Economics 106P

E. McDevitt Study Questions-Set #1

1. Assume that an industry with two firms face the following market demand curve: P = 90-Q, where
Q= Q1 + Q2. Marginal cost is constant at $10 for each firm.
a. What is the joint profit-maximizing output (that is, monopoly output)? What is price at this output?
What is joint profit at this output?
b. What is each firm's equilibrium output if they behave non-cooperatively? Use the Cournot model.
What is price? What is each firm's profit? Draw each firm's reaction curve and show the equilibrium.
c. Suppose the industry consists of 19 identical firms. What is the Cournot outcome now? Assume the
industry consists of 79 identical firms. What is the Cournot Solution in this case?
d. What is each firm's equilibrium output and profit under the Stackelberg model. Assume Firm 1 sets its
ouput first. What is price? What is the equation for the residual demand curve facing Firm 1?
e. What is price and profit in the Bertrand Model with identical products?
2. Consider the Bertrand Model with differentiated products. Assume the following demand functions:
Firm 1's demand: Q1 = 20-2P1+P2
Firm 2's demand: Q2 = 20-2P2+P1 MC = 2 for both firms.
a. Find the profit-maximizing price for each firm. What is each firm's quantity and profit at these prices?
b. Draw each firm's reaction curve and show the equilibrium set of prices.
c. If the firms were to collude and set a single price, then what price what maximize their joint profits?
What is total output and joint profit at this price?
3. Firm A is the dominant firm in an industry consisting of itself and many other small firms. The market
demand is given by QM= 1200-0.5P. The supply curve for the fringe firms is QSF = -300 + 0.5P and
MC of the dominant firm is $700.
a. Find the dominant firm's residual demand curve.
b. Find price, dominant firm output, and fringe firm output in this industry.
c. What is the dominant firm's profit?
d. Draw a graph the showing the above.
e. Suppose the supply curve for the fringe firms becomes flatter (assume the same vertical axis intercept
value)--that is, becomes more elastic. How will this influence the price charged by the dominant firm.
Show your answer on a graph.
4. Consider the following promotion game between two department stores. Each must decide what
kind of product to promote.
Department Store 2

Promote Product X Promote Product Y

Promote X 0,0 4,2

Department Store 1
Promote Y 2,2 2,4

a. Does either store have a dominant strategy?

b. Find the Nash equilibrium for this game.
5. Two major networks are competing for viewer ratings in the 8:00-9:00 p.m. and 9:00-10:00 pm.
slots on a given weeknight. Each has two shows to this time period and is changing its lineup.
Each can choose to put its "bigger" show first or to place it second in the 9:00 to 10:00 p.m. slot.
The combination of decisions leads to the above "ratings points" results. The payoff table is on p. 2.
a. Do either or both have a dominant strategy?
b. Find the Nash equilibria for this ratings game, assuming both networks make their decision
simultaneously.
c. If each network used a maximin strategy, what will be the resulting equilibrium?
d. What will be the equilibrium if Network 1 makes its selection first? If Network 2 goes first?
Network 2
 First Second

First 18,18 23,20

Network 1
Second 4,23 16,16

5. Two companies each own property and mineral rights in an oil field. Each firm therefore has a legal
right to drill for oil on its land and take out as much oil as it can. The problem is that one company's actions
affect how much oil the other company can produce. The terms outside the payoff matrix below represent
oil output by each firm (low, medium, high) while the numbers in each cell represent the present value of
all oil to extracted by each company, given the two extraction policies. The first number represents the
value to Company A and the second number represents the value to B. Decisions are made simultaneously.

Company B's Extraction Rate

Low Medium High

Company Low 100,8 80,15 50,30

A's
Extraction Med. 125,5 110,10 55,22
Rate
High 120,3 115,8 60,20

a. What extraction rates maximize the total value of the oil field?
b. Does the set of extraction rates from part (a) represent a stable situation?
c. Is there a dominant strategy for either or both players? Explain.
d. Is there a Nash equilibrium set of extraction rates? Does this set of extraction rates maximize the total
value of the oil field?
6. The table below shows the profits for Firm 1 and Firm 2 for different quantities of output.

