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# Chapter 10: Test Bank

## Multiple Choice Questions

1. Consider the following information for a simultaneous move game: If you advertise and
your rival advertises, you each will earn \$5 million in profits. If neither of you advertise, you
will each earn \$10 million in profits. However, if one of you advertises and the other does
not, the firm that advertises will earn \$15 million and the non advertising firm will earn \$1
million. If you and your rival plan to be in business for only one year, the Nash equilibrium is
a) For each firm to advertise.
b) For neither firm to advertise.
d) None of the above.
2. Consider the following information for a simultaneous move game: If you advertise and
your rival advertises, you each will earn \$5 million in profits. If neither of you advertise, you
will each earn \$10 million in profits. However, if one of you advertises and the other does
not, the firm that advertises will earn \$15 million and the non advertising firm will earn \$1
million. If you and your rival plan to be in business for 10 years, then the Nash equilibrium is
a) For each firm to advertise every year.
b) For neither firm to advertise in early years, but to advertise in later years.
c) For each firm to not advertise in any year.
d) For each firm to advertise in early years, but not advertise in later years.
3. Consider the following information for a simultaneous move game: If you advertise and
your rival advertises, you each will earn \$5 million in profits. If neither of you advertise, you
will each earn \$10 million in profits. However, if one of you advertises and the other does
not, the firm that advertises will earn \$15 million and the non advertising firm will earn \$1
"bequest" goes on forever) then a Nash equilibrium when the interest rate is zero is
a) for each firm to not advertise until the rival does, and then to advertise forever.
d) for each firm to advertise until the rival does not advertise, and then not advertise forever.

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4. If you advertise and your rival advertises, you each will earn \$4 million in profits. If
neither of you advertise, you will each earn \$10 million in profits. However, if one of you
advertises and the other does not, the firm that advertises will earn \$1 million and the non
advertising firm will earn \$5 million. If you and your rival plan to be in business for only one
year, the Nash equilibrium is
a) For each firm to advertise.
b) For neither firm to advertise.
d) None of the above.
5. If you advertise and your rival advertises, you each will earn \$4 million in profits. If
neither of you advertise, you will each earn \$10 million in profits. However, if one of you
advertises and the other does not, the firm that advertises will earn \$1 million and the non
advertising firm will earn \$5 million. If you and your rival plan to be in business for 10 years,
then the Nash equilibrium is
a) For each firm to advertise every year.
b) For neither firm to advertise in early years, but to advertise in later years.
c) For each firm to not advertise in any year.
d) For each firm to advertise in early years, but not advertise in later years.
6. If you advertise and your rival advertises, you each will earn \$4 million in profits. If
neither of you advertise, you will each earn \$10 million in profits. However, if one of you
advertises and the other does not, the firm that advertises will earn \$1 million and the non
your children (and this "bequest" goes on forever) then a Nash equilibrium is
a) for each firm to not advertise until the rival does, and then to advertise for ever.
b) for each firm to never advertise.
c) for each firm to always advertise.
d) for each firm to advertise until the rival does not advertise, and then not advertise forever.

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Michael R. Baye

Questions 7, 8, and 9 are based on the following game, where firms one and two must
independently decide whether to charge high or low prices.
Firm Two

Firm One

High Price

Low Price

High Price

(10, 10)

(5, -5)

Low Price

(5, -5)

(0, 0)

7. Which of the following are Nash equilibrium payoffs in the one-shot game?
a) (0, 0)
b) (5, -5)
c) (-5, 5)
d) (10, 10)
8. Which of the following are the Nash equilibrium payoffs (each period) if the game is
repeated 10 times?
a) (0, 0)
b) (5, -5)
c) (-5, 5)
d) (10, 10)
e) none of the above
9. Suppose the game is infinitely repeated. Then the "best" the firms could do in a Nash
equilibrium is to earn
per period.
a) (0, 0)
b) (5, -5)
c) (-5, 5)
d) (10, 10)
e) none of the above

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10. Consider the following entry game. Here, firm B is an existing firm in the market, and
firm A is a potential entrant. Firm A must decide whether to enter the market (play "enter") or
stay out of the market (play "not enter"). If firm A decides to enter the market, firm B must
decide whether to engage in a price war (play "hard"), or not (play "soft"). By playing "hard",
firm B ensures that firm A makes a loss of \$1 million, but firm B only makes \$1 million in
profits. On the other hand, if firm B plays "soft", the new entrant takes half of the market, and
each firm earns profits of \$5 million. If firm A stays out, it earns zero while firm B earns \$10
million. Which of the following are Nash equilibrium strategies?
a) (enter, hard) and (not enter, hard)
b) (enter, soft) and (not enter, soft)
c) (not enter, hard) and (enter, soft)
d) (enter, hard) and (not enter, soft)
11. Consider the following entry game. Here, firm B is an existing firm in the market, and
firm A is a potential entrant. Firm A must decide whether to enter the market (play "enter") or
stay out of the market (play "not enter"). If firm A decides to enter the market, firm B must
decide whether to engage in a price war (play "hard"), or not (play "soft"). By playing "hard",
firm B ensures that firm A makes a loss of \$1 million, but firm B only makes \$1 million in
profits. On the other hand, if firm B plays "soft", the new entrant takes half of the market, and
each firm earns profits of \$5 million. If firm A stays out, it earns zero while firm B earns \$10
million. Which of the following are perfect equilibrium strategies?
a) (enter, soft)
b) (not enter, soft)
c) (enter, hard)
d) (not enter, hard)

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Answer questions 12 -15 based on the following information for a one-shot game:
Firm B

Firm A

Low Price

High Price

Low Price

(2, 2)

(10, -8)

High Price

(-8, 10)

(6, 6)

12. What are dominant strategies for Firm A and Firm B respectively?
a) (low price, high price)
b) (high price, low price)
c) (high price, high price)
d) (low price, low price)
13. What are secure strategies for firm A and firm B respectively?
a) (low price, high price)
b) (high price, low price)
c) (high price, high price)
d) (low price, low price)
14. What are the Nash equilibrium strategies for firm A and B respectively?
a) (low price, high price)
b) (high price, low price)
c) (high price, high price)
d) (low price, low price)
15. If this one-shot game is repeated 100 times, the Nash-equilibrium payoffs of the players
will be ________________ each period.
a) (2, 2)
b) (10, -8)
c) (-8, 10)
d) (6, 6)

