equilibrium. Unfortunately, your friend goes to Aroma
thinking she would be nice and try to coordinate on your preferred equilibrium . . .
(e) Let us change the rules of the game a bit. Your friend gets to publicly move first. For
example, while you both have cell phones, you both know that hers is broken, and the
only thing she can do is send, but not receive, text messages. Use the logic of game
theory to predict the outcome of this game.
Suggested Solution: First, note that we no longer have the possibility of miscoordi-
nation. If your friend says she is on her way to Aroma, you head there.

Second, assuming the payoffs are as specified, we can predict that she chooses her
favoured spot (Mercurio) and you head there. Why? Because she gets a payoff of 3
by texting Mercurio to you, and only 2 by texting Aroma to you.
10. Boeing and Airbus are both considering introducing a 1,000-seat passenger jet. Each simul-
taneously and independently chooses whether to produce. If one produces and the other does
not, the producing firm earns 100. Unfortunately, the market is not large enough for both
manufacturers to earn a profit: if they both produce, each loses 10.
(a) With Boeing the row player, depict the payoff matrix for this game.
Suggested Solution:
Yes No
Yes -10,-10 100,0
No 0,100 0,0
(b) Identify any and all Nash equilibria for this game.
Suggested Solution:
Yes No
Yes -10,-10 100,0
No 0,100 0,0
(c) Does either player have a dominant strategy?
Suggested Solution: Nope. Each firm want wants to produce if the other stays out,
and stay out if the other produces.
(d) The European Union announces that it will subsidize development of the aircraft with a
payment of 25 if Airbus chooses to produce. Modify the payoff matrix. Identify any and
all Nash equilibria of the modified game. Explain the qualitative effect of the subsidy.
Suggested Solution: We now have a unique Nash equilibrium: Airbus produces,
Boeing does not.
Yes No
Yes -10,15 100,0
No 0,125 0,0
By covering Airbus’ losses in the event that both firms enter, the EU has made produce
a dominant strategy for Airbus.3 This has the added “benefit” of simplifying Boeing’s
problem: if your opponent has a dominant strategy, then your strategic situation is
rather easy as you just have to make sure you best respond to what you know your
opponent is going to do. As Boeing knows that producing is Airbus’ dominant strategy,
Boeing must choose not to produce.
11. Matching Pennies I can guarantee you that a question like this will not appear on a test or
exam. I include it because understanding the equilibrium in this game solidifies understanding
of what we mean by a Nash equilibrium.
3
The fact that it pays 25 in the event that only Airbus enters does not change the strategic incentives of this
interactions. From the point of view of the EU, a “better” strategy would be to announce that the subsidy is only
available if both enter.

Mr. Match and Ms. Match play the following game: they each simultaneously put a penny4
on the table. If both are heads or both are tails, Mr. Match takes both of the pennies. If one
is heads and the other is tails, Ms. Match takes both of the pennies.
While not a necessary assumption, it might be helpful to think of this game played thousands
of times. Mr. Match and Ms. Match do not have much of a social life and are too cheap to
pay for cable television—they play this game every night for hours.
(a) Before analyzing this game formally, put yourself in the shoes of Mr. Match. To guide
your thinking:
• If Ms. Match knew you were going to certainly play heads, what should she do?
Knowing this, would you want to play heads with certainty?
• If Ms. Match knew you were going to play heads with a 90% probability this round,
what should she do?5 Knowing this, would you want to play heads with a 90%
probability?
what should she do? Knowing this, would you want to play heads with a 60%
probability?
what should she do? Knowing this, would you want to play heads with a 40%
probability?
Suggested Solution: As Mr. Match, you playing heads 100% of the time cannot be
an equilibrium. If this is part of an equilibrium it must be the case that Ms. Match
always plays tails. Of course, if Ms. Match always plays tails, your best response is to
never play heads.
By the same logic, you playing heads with a 90% (or 60%) probability cannot be an
equilibrium. Ms. Match’s best response is to always play tails, and if she always plays
tails, your best response is to never play heads.
Likewise, you playing heads with a 40% probability cannot be an equilibrium. Ms. Match’s
best response is to always play heads, and if she always plays heads, your best response
is to always play heads.
Hmmm . . .
(b) With Mr. Match the row player, depict this game in a payoff matrix.
Suggested Solution:
H T
H 1,-1 -1,1
T -1,1 1,-1
(c) Identify any and all equilibria of this game. I remind you that John Nash proved that if
each players have a finite number of actions, then at least one Nash equilibrium MUST
exist. Two is of course a finite number.
Suggested Solution: So, let us try the traditional method.
H T
H 1,-1 -1,1
T -1,1 1,-1
4
There was a reason they were hoarding Canadian pennies.
5
You are going to secretly roll a 10-sided die. If it comes up 1–9, you play heads. If it comes up 10, you play tails.