Firm 2

50 75 100

Firm 1 50 16,16 14,21 10,20

75 21,14 15,15 9,12

100 20,10 12, 9 5,5

a. Do either or both have a dominant strategy?

b. Find the Nash equilibrium for this output game, assuming both firms make their decision
simultaneously.
c. Is this Nash equilibrium plausible if the game is played sequentially with Firm 1 making the first move?
Explain.
7. Consider the following sequential game. Firm X is considering entering or not entering an industry.
If this firm enters, the incumbent can respond one of two ways. It can accommodate entry, in which case
the payoff is $300 for each firm, or can engage in a price war to attempt to drive the entrant out. If the
incumbent engages in a price war, its profit will be -$100 and the entrant's profit will be -$100. If Firm X
does not enter, then the incumbent's profit will be $500.
a. Draw a payoff tree (that is, extensive form of game) using the above information.
b. Suppose the incumbent declares it will engage in a price war if Firm X was to enter. Is this threat
credible? Explain. Will Firm X enter?
c. Suppose the incumbent invests in equipment that has a high fixed cost but lowers its marginal cost , thus
allowing it to make some profit at high rate of output. This changes the payoff tree to:

accommodate ($300,0)

incumbent
enter

Entrant Price war (-$100,$50)

not enter
(0, $350)

Does this commitment by the incumbent make its threat to engage in a price war credible? What is the
outcome of game now and how does it compare with the outcome from part (b)?
d. Suppose the incumbent does not invest in this equipment (and so we are back to the original tree).
However, suppose the managers of the incumbent firm have gained a reputation for acting "irrationally".
How might that change your answer to part (b)?
8. The table below shows the payoffs to Firm 1 and Firm 2 under different pricing strategies.
Firm 2

Low Price High Price

Low Price 0,0 50,-40

Firm 1
High Price -40,50 10,10

a. Assume that is game is played simultaneously and is played only once. Does either or both firms have a
dominant strategy? What is the Nash Equilibrium?
b. Let us assume that the game is now infinitely repeated. Each firm adopts the following strategy: "We
will each charge the high price, provided neither of us has ever 'cheated' in the past (that is, charged a low
price in any previous period). If one of us cheats and charges the low price, the other player will punish the
violator by charging the low price in every period thereafter". If Firm 1 was to cheat on this agreement by
charging a low price in the current period, then what will Firm's one payoff be? What will Firm's 1 payoff
be in every period after the current period? Is it profitable for Firm 1 to cheat? (Assume that the interest
rate = 0%). Could your answer possibly change if the interest rate >0%?
9. Two cigarette producers are considering billboard advertising. The payoffs under different strategies
are presented in the table below (on next page). Decisions are made simulatenously.
a. Assume the game lasts only one period. Does either or both have a dominant strategy? What is the
Nash equilibrium?
b. Now let us assume the game is repeated for a finite period of time. The final period is uncertain, but
there is 10% chance the government will ban cigarette sales in any given period. Each firm adopts the
following strategy: "We will not advertise, provided neither of us has ever 'cheated' in the past (that is,
advertised in any previous period). If one of us "cheats" and advertises, the other player will punish the
violator by advertising in every period thereafter". Will either firm have an incentive to cheat on the
agreement by advertising? Assume a zero interest rate.
c. How would your answer change to part (b) if there is 50% chance the government will ban cigarette sales
in any given period and the interest rate is 20%?
 Firm 2

Advertise Don't Advertise

Advertise 0,0 20,-1

Firm 1
Don't Advertise -1,20 10,10

10. Consider the following game between players 1 and 2.

Player 2
Up Down
Up 40, 40 20,20
Player 1
Down 100,-20 0,0

a. Does a Nash equilibrium in pure strategies exist?

b. What is the Nash equilibrium in mixed strategies? Show work. What is each player's expected payoff in
the mixed strategy equilibrium?
c. Suppose player 1 picked x = 0.60. How would this change affect player 2's strategy? Explain.

11. Assume that skiing season only lasts 100 days. Each day a particular ski resort is open it makes
a profit of $10,000 per day. A union representing employees threatens to close the resort down unless they
get some share in the profits. An offer is first made by the management. The offer is either accepted or
rejected by the union. If rejected, the union makes an offer the next day.

Days Left Total Profits Offer Made By Offer (Total& Per-Day) .