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16. Which of the following are important determinants of collusion in pricing games?
a) the number of firms
b) firm size
c) history
d) all of the above
Answer questions 17 - 20 based on the following payoff matrix:
Firm B

Firm A

Low Price

High Price

Low Price

(10, 9)

(15, 8)

High Price

(-10, 7)

(11, 11)

17. What are the secure strategies for Firm A and Firm B respectively?
a) (low price, high price)
b) (high price, low price)
c) (high price, high price)
d) (low price, low price)
18. Which of the following is true?
a) A dominant strategy for Firm A is "high price".
b) There does not exist a dominant strategy for Firm A.
c) A dominant strategy for Firm B is "low price".
d) none of the above
19. What are the Nash equilibrium strategies for Firm A and Firm B respectively in a one-shot
game?
a) (low price, low price)
b) (high price, high price)
c) (low price, high price)
d) a and b

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Michael R. Baye

20. If this one-shot game is repeated three times, the Nash equilibrium payoffs for Firm A and
B will be ______ each period)
a) (10, 9)
b) (11, 11)
c) (-10, 7)
d) (15, 8)
21. Which of the following is true?
a) In a one-shot game, a collusive strategy always represents a Nash equilibrium.
b) A perfect equilibrium occurs when each player is doing the best he can regardless of what
the other player is doing.
c) Each Nash equilibrium is a perfect equilibrium.
d) Every perfect equilibrium is a Nash equilibrium.
e) none of the above
Answer questions 22 - 23 based on the following payoff matrix:
Firm B

Firm A

Low Price

High Price

Low Price

(9, 10)

(8, 15)

High Price

(7, -10)

(11, 11)

## 22. Which of the following is true?

a) A dominant strategy for Firm A is "high price".
b) There does not exist a dominant strategy for Firm A.
c) A dominant strategy for Firm B is low price.
d) none of the above
23. What are the Nash equilibrium strategies for Firm A and Firm B respectively?
a) (low price, low price)
b) (high price, high price)
c) (low price, high price)
d) a. and b.

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## 24. Which of the following is true?

a) In an infinitely repeated game, collusion is always a Nash equilibrium.
b) In a finitely repeated game with a certain end period, collusion is unlikely because effective
punishments cannot be used during any time period.
c) all of the above
d) none of the above
25. Which of the following is true?
a) For a finitely repeated game, the game is played enough times to effectively punish
cheaters and therefore collusion is likely.
b) In an infinitely repeated game with a low interest rate, collusion is unlikely because the
game unravels so that effective punishment cannot be used during any time period.
c) A secure strategy is the optimal strategy for a player no matter what the opponent does.
d) none of the above
26. Which of the following enhances the ability of waste companies to collude?
a) decals on waste receptacles
b) high interest rates
c) differentiated nature of products
d) large number of firms
27. Collusion is:
a) legal in the United States.
b) not possible when firms interact repeatedly forever.
c) more likely in industries with a large number of firms.
d) none of the above.

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Michael R. Baye

## Refer to the following payoff matrix for questions 28 - 30:

Player 2
t1

t2

t3

S1

4, 10

3, 0

1, 3

S2

0, 0

2, 10

10, 3

Player 1
28. The dominant strategy for Player 2 is:
a) t1
b) t1 and t2
c) t3
d) none of the above
29. The dominant strategy for Player 1 is:
a) S1
b) S2
c) S1 and S2
d) none of the above
30. Which of the following strategies constitutes a Nash equilibrium of the game:
a) S1, t1
b) S2, t2
c) S2, t3
d) S1, t2
31. Which of the following conditions are necessary for the existence of a Nash equilibrium?
a) The existence of dominant strategies for both players.
b) The existence of a dominant strategy for one player and the existence of secure strategy for
another player.
c) The existence of secure strategy for both players.
d) none of the above

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## Refer to the following payoff matrix for questions 32 and 33:

Player 2
t1

t2

t3

S1

10, 0

5, 1

4, -200

S2

10, 100

5, 0

0, -100

Player 1
32. The dominant strategy of Player 1 is:
a) S1
b) S2
c) S1 and S2
d) a dominant strategy does not exist.
33. Which of the following pair of strategies constitute a Nash equilibrium of the game?
a) S1, t1
b) S1, t2
c) S2, t1
d) both b and c
34. Based on the following game, what are the secure strategies for Player One and Player
Two?
Player 2
t1

t2

S1

10, 15

15, 8

S2

-10, 7

10, 20

Player 1
a) S1 and t2
b) S1 and t1
c) S2 and t2
d) S2 and t1

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Michael R. Baye

35. Which of the following is true for a Nash equilibrium of a two-player game?
a) The joint payoffs of the two players are highest compared to other strategy pairs.
b) Given another player's strategy stipulated in that Nash equilibrium, a player cannot
improve his welfare by changing his strategy.
c) A Nash equilibrium is always unique in real world problems.
d) b and c
36. Game theory is especially useful for analysis in the following types of markets:
a) perfect competition.
b) monopolistic competition.
c) oligopoly.
d) monopoly.
37. Economists use game theory to predict the behavior of oligopolists. Which of the
following is crucial for the success of the analysis?
a) Make sure the payoffs reflect the true payoffs of the oligopolists.
b) Make sure whether the oligopolists move simultaneously or sequentially.
c) Make sure the problem considered is of a one-shot or repeated nature.
d) All of the above.
Use the following information to answer questions 38 and 39:
Suppose that you are a manager. You are considering whether or not to monitor employees
with the payoffs in the following normal form game.
Worker

Manager

Work

Shirk

Monitor

-1, 1

1, -1

Don't
Monitor

1, -1

-1, 1

## 38. Which of the following pair of strategies constitute a Nash equilibrium?

a) Manager monitors and worker works.
b) Manager does not monitor and worker works.
c) Manager monitors and worker shirks.
d) None of the above.

