214ECN Managerial Economics

Seminar 3

1. Firms E and F are duopolists. They each have two possible strategies for product
development. The payoff matrix is as follows:

Possible strategies for firm F

Possible strategies for E A B
1 $5 million, $6 million $4 million, $5 million
2 $6 million, $5 million $5 million, $4 million

a. What is Firm E’s optimal strategy?

b. What is firm F’s optimal strategy?
c. Is this an example of the prisoner’s dilemma?
d. Is there a dominant strategy for firm E? Explain
e. Is there a dominant strategy for firm F? Explain

2. While there is a degree of differentiation among general merchandise retailers like

Target and Kmart, weekly newspaper circulars announcing sales provide evidence
that these firms engage in price competition. This suggests that Target and Kmart
simultaneously choose to announce one of two prices for a given product: a regular
price or sale price. Suppose that when one firm announces the sale price and the
other announces the regular price for a particular product, the firm announcing the
sale price attracts 50 million extra customers to earn a profit of $5 billion, compared
to the $3 billion earned by the firm announcing the regular price. When both firms
announce the sale price, the two firms split the market equally (each getting an extra
25 million customers) to earn profits of $1 billion each. When both firms announce
the regular price, each company attracts only its 50 million loyal customers and the
firms each earn $3 billion in profits. If you were in charge of pricing at one of these
firms, would you have a clear-cut pricing strategy? If so, explain why. If not, explain
why not and propose a mechanism that might solve your dilemma. (Hint: unlike Wal-
mart, neither of these two firms guarantees “Everyday low Prices”)

3. Suppose Toyota and Honda must decide whether to make a new breed of side-
impact airbags standard equipment on all models. Side-impact airbags raise the price
of each automobile by $500. If both firms make side-impact airbags standard
equipment, each company will earn profits of $1.5 billion. If neither company adopts

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the side-impact airbag technology, each company will earn $0.5 billion (due to lost
sales to other automakers) If one company adopts the technology as standard
equipment and the other does not, the adopting company will earn a profit of $2
billion and the other company will lose $1 billion . If you were decision makers at
Honda, would you make side impact airbags standard equipment? Explain.

4. 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 isn't 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?

5. 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.

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6. You are the manager of XYZ Inc. and must decide how much output to produce to
maximize your firm's 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:

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. XYZ's accounting department has provided the following data about its unit
production costs:

Reports from industry experts suggest that ABC's cost structure is similar to XYZ's
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?

7. Indentify the key features of game thoery and evaluate its contribution to our
understanding of business decisions.

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8. Use the following extensive-form game to answer the questions below.
a. List the feasible strategies of player 1 and player 2.
b. Identify the Nash equilibria to this game.
c. Find the subgame perfect equilibrium.

W 60, 120

A 2
X 50, 50
1

B W 0, 0
2

X
100, 150