1 $10,000 Union Union: Management: .
2 $20,000 Management .
3 $30,000 Union .
4 .
.
.
99 .
100 $1,000,000 Management .

a. Fill in the rest in table and explain your answer.

b. If each side is rational, they will agree on what kind of division in the first round?
c. Suppose union members could earn $2,000/day in some alternative employment. How would this change
the table and why?
d. How would they split the profits if management had outside opportunities of $4,000/day and the union
had no alternative opportunities? What if the union had outside opportunities worth $2,000 and
management had outside opportunities of $4,000/day?
ANSWERS
1. a. To find monopoly output, let us first set up the profit function, substituting 90-Q for P:
π = (P-MC)(Q) = (90-Q-10)(Q)
Second, we take the derivative of π with respect to Q and set it equal to zero: dπ/dQ = 80-2Q = 0
Finally, we solve for Q: Q = 40
Plugging Q=40 back into the demand gives us: P = 90-40= $50
Monopoly profit is: π = (50-10)(40)= $1,600
b. To find the Cournot solution, we first set up the profit function, substituting 90- Q1-Q2 for P:
[recall that Q = Q1+Q2]
π1 = P1Q1-MC1Q1 = (P1- MC1) Q1 = (90-Q1-Q2-10)(Q1)
Second, we take the derivative of π with respect to Q1 and set it equal to zero: dπ1/dQ1 = 80 - 2Q1-Q2 = 0
Third, we solve for Q1 (this will give us firm 1's reaction curve):
rearranging the above first-order condition gives us Q1= 40 - 0.5Q2 (Firm 1's Reaction Curve)
You follow the same steps for Firm 2. Since Firm 2 has the same MC, the answer is symmetrical:
Q2= 40 - 0.5Q1 (Firm 2's Reaction Curve)
Once you have derived the reaction curve for each firm, you can then use them to solve for Q1 and Q2 since
we now have two equations and two unknowns. Substituting Firm 2's reaction curve into Firm 1's gives us:
Q1= 40 - 0.5(40-0.5Q1) = 20 + 0.25Q1 or Q1= 26.67
You can verify that Q2 = 26.67 and Q = 53.34
Find price by using the demand curve P = 90- Q1-Q2 : P = 90-26.67-26.67= $36.66
π1 = π2 = (P1- MC1) Q1 = (36.66-10)(26.67)= $711.29
c. Since output per firm is Qi = [(a-c)]/[b(1+n)], then Qi = [90-10]/[20] = 4. Market output would therefore
be (19)(4) or 76 units. P = 90-Q= 90-76 = $14. Profit per firm = (14-10)(4)= $16.
If there 79 identical firms: Qi = [90-10]/[80] = 1. Qmarket = (79)(1) = 79. P=90-79=$11. π=(11-10)(1)=$1.
d. Step One--set up profit function, substituting 90- Q1-Q2 for P:
π1 = P1Q1-MC1Q1 = (P1- MC1) Q1 = (90-Q1-Q2-10)(Q1)
Step Two. Since Firm One selects its output first, it anticipates that given this choice of output that
Firm 2 will respond by selecting its output as given by Firm 2's reaction function. So in Firm 1's profit
function we can take out Q2 and substitute in 40 - 0.5Q1 (note: recall that Firm 2's reaction
function is Q2= 40 - 0.5Q1). This gives us:
π1 = [80- Q1-(40-0.5Q1)](Q1) = [40-0.5Q1] (Q1)
Step Three is to take the derivative of this profit function with respect to Q1 and set it equal to zero:
dπ1/dQ1 = 40-Q1 = 0
Using this first-order condition gives us Q1 = 40