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## 39. What should the manager do to solve the shirking problem?

a) Always monitor.
b) Never monitor.
c) Sincerely tell workers not to shirk.
d) Engage in "random" spot checks of the work place.
40. Management and a labor union are bargaining over how much of a \$50 surplus to give to
the union. The \$50 is divisible up to one cent. The players have one-shot to reach an
agreement. Management has the ability to announce what it wants first, and then the labor
union can accept or reject the offer. Both players get zero if the total amounts asked for
exceed \$50. Which of the following is true?
a) There are multiple Nash equilibria.
b) (\$25, \$25) is a Nash equilibrium.
c) A Nash equilibrium is also a perfect equilibrium.
d) a and b.
41. Management and a labor union are bargaining over how much of a \$50 surplus to give to
the union. The \$50 is divisible up to one cent. The players have one-shot to reach an
agreement. Management has the ability to announce what it wants first, and then the labor
union can accept or reject the offer. Both players get zero if the total amounts asked for
exceed \$50. Which of the following is not a Nash equilibrium?
a) Management requests \$50 and the labor union accepts \$0.
b) Management requests \$30 and the labor union accepts \$10.
c) Management requests \$25 and the labor union accepts \$25.
d) neither a nor b are Nash equilibria.
42. Management and a labor union are bargaining over how much of a \$50 surplus to give to
the union. The \$50 is divisible up to one cent. The players have one-shot to reach an
agreement. Management has the ability to announce what it wants first, and then the labor
union can accept or reject the offer. Both players get zero if the total amounts asked for
exceed \$50. Which of the following is a perfect equilibrium?
a) Management requests \$49.99, and the labor union accepts \$0.01.
b) Management requests \$25, and the labor union accepts \$25.
c) Management requests \$0, and the labor union accepts \$50.
d) none of the above.

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Michael R. Baye

43. Management and a labor union are bargaining over how much of a \$50 surplus to give to
the union. The \$50 is divisible up to one cent. The players have one-shot to reach an
agreement. Management has the ability to announce what it wants first, and then the labor
union can accept or reject the offer. Both players get zero if the total amounts asked for
exceed \$50. If you were the labor union, which type of "rules of play" would you prefer to
divide the \$50 surplus?
a) one-shot simultaneous-move game.
b) one-shot sequential-move game with management as the first mover.
c) one-shot sequential-move game with labor union as the first mover.
d) a and b.
44. Which of the following is true?
a) A Nash equilibrium is always perfect.
b) A perfect equilibrium is always Nash.
c) A Nash equilibrium is always perfect in a multistage game.
d) Perfect equilibrium and Nash equilibrium are the same concept but with different names.
Refer to the following normal form game of price competition for questions 45 - 47.
Firm B
Low Price

High Price

Low Price

0, 0

50, -10

High Price

-10, 50

20, 20

Firm A
45. Suppose the game is infinitely repeated, and the interest rate is 10%. Both firms agree to
charge a high price, provided no player has charged in low price in the past. If both firms stick
to this agreement, then the present value of Firm A's payoffs are:
a) 220.
b) 110.
c) 330.
d) 550.

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46. Suppose that Firm A deviates from a trigger strategy to support a high price. What is the
present value of A's payoff from cheating?
a) 70.
b) 50.
c) 30.
d) 20.
47. What is the maximum interest rate that can sustain collusion?
a) 30%.
b) 15%.
c) 66.7%.
d) 20%.
48. It is easier to sustain tacit collusion in an infinitely repeated game if:
a) the present value of cheating is higher.
b) there are more players in the game.
c) the interest rate is lower.
d) both a and c.
49. When a worker announces that he plans to quit, say next month, the "threat" of being
fired has no bite. The worker may find it in his interest to shirk. What can the manager do to
overcome this problem?
a) "Fire" the worker as soon as he announces his plans to quit.
b) Provide the worker some rewards for good work that extend beyond the termination of
c) Monitor the worker more frequently than usual and fire him when he is caught shirking.
d) Pay the worker some rewards when he announces his plan to quit.
50. A finitely repeated game differs from an infinitely repeated game in that:
a) The former needs a lower interest rate to support collusion than the latter needs.
b) There is an "end-of-period" problem for the former.
c) A collusive outcome can usually be sustained in the former but not the latter.
d) All of the above.
51. Which of the following is a factor(s) affecting collusion in an infinitely repeated pricing
game?
a) number of firms.
b) firm size.
c) history.
d) all of the above.
52. A coordination problem arises whenever:
a) there is no Nash equilibrium in a game.
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Michael R. Baye

## b) there is a unique Nash equilibrium but it is not very desirable.

c) there are multiple Nash equilibria.
d) there are no dominant strategies for both players.
53. Which of the following is the major means to signal good quality of goods by firms?
a) sales.
c) warranties/guarantees.
d) both a and b.
54. Which of the following is not true?
a) An extensive form representation usually provides more information than a normal form
representation of a game.
b) A normal form game is most useful for sequential-move games.
c) The notion of perfect equilibrium is more useful in analyzing extensive form games than
normal form games.
d) The notion of credible threats makes more sense in extensive form representations than in
normal form representations of a game.
55. A Nash equilibrium with a non-credible threat as a component is:
a) a perfect equilibrium.
b) not a perfect equilibrium.
c) a sequential equilibrium.
d) a somewhat perfect equilibrium.
57. Which of the following is a valid critique of the use of game theory in economics?
a) Payoffs to players may be difficult to measure.
b) Players may not have complete information about each other's payoffs.
c) Game theory assumes rational players.
d) All of the above.