Yikes! We have no cell in the payoff matrix where we have highlighted both payoffs. In
game theory terminology, we have no pure-strategy equilibrium. (By pure strategy,
we mean in equilibrium a player always plays a particular strategy. The equilibrium in
the Prisoners’ dilemma, for example, in a pure-strategy equilibrium: each player plays
defect with probability equal to 100%).
While Mr. Nash proved that this game has at least one Nash equilibrium, he did not say
that it had to be in pure strategies. Consider the following mixed-strategy equili-
brium: Mr. Match plays heads with probability equal to 50% (and therefore tails with
probability equal to 50%). Mr. Match plays heads with probability equal to 50% (and
therefore tails with probability equal to 50%). We know that a proposed equilibrium
is in fact an equilibrium if neither player can increase payoffs by deviating from the
proposed equilibrium:
Is Mr. Match Best Responding? Given that Ms. Match plays each action with 50%
probability, it does not matter what Mr. Match does—he expects to win 50% of the
time. (Alternatively, given Ms. Match’s strategy, he is indifferent between heads and
tails.) As Mr. Match cannot increase his payoffs by choosing a different strategy, he
is best responding.
Is Ms. Match Best Responding? Given that Mr. Match plays each action with 50%
probability, it does not matter what Ms. Match does—she expects to win 50% of the
time. (Alternatively, given Mr. Match’s strategy, she is indifferent between heads
and tails.) As Ms. Match cannot increase her payoffs by choosing a different strategy,
she is best responding.
What should I take away from this problem? In second-year micro, we show how
to solve for the mixed-strategy equilibrium. For ECO101, here is what I hope you
take away from this problem:
• You should be able to set up the payoff matrix.
• You should be able to use our standard algorithm to show that in games like
this, there is no equilibrium in pure strategies.
• You should then understand that because there must be a Nash equilibrium, it
must be the case that it is a mixed strategy equilibrium when there are no pure
strategy equilibria.
Are there any real-world applications? One application is penalty kicks in soccer
(what the rest of the world calls football). At the professional level, it pretty much
is a simultaneous-move game: if the goalie waits until the shooter reveals whether
she is shooting left or right, the goalie will almost certainly not be able to stop the
kick. Empirically, it does appear as though professional soccer players do a good
job of playing a mixed-strategy equilibrium: given what shooters choose, goalies are
equally successful whether they dive left or right; and given what goalies choose,
shooter are equally successful whether they shoot left or right.
Another real-world application is sales (i.e., temporarily offering a low price) and
how stores compete by having sales. While some consumers are going to always seek
at the lowest prices (i.e., price sensitive consumers who make it their business to
be informed), less informed consumers might only know average prices at the two
stores. By each store randomly putting stuff on sale, they “compete” over the price
sensitive consumers without having to compete over the less informed consumers.
That is the theory, anyway . . .

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University of Toronto ECO101: Principles of Microeconomics

Department of Economics Robert Gazzale, PhD

Solved Problems: Games and Oligopoly

(a) producer surplus;

3. Assume the following market:

(a) For each firm, what is the marginal cost of production?

20171106: Page 1 Games and Oligopoly: Problems: Solutions

π1 (q1 , q2 ) = P (q1 + q2 ) × q1 − C(q1 )

4. Assume a homogeneous good (i.e., no product differentiation). Per-period market demand is

20171106: Page 2 Games and Oligopoly: Problems: Solutions

(a) True, False, Uncertain: Neither player has a dominant strategy.

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7. Assume a homogeneous good (i.e., no product differentiation). Per-period market demand is

(a) What is the marginal cost of producing 1 more unit?

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