Plugging 40 into Firm 2's reaction function gives us Q2 = 20.
Plugging these quantities into the demand curve gives us P = 90-40-20= $30.
π1 = ($30-$10)(40)= $800 π2 = ($30-$10)(20)= $400 Joint profit = $1,200
Residual demand curve for Firm 1: P = 90-Q1 –[40 - 0.5Q1] = 50- 0.5Q1 for Q1<80, and
P = 90-Q1 for Q1>80. Note: From this residual demand (less than 80), we get MR1 = 50-Q1, and when we
set MR1 = MC, we get 50-Q1 = 10, or Q1 = 40.
e. In this case price will be bid down to MC, so P = $10 and profit is zero.
2. Bertrand Model with differentiated products.
Step 1. Set up Firm 1's profit function, substituting in 20-2P1+P2 for Q1. This gives us:
π1 = P1Q1-MC1Q1 = (P1- MC1) Q1
π1 = (P1 -2) (20-2P1+P2)
Step 2. Take the derivative this profit function with respect to P1 and set it equal to zero:
dπ1/dP1 = (20-2P1+P2) + (P1 -2) (-2) = 0
= 24 - 4P1 +P2 =0
Step 3. Solve for P1. This will give us Firm 1's reaction function.
P1 = 6 + 0.25P2 (Firm One's reaction function)
Repeat these steps for Firm 2. Since MC is the same for both firms, then by symmetry Firm Two's reaction
function is: 6 + 0.25P1 = P2
Once you have derived each firm's reaction function, you can use them to solve for their prices:
To find prices, 6 + 0.25(6+0.25P1) = P1 or P1 = $8 and P2 = $8
Plugging these prices back into each firm's demand curve gives us:
Q1 = 20-2P1+P2 = 20-16+8= 12 Q2 = 20-2P2+P1=20-16+8= 12.
π1 = π2 = ($8-$2)(12)= $72.
c. To find maximum joint profit, we first set up the joint profit function, substituting
in for each Q the term 20-P [Note: P1=P2 = P under collusion, so Q1 = 20-2P1+P2 = 20-2P+P = 20-P and by
the same logic Q2 = 20-P]. This gives us:
πJ = π1 + π2 = (P1- MC1) Q1 + (P2- MC2) Q2 = (P- 2)(20-P) + (P- 2) (20-P) = (P-2)(40-2P)
Step Two. Take the derivative of the profit function with respect to P and set it equal to zero.
dπJ /dP = (40-2P) + (4 -2P) = 44 - 4P = 0
Step Three. Solve for P using the first-order condition. P = 44/4= $11.
To find output for each firm use Q = 20-P and plug in P = $11:
Q1 = Q2 = 20-11= 9. Combined output is 18 units.
πJ = (11-2)(9) + (11-2)(9) = $162.
3. a. The dominant firm's residual demand curve = Market demand - Supply from fringe firms
QRD = QM - QSF = (1200-0.5P) - (-300 + 0.5P) = 1500 - P
(or , inverse demand curve of P = 1500 - Q)
b. Step 1. Set up profit function, substituting 1500-Q in for P( you also could simply find the MR equation
and set it equal to MC): π = (P-MC)( QRD ) = (1500-Q-700)(Q)= 800Q-Q2.
Step Two. Take the derivative of this profit function with respect to Q and set it equal to zero:
dπ/dQ = 800 - 2Q = 0 and solving for Q gives us Q = 400.
(alternatively, MR = 1500 -2Q and setting MR = MC gives 1500-2Q =700, or Q=400).
To find P, plug Q=400 into residual demand curve:
P = 1500 -Q = 1500-400 = $1,100
To find the quantity produced by the fringe firms, plug P=800 into the fringe supply function:
QSF = (-300 + 0.5P) = -300 + 0.5(1,100) = 250.
Dominant firm π = (1,100-700)(400) = $160,000.
4. Department Store 2