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## Use the following information to answer questions 58 - 60:

There are two existing firms in the market for computer chips. Firm A knows how to reduce
the production costs for the chip and is considering whether to adopt the innovation or not.
Innovation incurs a fixed set-up cost of C, while increasing the revenue. However, once the
new technology is adopted, another firm, B, can adopt it with a smaller set-up cost of C/2. If
A innovates and B does not, A earns \$20 in revenue while B earns \$0. If A innovates and B
does likewise, both firms earn \$15 in revenue. If neither firm innovates, both earn \$5.
58. Under what condition will Firm B have an incentive to adopt if Firm A adopts the
innovation?
a) C > 30.
b) C < 30.
c) 10 > C > 0.
d) 35 > C > 25.
59. Under what condition will Firm A innovate?
a) C > 30.
b) C < 30.
c) 10 > C > 0.
d) 35 > C > 25.
60. If C = 15, which is the perfect equilibrium of the game?
a) A innovates, B does not.
b) A innovates, B innovates.
c) Neither firm innovates.
d) None of the above.
61. Game theory suggests that, in the absence of patents, the privately motivated innovation
decisions of firms might lead to:
a) too little innovation.
b) too much innovation.
c) the socially efficient level of innovation.
d) none of the above.

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Michael R. Baye

62. If you advertise and your rival advertises, you each will earn \$5 million in profits. If
neither of you advertise, you will each earn \$10 million in profits. However, if one of you
advertises and the other does not, the firm that advertises will earn \$15 million and the non
advertising firm will earn \$1 million. Which of the following is true?
a) A dominant strategy for Firm A is to advertise.
b) A dominant strategy for Firm B is to advertise.
c) A Nash equilibrium is for both firms to advertise.
d) All of the above are true.
63. If you advertise and your rival advertises, you each will earn \$5 million in profits. If
neither of you advertise, you will each earn \$10 million in profits. However, if one of you
advertises and the other does not, the firm that advertises will earn \$15 million and the non
advertising firm will earn \$1 million. Which of the following is true?
a) A secure strategy for Firm A is to not advertise.
b) A secure strategy for Firm B is to not advertise.
c) Firm A does not have a secure strategy.
d) None of the above are true.
64. If you advertise and your rival advertises, you each will earn \$5 million in profits. If
neither of you advertise, you will each earn \$10 million in profits. However, if one of you
advertises and the other does not, the firm that advertises will earn \$15 million and the non
advertising firm will earn \$1 million. Suppose this game is repeated for a finite number of
times, but the players do not know the exact date at which the game will end. The players can
earn collusive profits as a Nash equilibrium to the repeated play of the game if the probability
the game terminates in any period is
a) 1.
b) greater than one.
c) close to zero.
d) none of the above.
65. If you advertise and your rival advertises, you each will earn \$4 million in profits. If
neither of you advertise, you will each earn \$10 million in profits. However, if one of you
advertises and the other does not, the firm that advertises will earn \$1 million and the non
advertising firm will earn \$5 million.
Which of the following is true?
a) A dominant strategy for Firm A is to advertise.
b) A dominant strategy for Firm B is to advertise.
c) A Nash equilibrium is for both firms to advertise.
d) None of the above are true.

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66. If you advertise and your rival advertises, you each will earn \$4 million in profits. If
neither of you advertise, you will each earn \$10 million in profits. However, if one of you
advertises and the other does not, the firm that advertises will earn \$1 million and the non
advertising firm will earn \$5 million.
Which of the following is true?
a) A secure strategy for Firm A is to not advertise.
b) A secure strategy for Firm B is to advertise.
c) Firm A does not have a secure strategy.
d) None of the above are true.
67. If you advertise and your rival advertises, you each will earn \$4 million in profits. If
neither of you advertise, you will each earn \$10 million in profits. However, if one of you
advertises and the other does not, the firm that advertises will earn \$1 million and the non
advertising firm will earn \$5 million. Suppose this game is repeated for a finite number of
times, but the players do not know the exact date at which the game will end. The players can
earn profits of \$10 each period as a Nash equilibrium to a repeated play of the game if the
probability the game terminates at the end of any period is
a) close to 1.
b) close to 0.
c) between zero and one.
d) all of the above.
Questions 68, 69, and 70 are based on the following game, where firms one and two must
independently decide whether to charge high or low prices.
Firm Two

Firm One

High Price

Low Price

High Price

(10, 10)

(5, -5)

Low Price

(-5, 5)

(0, 0)

68. Which of the following are secure strategies for players one and two, respectively?
a) (High Price, High Price).
b) (High Price, Low Price).
c) (Low Price, High Price).
d) (Low Price, Low Price).

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69. If player one charges a High Price when player two charges a Low Price, then player two
earns:
a) 10.
b) 5.
c) -5.
d) 0.
70. A dominant strategy for firm one is
a) high price.
b) low price.
c) different from firm one's secure strategy.
d) b and c.
71. Consider the following innovation game. Firm A must decide whether or not to introduce
a new product. Firm B must decide whether or not to clone firm A's product. If firm A
introduces and B clones, then firm A earns \$1 and B earns \$10. If A introduces and B does
not clone, then A earns \$10 and B earns \$2. If firm A does not introduce, both firms earn
profits of 0. Which of the following is true.
a) The subgame perfect Nash equilibrium profits are (\$10,2).
b) It is not in A's interest to introduce.
c) Firm A does not care if B clones.
d) None of the above are true.
72. Consider the following innovation game. Firm A must decide whether or not to introduce
a new product. Firm B must decide whether or not to clone firm A's product. If firm A
introduces and B clones, then firm A earns \$1 and B earns \$10. If A introduces and B does
not clone, then A earns \$10 and B earns \$2. If firm A does not introduce, both firms earn
profits of 0. How many Nash equilibria are there for this game.
a) 0.
b) 1.
c) 2.
d) 0, but there are secure strategies.

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## Answer questions 73 - 75 based on the following information for a one-shot game:

Firm B

Firm A
`

Low Price

High Price

Low Price

(2, 2)

(10, -8)

High Price

(-8, 10)

(15, 15)

73. What are the dominant strategies for Firm A and Firm B respectively?
a) (low price, high price).
b) (high price, low price).
c) (high price, high price).
d) neither firm has a dominant strategy.
74. What are secure strategies for firm A and firm B respectively?
a) (low price, low price).
b) (high price, low price).
c) (high price, high price).
d) neither firm has a secure strategy.
75. What are the Nash equilibrium strategies for this game?
a) (low price, low price).
b) (high price, high price).
c) a and b.
d) none of the above.
For questions 76-78, consider the following information for a simultaneous move game: If
you advertise and your rival advertises, you each will earn \$3 million in profits. If neither of
you advertise, you will each earn \$7 million in profits. However, if one of you advertises and
the other does not, the firm that advertises will earn \$10 million and the non advertising firm
will earn \$1 million.
76. If you and your rival plan to be in business for only one year, the Nash equilibrium is for

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Michael R. Baye

77. If you and your rival plan to be in business for 15 years, then the Nash equilibrium is for
c) neither firm to advertise in early years, but to advertise in later years.
d) each firm to advertise in early years, but not advertise in later years.
goes on forever, then a Nash equilibrium when the interest rate is zero is for
sufficiently large.
c) each firm to not advertise until the rival does, and then to advertise forever provided the
interest rate is sufficiently low.
79. Which of the following is a correct statement about a Nash equilibrium in a two-player
game?
a) The joint payoffs of the two players are highest compared to other strategy pairs.
b) A Nash equilibrium is always unique in real world problems.
c) Given another player's strategy, no player can improve her welfare by unilaterally changing
her strategy.
d) All of the above.
80. Game theory is best applied to analysis of
a) perfect competition.
b) oligopoly.
c) monopoly.
d) All of the above.
81. When analyzing the behavior of oligopolists, which of the following is crucial for the
success of game theoretic analysis?
a) Payoffs do not need to reflect the true payoffs of the oligopolists, they just need to be
greater than or equal to zero.
b) Assume that oligopolists always move simultaneously.
c) Do not construct the payoffs of the oligopolists to be interdependent, as the payoff of one
player usually does not affect the payoff of the other players.
d) Make sure the problem you are considering is of a one-shot or repeated nature, and you
model it accordingly because the order in which players make decisions is important.

## Managerial Economics and Business Strategy, 5e

Page 21

82. Management and a labor union are bargaining over how much of a \$50 surplus to give to
the union. The \$50 is divisible up to one cent. The players have one-shot to reach an
agreement. Management has the ability to announce what it wants first, and then the labor
union can accept or reject the offer. Both players get zero if the total amounts asked for
exceed \$50. Which of the following is a Nash equilibrium?
a) Management requests \$50 and the labor union accepts \$0.
b) Management requests \$35 and the labor union accepts \$10.
c) Management requests \$20 and the labor union accepts \$20.
d) Management requests \$25 and the labor union accepts \$10.
83. Which of the following is a correct statement?
a) A Nash equilibrium is always perfect.
b) A perfect equilibrium is always Nash.
c) A Nash equilibrium is always perfect in a multistage game.
d) None of the above.
84. It is easier to sustain tacit collusion in an infinitely repeated game if
a) the present value of cheating is lower than collusion.
b) there are many players.
c) the interest rate is higher.
d) both a and c.
85. Firms will try to signal superior quality of their goods by
a) making sales information available to the public.
c) issuing warranties or guarantees.
d) both a and b.
86. A coordination problem usually occurs in situations where there is
a) no Nash equilibrium in a game.
b) a unique, but undesirable Nash equilibrium.
c) a unique secure strategies for both players.
d) more than one Nash equilibrium.
87. Which of the following is not an important determinant of collusion in pricing games?
a) the number of firms in the industry.
b) the punishment mechanisms that are in place.
c) the history of the particular market.
d) None of the above.

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Michael R. Baye

Refer to the following normal form game of price competition for questions 88 - 90.
Firm B
Low Price

High Price

Low Price

0, 0

25, -5

High Price

-5, 25

10, 10

Firm A

88. Suppose the game is infinitely repeated, and the interest rate is 5%. Both firms agree to
charge a high price, provided no player has charged in low price in the past. If both firms stick
to this agreement, then the present value of Firm B's payoffs are:
a) 105
b) 190
c) 210
d) 525
89. Suppose that Firm A deviates from a trigger strategy to support a high price. What is the
present value of A's payoff from cheating?
a) 5
b) 20
c) 25
d) 35
90. What is the maximum interest rate that can sustain collusion?
a) 66.7%
b) 33%
c) 25%
d) 15%

Page 23

## Technical Questions and Problems

1.

million in profits. If neither of you advertise, your rival will make \$4 million and you
will make \$2 million. If you advertise and your rival does not, you will make \$10
million and your rival will make \$3 million. If your rival advertises and you do not, you
will make \$1 million and your rival will make \$3 million.
a. Write the above game in normal form.
b. Do you have a dominant strategy?
c. Does your rival have a dominant strategy?
d. What is the Nash equilibrium for the one-shot game?
e. How much would you be willing to bribe your rival not to advertise?
a.

You

Do Not

Do Not

(5, 5)

(10, 3)

(1, 3)

(2, 4)

c. Your rival does not have a dominant strategy.
also.
e. You are willing to bribe your rival not to advertise by an amount up to \$5 million.
This is because when you bribe your rival by an amount less than \$5 million and if
your rival really cooperates, then you can get \$10 million gross profit. Subtracting
the bribe, you still get an amount of net profit greater than what you otherwise get
by not bribing. Of course, this ignores legal considerations as well as the problem
of ensuring that your rival does not cheat on the collusive agreement.

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Michael R. Baye

2.

You operate in a duopoly in which you and a rival must simultaneously decide what
price to advertise in the weekly newspaper. If you each charge a low price, you each
earn zero profits. If you each charge a high price, you each earn profits of \$3. If you
charge different prices, the one charging the higher price loses \$5 and the one charging
the lower price makes \$5.
a. Find the Nash equilibrium for a one-shot version of this game.
b. Now suppose the game is infinitely repeated. If the interest rate is 10 percent, can
you do better than you could in a one-shot play of the game? Explain.
c. Explain how history affects the ability of firms in this game to achieve an
outcome superior to that of the one-shot version of the game.
a. Both players charging low prices is a unique Nash equilibrium for a one-shot
version of the game.
Low Price

High Price

Low Price

(0, 0)

(5, -5)

High Price

(-5, 5)

(3, 3)

You

## b. The cooperative (collusive) outcome can be sustained in the infinitely repeated

game with the following trigger strategy: Cooperate provided no player has ever
cheated in the past. If any player cheats, "punish" the player by choosing the oneshot Nash equilibrium strategy forever after. In particular, for this game we know
Cheat Coop 5 3

1 Coop
1

N 3 0 30.
i
.1

The left-hand side of this equation represents the one-time gain of breaking the
collusive agreement today. The right-hand-side represents the present value of
what is given up in the future by cheating today. Since the one-time gain is less
than the present value of what would be given up by cheating, players find it in
their interest to live up to the agreement.
c. By definition, a trigger strategy stipulates that each player uses the history of what
its rival did to decide whether it should cooperate or not. Hence, whenever one
player cheats last period, the rival of it should choose not to cooperate. In other
words, history is very important.