Promote Product X Promote Product Y

Promote X 0,0 4,2

Department Store 1
Promote Y 2,2 2,4

a. Store 2 has a dominant strategy, namely, promote product Y. If store 1 promotes X,then store 2's best
play is to promote Y since it gets 2 whereas it would get 0 if it selected to promote X. If store 1 promotes
Y, then store 2's best play is to promote Y since it gets 4 instead of 2.Thus, no matter what store 1 does,
store 2 will always choose to promote Y.
Store 1 does not have a dominant strategy since its choice depends upon what store 2 does. If store 2 selects
X, then store 1's best play is to promote Y (it gets 2 rather than 0 if it had instead selected X). On the other
hand, if store 2 selects to promote Y, then store 1's best play is to promote X.
b. The Nash equilibrium for this game (the cell where you find the circle and square) is Store 1 promotes
X and store 2 promotes Y. Neither store will desire to change its play from this since each is doing the
best it can, GIVEN what the other player is doing. That is, given that store 2 plays Y, store 1 desires to play
one, and given that store 1 plays X, store 2 desires to play Y. No one desires to move away from its
choice.
5. a. Network 1 has dominant strategy--put the "bigger" show on First. It will do this no matter what
Network 2 chooses to do. If Network 2 chooses "First", then Network 1's best play is "First" since 18 is
better than 4. If Network 2 chooses "Second", then Network 1's best play is "First" since 23 is better
than 16.
Network Two does not have a dominant strategy--what it plays depends upon what Network 1 plays. If
Network 1 plays "First", then Network 2 plays "Second". However, if Network 1 plays "Second" then
Network 2 chooses to play "First".
b. The Nash equilibrium is Network 1 plays "First" and Network 2 plays "Second".
c. For Network 1, if it plays "First" its worst possible outcome is 18. If it plays "Second", then its worst
possible outcome is 4. The maximin strategy would therefore entail playing "First".
For Network 2, if plays "First" its worst possible outcome is 18. If it plays "Second",its worst possible
outcome is 16. The maximin strategy would therefore entail that Network 2 plays "First".
If each network uses a maximin strategy, then the outcome is for both to play "First".
[Of course, if Network 2 knows that Network 1 has a dominant strategy (namely, play "First) and so knows
that Network 1 will always play "First", then it would make no sense for Network 2 to play "First"].
d. Network 1 chooses first. To determine the outcome of this sequential game, we must work backwards.
Network 1 knows that if it selects "First", then Network 2 will select "Second" and therefore Network 1
will get a payoff of 23. Network 1 also knows that if it selects "Second", then Network 2 will play
"First" and therefore Network 1 will have a payoff of 4. Network 1 will therefore play "First" and Network
2 will then play "Second".
Network 2 selects first. Network 2 knows that if it selects "First", then Network 1 will select "First" and
therefore Network 2 will have a payoff of 18. Network 2 also knows that if it selects "Second", that
Network 1 will select "First" and therefore Network 2 will have a payoff of 20. So when Network 2 selects
first, it will play "Second" and Network 1 will then play "First".
5.
Company B's Extraction Rate

Low Medium High

Company Low 100,8 80,15 50,30

A's
Extraction Med. 125,5 110,10 55,22
Rate
High 120,3 115,8 60,20

a. If A's output rate was "medium" and B's output rate was "low", this would maximize the total value
of the field at 130. (130= 125+5).
b. No. If A selected a medium output, B would maximize its value by choosing a high output (22 is greater
than 5 or 10 in the medium row).
c. Company B has a dominant strategy---a high output rate. No matter what output rate A selects, B's
highest value is from choosing a high output rate.
d. Yes, when both choose high rates of output this will be a Nash equilibrium. With each producing a
high rate of output, neither company has an incentive to change to some other output rate.
No, this set of extraction rates does not maximize the total value of the field. The total value of the
field is now 80 (=60+20). This outcome is not efficient.
6.
Firm 2

50 75 100

Firm 1 50 16,16 14,21 10,20

75 21,14 15,15 9,12

100 20,10 12, 9 5,5

a. Neither firm has a dominant strategy. If Firm 2 chooses 50, then Firm 1's best output is75. If Firm 2
chooses output of 75, then Firm 1's best output is 75. However, if Firm 2 chooses 100, then Firm 1's best
output is 50. So Firm 1's best output depends upon what output Firm 2 chooses. A similar story can told
for Firm2. If Firm 1 chooses 50, the Firm 2's best output is 75. If Firm 1 chooses 75, the Firm 2's best
output is 75. Finally, if Firm 1 chooses 100, then Firm 2's best output is50. Therefore, Firm 2 's best output
depends upon which output Firm 1 chooses.
b. The Nash equilibrium is Firm 1 chooses 75 and Firm 2 chooses 75. At this combination, neither firm has
an incentive to change their output.
c. No. If Firm One makes the first move, then it knows that if it selects 50, Firm 2 will select 75. This
leaves Firm One with a payoff of $14.
If Firm 1 chooses 75, then it knows that Firm 2 will select 75. This leaves Firm 1 with a payoff of $15.
If Firm 1 chooses 100, then it knows that Firm 2 will select 50. This leaves Firm 1 with a payoff of $20.
Among these choices, Firm 1 prefers the last one---to produce 100 units, which means that Firm 2 produces
50 units. [Notice that the payoff to Firm 1 is greater when it moves first versus the simulataneous game.
Recall the Stackelberg outcome with the Cournot outcome?]
7. a. The payoff tree is:

accommodate ($300,$300)

incumbent
enter

Entrant Price war (-$100,-$100)

not enter
(0, $500)