## Managerial Economics and Business Strategy, 5e

Page 25

3.

You are considering entering a market serviced by a monopolist. You currently earn \$0
economic profits, while the monopolist earns \$5. If you enter the market and the
monopolist engages in a price war, you will lose \$5 and the monopolist will earn \$1. If
the monopolist doesnt engage in a price war, you will each earn profits of \$2.
a. Write out the extensive form of the above game.
b. There are two Nash equilibria for the game. What are they?
c. Is there a subgame perfect equilibrium? Explain.
d. If you were the potential entrant, would you enter? Explain why or why not.
a. The extensive form is presented in Figure 10-3 below.

PRICE WAR

(-5, 1)

INCUMBENT
ENTER
(2, 2)
NO PRICE WAR
YOU
DONT ENTER
(0, 5)

Figure 10-3
b. One Nash equilibrium is that you stay out; your rival engages a price war should
you enter. Another Nash equilibrium is that you enter; your rival does not engage
a price war if you enter.
c. The second one is a perfect equilibrium, while the first one is not. This is because
if you enter, the incumbent can get \$2 profits by not engaging a price war, which is
greater than \$1 profits otherwise obtained by engaging a price war. The threat to
engage in a price war is not credible.
d. If you were the potential entrant, you should enter. You get \$2 profits by entering,
which is greater than the zero you earn by not entering.

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Michael R. Baye

4.

OPEC was an effective cartel for many years, but recently it has been unable to
maintain a high price of oil. What factors do you think are contributing to the demise
of OPEC?
At least three factors account for the demise of OPEC. First, it is difficult for
members to verify whether other countries are in fact living up to the collusive
agreements. Secondly, as reserves of smaller countries diminish, the penalty to
cheating members has been becoming increasingly ineffective and not large enough to
deter cheating. Finally, several OPEC members have recently engaged in armed
conflict, which has decreased the present value of future earnings derived from
colluding. That is, a country that loses a war loses the future value of would-be
collusive profits; to the victor go the spoils.

5.

The NCAA prohibits schools that are caught paying athletes from participating in bowl
games, and sometimes the punishment is even more severe. Explain why schools dont
break away from the NCAA and form a league in which athletes can legitimately be
paid. (Hint: Use hypothetical payoffs to construct an illustrative normal-form game in
which the strategies are pay players and dont pay players. Then analyze the game
in one-shot and infinitely repeated contexts.)
Pay Athletes
School
A

School B
Dont Pay Athletes

Pay Athletes

(0, 0)

(10, -10)

Dont Pay
Athletes

(-10, 10)

(7, 7)

The above hypothetical pay-off matrix shows that, in a one-shot game, each school has
an incentive to pay athletes, in an attempt to obtain the best athletes and be assured of
bowl revenues. But when all schools do this, athletes extract virtually all of the
profits, and the schools are left with nothing. If schools "collude" and agree not to pay
athletes, each school earns higher profits, since less money goes to the athletes. In an
infinitely repeated game, the schools threaten to punish those who pay athletes by
precluding them from participating in bowl games long enough to wipe out any gains
to cheating. This can support the equilibrium where schools do better than they would
by forming an independent league that permitted college athletes to be paid larger
sums.

## Managerial Economics and Business Strategy, 5e

Page 27

6.

Based on your knowledge of one-shot and repeated games, would you expect tipping
behavior to differ depending on whether a person is eating in a hometown diner or in a
restaurant located in Timbuktu? Explain.
Eating at the local diner is a repeated game: there is a high probability that the waiter
at the local diner will serve you again and thus can "punish" you next time (by
providing less service) if you don't tip today. In contrast, in Timbuktu, you play a oneshot game and have a reduced incentive to tip.

7.

According to a spokesperson for cereal maker Kellogg, for the past several years,
our individual company growth has come out of the other fellows hide.1
a. What implications does this statement have for the level of advertising in the cereal
industry?
b. Using the following hypothetical payoff matrix, explain how trigger strategies can
be used to support the collusive level of advertising in an infinitely repeated game.
For what values of the interest can collusion be sustained?
Firm B
4, 4
1, 20

Strategy

20, 1
10, 10

a. The news implies that advertising increases the demand for a firm's product by
taking customers away from other firms in the industry. The end result in a oneshot game is that cereal firms spend money on advertising, with no real change in
their demand.
b. The cooperative (collusive) outcome can be sustained in the infinitely repeated
game with the following trigger strategy: Don't advertise provided no player has
ever cheated in the past. If any player cheats, "punish" the player by advertising
forever after. In particular, there is no incentive to cheat on this agreement if
Cheat Coop 20 10

1 Coop
1
6

N 10 4 .
i
i
i

Solving this for i, we see that for any interest rate less than or equal to 60 percent,
there is no incentive to cheat.

1 See F.F. Scherer, The Welfare Economics of Product Variety: An Application to the Ready-to-Eat Cereals
Industry, Journal of Industrial Economics (December 1979).

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Michael R. Baye

8.

You are the manager of a firm that is bargaining with another firm over how much to
pay for a key input your firm uses in production. Which type of bargaining would be
"better from your firms point of view, simultaneous-move bargaining or take-it-overleave-it bargaining? Explain carefully.
Sequential, take-it or leave-it bargaining is preferable for the manager if she has the
first move advantage. This is because any proposal leaving a positive amount of
money to labor will be acceptable to the other firm under this setting.

9.

You are the manager of the ABC novelty store, and your only competitor is the XYZ
novelty store. You are both trying to decide on which magic tricks and party favors to
carry in stock. The product mixes available to both of you are low, medium, and high
in variety. Your expected earnings in this market are shown in the following table.
Strategy
Low
Firm ABC
Medium
High

Firm XYZ
Low
Medium
100,100
150, 200
200, 75
125, 150
300, 200 100, 225

High
200, 300
225, 195
150, 250

a. Find the Nash equilibrium (or equilibria) for a simultaneous-move, one-shot play of
this game.
b. What outcome would you expect in this one-shot game? Why?
a. The only Nash equilibrium is that Firm ABC chooses medium while Firm XYZ
chooses high.
b. In a one-shot game, we expect the two firms to choose medium (Firm ABC) and
high (Firm XYZ) to obtain 225 and 195 units of profit, respectively.
10.

You are the owner-operator of the Better Gas Station in a small southeastern town.
Over the past 20 years, you and your rival have successfully kept prices at a very high
level. You recently learned that your competitor is retiring and closing his station in
two weeks. What should you do today? Why?
You'd better lower your price today; the game is now a finitely repeated game with a
known end point, and collusion will no longer be sustainable with trigger strategies.

## Managerial Economics and Business Strategy, 5e

Page 29

11.

You are the manager of Copies Are Us. The only other copy store in town, the Carbon
Copy, recently got bids on adding a color copier. You must decide whether to obtain a
color copier, but you can base decision on what your rival does. If your rival adds a
color copier and you dont, you expect your profits to fall by \$1,000 per week and its
profits to rise by \$1,500 per week. Conversely, if you add the color copier and your
rival does not, your profits will increase by \$1,500 per week and your rivals profits
will fall by \$1,000 per week. However, if you both do the same thing (add color copies
or not), you each expect profits to stay at their current level. Show the extensive form
of this game, and find the Nash equilibrium (or equilibria). Is there a subgame perfect
equilibrium?
The extensive form game is shown in Figure 10-11. The subgame perfect Nash
equilibrium is for both of you to add color copiers, to earn zero profits.

(0, 0)
You

(1500, -1000)

Carbon Copy
(-1000, 1500)

You

(0, 0)

Figure 10-11

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Michael R. Baye

12.

You are the bargaining coordinator for Sun Car Manufacturers. At present you are
renegotiating the labor contract with the union representative. You are bargaining over
an expected 20 percent increase in earnings over the next three-year contract period.
You are trying to decide whether to offer one-third, one-half, or all of the increase in
earnings to the union. The union rules are such that all contracts must be voted on.
The additional earnings are contingent on getting started on the new contract next
week. If an agreement isnt reached on the first round of negotiations, the firm will go
out of business. The union representative tells you that if you do not give the union all
of the additional profits, the union members will not vote for the agreement.
a. Show the extensive form of this game.
b. What will you offer the union? Why?
a. See Figure 10-12.
Union

Yes

(13.3%, 6.7%)

No

(0, 0)

Yes

(10%, 10%)

No

(0, 0)

Yes

(0, 20%)

No

(0, 0)

33%
You

Union
50%
100%
Union

Figure 10-12
b. The bargaining coordinator should offer 33% of the increase to the union. The
union claims it will vote no if you do so, but by doing so, the firm will go bankrupt
and the members will lose their jobs. Obviously, a 6.7 percent pay hike is
preferable for the union; the Union's threat is not credible.

## Managerial Economics and Business Strategy, 5e

Page 31

13.

Would collusion be more likely in the shoe industry or in the airline industry? Why?
The airline industry seems to be more likely to have collusion than the shoe industry
because the former is more concentrated, sells more homogeneous products, has good
records of customers, and has an easier opportunity to observe and punish cheaters.

14.

According to various trade publications, over 200,000 changes are made in airfares
each day. Why do you think this is the case?
By randomizing prices it makes price shopping more costly to consumers, and reduces
the ability of rivals to systematically undercut their fares.

15.

Two executives were arrested by authorities for embezzling money from their firm.
Short of a confession, the prosecutor only had enough evidence to put them away for
10 years. Given a confession, however, she was certain to put them behind bars for life
without parole, since they killed a law enforcement officer who was investigating the
case. The prosecutor put the two prisoners in separate rooms, and told them the
following: If you confess and your partner does not, Ill give you a years probated
sentence but put your partner in the slammer for life without parole. Of course, if your
partner confesses and you dont, youll get the life sentence without parole and hell
get one years probation. I must warn you, however, that if you both confess Ill have
enough evidence to put you both away for life without parole.
a. Do you think the prosecutors bargain will induce the two executives to confess?
Explain.
b. Would your answer change if the life sentence carried the possibility of parole?
Explain.
a. Yes. Given no parole, this is a one-shot game and the dominant strategy for each
executive is to confess. Notice that both end up with life sentences without parole.
b. It might. If parole is a possibility, then the game is not a one shot game but a
finitely repeated game with an uncertain end-point (the parole date). In this case,
the executives might be able to successfully "collude" by not confessing -provided that each executive fears that his own confession will result in a
sufficiently harsh punishment if the other executive gets paroled.

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Michael R. Baye

16.

In the early 1990s, there was considerable uncertainty in the computer industry about
whether the dominant operating system for future personal computers would be IBMs
OS/2 or Microsofts Windows. Ultimately, Windows emerged as the dominant system
despite the fact that several trade publications viewed OS/2 as the superior system.
Why do you think this outcome prevailed?
The problem of selecting an operating system can be thought of as a coordination
game, in which it is often difficult to achieve a Nash equilibrium. Consider, for
example, the decision by personal computer users to use Microsoft's Windows
operating system or IBM's OS/2. If all other users decided to use Windows, then your
best choice would also be to use Windows, even if you personally like the OS/2
environment. This is because there would be a much greater selection of software
available if you used the same system that everyone else uses. On the other hand, if all
other users decided to use OS/2, then your best choice would be to use OS/2, even if
you personally like the Windows environment. Again, the reason is that you would
have a much better selection of software if you use the system everyone else is using.
One reason Windows ultimately prevailed is that consumers perceived that everyone
else was opting for Windows.

## Managerial Economics and Business Strategy, 5e

Page 33

17.