The first figure in parentheses is the gain to the entrant and the second figure is the gain to the incumbent.
b. No, it is not credible. The entrant knows that once it has entered, the incumbent's best strategy is
to accommodate since the incumbent gains $300 by accommodating but suffers a loss of $100 by engaging
in a price war. Therefore, if the entrant enters it will have a payoff of $300. If it does not enter, it will have
a payoff of 0. It will therefore enter, and once it has done so the incumbent will accommodate.
c. Yes, now the threat is credible. The entrant knows that once it has entered, the incumbent's best
strategy would be to engage in price war. If the incumbent accomodates, its payoff will be 0, but if it
engages in a price war the incumbent's payoff is $50. It is therefore rational for the incumbent to engage
in a price war once the entrant has entered.
The entrant knows that if if enters, the incumbent will choose price war and therefore the entrant will
suffer losses of $100. If the entrant does not enter it will have a payoff of 0. It is therefore better not to
enter.
d. Looking at the original tree we earlier concluded that it was not rational for the incumbent to engage in a
price war once the entrant entered since it would lose $100 by doing so, whereas it would gain $300 by
accommodating. But if the entrant believes that the incumbent is "irrational" and may therefore still engage
in a price war, then this would deter the entrant from entering.
8. Firm 2
Low Price High Price

Low Price 0,0 50,-40

Firm 1
High Price -40,50 10,10

a. Both have dominant strategies. For Firm 1, it will play low price not matter what Firm 2 does.
For Firm 2, it will play low price no matter what Firm 1 does.
Low price, Low price is the Nash equilibrium. Neither firm has an incentive to depart from
outcome.
b. If Firm 1 cheats by charging the low price, then its profit will be $50 in the current period (see upper
righthand cell). However, since Firm 2 will now charge the low price in the periods thereafter, Firm 1's
profits will be 0 in all periods after the current period.
So the present value (PV) of cheating to Firm 1 = $50 + 0 + ……… =50
The PV of cooperating to Firm 1 (assuming interest rate to be zero) = 10 + 10 + 10 +……….
Since the game is infinitely repeated it must be true that
PV of cooperating 10+10+10….. > PV of cheating = 50 + 0 + 0 +….
Thus, Firm 1 would not cheat.
If the interest rate (i) is positive then the relevant comparison is:
PV of cheating = 50 + 0 + 0….. = 50 versus PV of cooperating = 10 + 10/i .
[NOTE: the present value of a series of equal payments that last forever, where the first in the series is one
year from today, is given by the formula PV =V/i. It is called the perpetuity formula].
Firm 1 will cooperate if 50 < 10 + 10/i . If we solve for i then we can see that if i = 25%, this firm
is indifferent between cheating and cooperating, but if the interest rate is below 25%, then the PV
cooperating is greater than the PV of cheating.
9. Firm 2

Advertise Don't Advertise

Advertise 0,0 20,-1

Firm 1
Don't Advertise -1,20 10,10

a. This question is similar to question 8. Both have dominant strategies--to advertise.

The Nash equilibrium is Advertise, Advertise.
b. If Firm 1 cheats by charging the advertising, then its profit will be $20 in the current period (see upper
righthand cell). However, since Firm 2 will now advertise in the periods thereafter, Firm 1's profits will be
0 in all periods after the current period. Thus, PV of cheating = 20+ 0 + ….0 = $20.
Notice that θ = probability game ends after any given play = 0.10 and therefore the probability the game
continues is (1-θ)= 0.90. Therefore,
Expected PV of cooperating = 10 + (.9)(10) + (.9)2(10) + (.9)3(10) + …..= [10/θ] = [10/0.10] = $100.
Since PV cheating =20< PV of cooperating = $100, neither firm will cheat.
c. Expected present value of cooperating = $10{[1+i]/[θ+i]} =10{[1.2]/[0.5+0.2]} =10[1.71]=$17.10.
Since expected PV of cooperating < PV of cheating, firms will cheat.
 Q2 P2