You are the manager of XYZ Inc. and must decide how much output to produce to
maximize your firms profit. XYZ and its rival, ABC Corp., produce a good that
consumers view as essentially identical. These two firms make up the entire industry,
so the market price for the good depends on the total amount produced by the two
firms. A survey reveals that the market price of the product depends on total market
output as follows:
Combined Output of XYZ and ABC
200 units
300 units
400 units

Product Price
\$6
\$5
\$4

XYZ and ABC each use labor, materials, and machines to produce output. XYZ
purchases labor and materials on an as-needed basis; their machines were purchased
three years ago and are being depreciated according to the straight-line method.
XYZs accounting department has provided the following data about its unit
production costs:
Item
Direct labor
Direct materials
Depreciation charge

## XYZs Unit Cost for an Output of:

100 units
200 units
\$2
\$2
\$3
\$3
\$2
\$1

Reports from industry experts suggest that ABCs cost structure is similar to XYZs
cost structure and that technological constraints require each firm to produce either
100 units or 200 units of output.
a. Briefly explain which costs are relevant for your decision, and why.
b. Write this game in normal form.
c. How many units should XYZ produce: 100 units or 200 units?
a. Direct labor and direct materials, since they are variable costs. Depreciation is a
fixed (or sunk) cost, and is therefore irrelevant to the decision (the firm's fixed
costs are \$200, since \$200/100 = \$2 \$200/200 = \$1. These later numbers are the
ones reported in the table).
b. The payoff matrix (normal form) below shows the relevant contributions to overall
profits (the sunk costs are irrelevant, remember!) for alternative levels of output by
the two firms. The key is to note that if each firm produces 100 units, total market
output is 200 units and the price is \$6. XYZ's contributions in this case are (\$6 \$5) x 100 = \$100. If one firm produces 100 units and the other firm produces 200
units, the market price is \$5. In this case, each firms contributions are zero (the
price equals relevant unit costs of \$5). If both firms produce 200 units, the market
price is \$4, and the contributions of each firm are (\$4 - 5) x 200 = \$ - 200.
ABC
XYZ Strategy
100 Units
200 Units
Page 34

100 Units
(\$100, \$100)
(\$0, \$0)

200 Units
(\$0, \$0)
(-\$200, -\$200)
Michael R. Baye

c. The dominant strategy for XYZ is to produce 100 units -- regardless of what ABC
does, XYZ is better off producing 100 units. Importantly, this is true regardless of
whether the game is simultaneous move or sequential move. The same is true for
ABC. Thus, if XYZ plays its dominant strategy it will contribute \$100 towards it's
fixed costs of \$200. Any other strategy leads to lower contributions and even
greater losses.
18.

Two firms produce identical products at zero cost, and they compete by setting prices.
If each firm charges a low price, the both firms earn profits of zero. If each firm
charges a high price, then each firm earns profits of \$30. if one firm charges a high
price and the other firm charges a low price, the firm that charges the lowest price
earns profits of \$50 and the firm charging the highest price earns profits of zero.
a. Which oligopoly model best describes this situation?
b. Write this game in normal form.
c. Suppose the game is infinitely repeated. Can the players sustain the collusive
outcome as a Nash equilibrium if the interest rate if 50 percent? Explain.
a. The Bertrand model (Cournot and Stackelberg are models of quantity competition,
and Sweezy assumes differentiated products).
b.

Firm 1

Strategy
Low Price
High Price

Firm 2
Low Price
(0, 0)
(0, 50)

High Price
(50, 0)
(30, 30)

## c. If it is possible to monitor the actions of rivals (and ignoring antitrust

considerations), the collusive outcome can be sustained in the infinitely repeated
game with the following trigger strategy: Charge a high price provided no player
has ever charged a low price. If any player charges a low price, punish the player
by charging a low price forever after. There is no incentive to cheat on this
301 0.5
50 90 .
agreement since 50
0.5

## Managerial Economics and Business Strategy, 5e

Page 35

19.

Suppose the market for computer chips is dominated by two firms: Intel and AMD.
Intel has discovered how to make superior chips and is considering whether or not to
adopt the new technology. Adoption would entail a fixed setup cost of C but would
increase revenues. However, if Intel adopts the new technology, AMD can easily copy
it at a lower setup cost of C/2. If Intel adopts and AMD does not, Intel would earn
\$20 in revenues while AMD would earn \$0. If Intel adopts and AMD does likewise,
each firm will earn \$15 in revenues. If Intel does not adopt the new technology, it will
earn \$5 and AMD will earn \$2.
a. Write this game in extensive form.
b. Under what conditions (i.e., for what values of C) does AMD have an incentive to
adopt the new technology if Intel introduces it?
c. If C = 12, should Intel adopt the new technology? Explain.
a.

AMD

(15 - C, 15 C/2)

(20 - C, 0)

Intel

(5, 2)

Figure 10-19
b. AMDs payoff from adopting must exceed its payoff from not adopting. This is
true if 15 C/2 > 0. Solving for C we find that AMD has an incentive to adopt if
Intel adopts whenever C < 30.
c. No. When C = 12, AMDs best strategy is to adopt if Intel Adopts, which means
Intel would earn only 3 by adopting. By not adopting, Intel can earn a payoff of 5;
Intels best option is not to adopt. This is the only Nash equilibrium, and it is also a
subgame perfect Nash equilibrium.

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Michael R. Baye

20.

Suppose Philips and Toshiba are the first companies to introduce digital versatile disk
(DVD) machines to the market. Studies by the firms suggest that consumers who
purchase consumer electronics are very brand-loyal. To capture future loyalties, each
firm will attempt to maximize its initial market share, for one time only, by setting
prices. An economist has estimated the initial market share of each firm under different
pricing scenarios. Her results are captured in the following payoff matrix.

Philips

Strategy
P = \$250
P = \$500
P = \$1,000

Toshiba
P = \$250
P = \$500
60%, 40% 75%, 25%
25%, 75% 90%, 10%
5%, 95%
25%, 75%

P = \$1,000
95%, 5%
75%, 25%
70%, 30%

a. Given this scenario, if you were in charge of pricing at Philips, what price would
you charge? Explain.
b. What market share would you anticipate as a result of your pricing strategy?
Explain.