1b. 2b. Firm One

80

Firm 1’s Reaction Curve Firm Two

$8
40

26.67 Firm 2’s reaction Curve $6

26.67 40 80 Q1 $6 $8 P1

Question 3d.
$2400 SFF
Market Demand
Curve

$1500

Residual Demand Curve

P=$1,100

MC=$700 MC

$600

MRr

QFF=250 QR=400 650 900 1200 Quantity

MIXED STRATEGIES AND BARGAINING-ANSWERS
Player 2
Up Down
Up 40, 40 20,20
Player 1
Down 100,-20 0,0

a. As can be seen in the table above, a Nash equilibrium in pure strategies does not exist.
If player 2 picks UP, then player 1 picks DOWN.
If player 2 picks DOWN, then player 1 picks UP.
If player 1 picks UP, then player 2 picks UP.
If player 1 picks DOWN, then player 2 picks DOWN.
No cell has both a circle and a square, so there is no Nash equilibrium in pure strategies. Rather, you
would get "cycling"--starting in any give cell, the players would move to another cell, etc.
b. Let x = probability that player 1 picks UP and 1-x = probability that player 1 picks DOWN.
Player 1 wants to pick x such that player 2 has the same expected payoff for any pure strategy.
So: Expected payoff to player 2 of UP = Expected payoff to player 2 of DOWN.
(x)(40)+(1-x)(-20) = (x)(20)+(1-x)(0)
Solving for x we get x = 0.5. Thus, player 1 plays UP with a probability of 0.5 and plays DOWN with a
probability of 0.5.
Let y = probability that player 2 picks UP and 1-y = probability that player 2 picks DOWN.
Player 2 picks y such that player 1 has the same expected payoff for any pure strategy.
So: Expected payoff to player 1 of UP = Expected payoff to player 1 of DOWN.
(y)(40) + (1-y)(20) = (y)(100) + (1-y)(0)
Solving for y we get y = 0.25. Thus, player 2 picks UP with a probability of 0.25 and DOWN with a
probability of 0.75.
Player 1's expected payoff= (y)(100) + (1-y)(0)= (0.25)(100) + (1-0.25)(0) = 25
Player 2's expected payoff= (x)(20)+(1-x)(0) = (0.50)(20)+(0.50)(0) = 10
c. First, notice that this would not change player 1's expected payoff given that player 2 picks 0.25.
That is, player 1's expected payoff from any given pure strategies depends on the probability picked
by PLAYER 2 and this has not changed. So there is no gain to doing so. The penalty of making such a
change is that it opens up an opportunity for player 2. To see this, notice that:
Expected payoff to player 2 of UP > Expected payoff to player 2 of DOWN.
(0.60)(40)+(1-0.60)(-20) > (0.60)(20)+(1-0.6)(0)
16 > 12
Since the expected payoff to player 2 of UP is now greater than the expected payoff to player 2 of DOWN
it would not be wise for player 2 to stick to its 0.25/0.75 mixed strategy, rather it would adopt the pure
strategy of UP. But if player 2 plays UP, then player 1 would play DOWN. But if player 1 plays DOWN,
then player 1 would play DOWN, Etc. We get cycling .

2.
The number in parentheses is the offer per day. Offer per day= Total Offer/Days Left
Days Left Total Profits Offer Made By Offer .
1 $10,000 Union U: $10,000, ($10,000) : 0(0) .
2 $20,000 Management U: $10,000($5,000); M: $10,000($5000) .
3 $30,000 Union U:$20,000($6,667); M: $10,000($3,333) .
4 $40,000 Management U: $20,000($10,000); M: $20,000($10,000) .
. . . .
. . . .
99 $990,000 Union U:$500,000($5,050); M:$490,000($4,950) .
100 $1,000,000 Management U: $500,000($5,000); M: $500,000 ($5,000) .

Using backward induction, with 1 day left in the season the union knows that management will accept any
positive offer (or else it would get zero if it refused), and therefore union offers $10,000 (or a little bit less)
to U and 0 for management. With 2 days left, management knows that is must offer the union at least
$10,000. If it did not, the union would refuse and wait for the next day when it knows it can get $10,000.
So management's offer is U:$10,000 and M: $10,000. With 3 days left, union knows it must offer
management at least $10,000 or else management would refuse the offer and wait until the next round
when it knows it can get $10,000. Thus, with 3 days to go, union offers U: $20,000 and M: $10,000.
Expressed on a per-day basis, the offer with 3 days to go is for $6,667 of the daily profits available to go
to the union and $3,333 of the daily profits to go to management.
And so the explanations continues. Notice that with an even number rounds to go, the offer is for an even
split. If the players are rational, then the best thing to do is to accept the first offer of the 50/50 split.
c. With 1 day left, the argument is the same--the union would be able to get virtually all of the $10,000
remaining profit. But we need to look at the situation with 2 days left. Of the $20,000 up for grabs, the
management would now have to offer the union at least $12,000. Why? Suppose the management only
offered $10,000 as before. The union knows that by rejecting the offer they can earn $2,000 by working
elsewhere that day plus the $10,000 they know they can get on the last day. So they must be offered at
least $12,000. That leaves $8,000 for the management. With 3 days left, the union knows they must offer
the management at least $8000 (since management knows it can get that amount by refusing the union's
offer and waiting for the next round). So the union offers M: $8,000 and U: $22,000. With 4 days to go
management knows that is must offer the union at least $22,000+$2,000= $24,000. Why this amount?
Because the management knows the union can get $22,000 in the next round PLUS $2,000 it could get in
this period by refusing the offer and working elsewhere on that day. So the management's offer is
$24,000 to the union and $16,000 for management.
Days Left Total Profits Offer Made By Offer .
1 $10,000 Union Union: $10,000(10,000) M: 0 .
2 $20,000 Management U: $12,000 (6,000); M: $8,000 (4,000) .
3 $30,000 Union U:$22,000($7,333) ; M: $8,000($2,667) .
4 $40,000 Management U: $24,000($6,000); M: $16,000($4,000) .
.
.
99 $990,000 Union U:$598,000($6.040); M:$392,000 ($3,960) .
100 $1,000,000 Management U: $600,000($6,000); M: $400,000 ($4,000)

A simple rule for this problem for determining the offered division per day (assuming management offers
first and there are an even number of rounds, or if union offers first when there are odd number of rounds):
(Amount available each day)- (payments/day union could be getting elsewhere)= Z, where Z is the amount
to be bargained over.
For even rounds, the amount Z is split 50/50. Thus, since Z = $10,000-$2,000 = $8,000, then it is the case
that with 100 days left, management's offer expressed on a daily basis is union $6,000 and management
$4,000. Offer to the union is $6,000 since the offer to them must be at least $2,000 (due to alternatives
available to labor) plus one-half of the $8,000.
For odd rounds, the union gets [(n+1)/2n] times Z plus its daily wage in alternative employment, and
management gets [(n-1)/2n] times Z.
Example: Given that Z = $10,000-$2,000 = $8,000/day , then with 99 rounds to go, the union offers for
itself [100/198][$8,000/day] + $2,000/day = $6,040/day and for management [98/198][$8000/day] =
$3,960/day. Expressed in totals, we get 99 days times $6,040/day = $598,000 (rounding off) for union.
d. If management had outside opportunities, then the rule is:
(Amount available per day)-(payments/day management could get elsewhere)=X, where X is the amount to
be bargained over.
For even rounds, X is split 50/50. Thus, management gets 0.5X + amount/day could get elsewhere and
union gets 0.5X.
For odd rounds, union gets [(n+1)/2n] times X, and management gets [(n-1)/2n] times X plus its outside
alternatives.
For example, suppose management could get $4,000/day by renting out its premises if it is not using them.,
Assuming 100 days left: X= $10,000-$4,000= $6,000. With an even number of days,this amount would
be split. So management's offer is $3,000+$4,000 = $7,000 for itself and $3,000 for the union. In total
terms, the $1,000,000 available with 100 days left would be $700,000 offer to management and $300,000
offer to union.
With 99 days left: Offer to union is [100/198][$6,000] = $3,030/day
and [98/198][$6,000] + $4,000 = $6,970/day to management.
If both had outside opportunities:
Y = (Amount available per day)-(payments/day in outside oppor. for union)-(payments/day in outside opp.
for management) where Y is the amount to be bargained over.
For even an even number of rounds, Y is split 50/50. So the union's offer is 0.5Y + payments from outside
opportunities. Y = $10,000-$2,000-$4,000 = $4,000 to be bargained over.
Union's offer from management is $2,000+$2,000= $4,000/day. Management's offer to itself is 0.5Y +
payments from outside oppor. =$2,000+$4,000= $6,000/day.
For odd number of rounds--Union gets [n+1/2n][Y] + $2,000 and Management gets [n-1/2n][Y]+ $4,000.
With 99 days to go, Union: [100/198][$4,000] + $2,000 = $4,020/day and management [98/198][$4,000]
+ $4,000= $5,980/day.