Running head: QCT51
Questions for Critical Thinking 5
Holly S Sutton
Liberty University
QCT5 2
Questions for Critical Thinking 5
Salvatore Chapter 10:
A)Discussion Question 3: What is the difference between limit pricing and contestable
markets?
Limit pricing is the charging of lower than the profit-maximizing price by a firm
in order to discourage the entrance of other firms into the market. By doing so,
they voluntarily sacrifice short-run profits in order to maximize long-run profits.
According to the theory of contestable markets, even if an industry has a single
firm or only a few firms, it would still operate as if it were perfectly competitive if
entry is “absolutely free” and if exit is “entirely costless.” When entry is
absolutely free and exit is entirely costless. The market is contestable. Firms will
then operate as if they were perfectly competitive and sell at a price that only
covers their average costs even if there is only one firm or a few of them in the
market.
Discussion Question 8: In what way does OPEC resemble a cartel? How successful is it?
There are two types of cartels: the centralized cartel and the market-sharing cartel.
The most well-known cartel is the centralized cartel. This is a formal agreement
among the oligopolistic producers of a product to set the monopoly price, allocate
output among its members, and determine how profits are to be shared. This was
attempted by OPEC, the Organization of Petroleum Exporting Countries. OPEC is
a cartel of petroleum earnings of its members. Twelve nations are presently
members of OPEC. According to current estimates, more than 80% of the world's
proven crude oil reserves are located in OPEC Member Countries, with the bulk
of OPEC oil reserves in the Middle East, amounting to 65% of the OPEC total.
OPEC is successful at being a cartel. This can be seen by looking at the high
prices of oil per barrel. The cost of oil and oil products have greatly increased,
meaning more profits for the cartel.
B)Problem 1: Find the Herfindahl index for an industry composed of (a) three firms—one
with 70 percent of the market, and the other two with 20 and 10 percent of the market,
respectively; (b) one firm with a 50 percent share of the market and the 10 other equal-
sized firms; (c) 10 equal sized firms. Note: Use 70 instead of 70% in your Herfindahl
index calculation (p.427).
(a)H = 702 + 202 + 102
4900 + 400 + 100
5400
(b)H = 502 + 52 + 52 +52 +52 +52 +52 +52 +52 +52 +52
2500 + 25 + 25 + 25 + 25 + 25 + 25 + 25 + 25 + 25 + 25
2750
(c)H = 102 + 102 + 102 + 102 +102 + 102 +102 + 102 +102 + 102
100 + 100 + 100 + 100 + 100 + 100 + 100 + 100 + 100 + 100
1000
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Problem 14: Since under price leadership by the dominant firm, the firms in the industry
following the leader behave as perfect competitors or price takers by always producing
where the price set by the leaders equals the sum of their marginal cost curves, the
followers break even in the long-run. True or false? Explain.
False. Even though the followers behave as perfect competitors or price takers
and produce where P = ΣMCF, the price set by the dominant firm to maximize its
total profits is not necessarily or usually equal to the LAC of the dominant or of
the follower firms with restricted entry in the long run.
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Froeb et al. Chapter 10:
Individual Problem 10-4: Examine the U.S. passenger airline industry using the Five
Forces. Is this an attractive industry? Why or why not?
According to Michael Porter’s Five Force model, the best industries are
characterized by:
Low threat of entry (high barriers to entry)
Low buyer power
Low supplier power
Low threat from substitutes, and
Low levels of rivalry between existing firms.
One can examine the U.S. passenger airline industry using the Five Forces, to
determine whether or not this is an attracting industry.
Low threat of entry (high barriers to entry)
oThe airline industry is highly competitive and barriers to entry are
low due to liberalization of market access, a result of globalization.
Low buyer power
oCustomers have a high bargaining power since the industry deals
with a perishable product with limited options to differentiate their
services from competitors’ products. Passengers, especially those
traveling for leisure purposes, are highly price-sensitive.
Low supplier power
oThe air transport supply chain consists of aircraft manufacturers,
lessors, air navigation service providers (or ANSPs), travel agents,
and freight forwarders. The supply chain also includes providers of
other services such as computer reservation systems (or CRS),
catering, ground services, and maintenance, repair, and overhaul
(or MRO). Airline suppliers generate higher returns compared to
airlines
Low threat from substitutes
oSubstitutes include traveling by car, boat, train, bus, private jet, or
not traveling at all.
oAdditionally, customer loyalty plays a part in a threat. Just because
a new airline is available, doesn’t mean customers are willing to
switch from an airline they are already loyal to.
Low levels of rivalry between existing firms
oHigh level of rivalry. According to IATA (International Air
Transport Association), about 1,300 new airlines were established
in the last 40 years.
Based on the information using the Five Forces, the U.S. Passenger airline
industry is not an attractive industry. In order to be an attractive industry by the
Five Forces, there must be a low threat of entry, low buyer power, low supplier
power, low threat of substitutes, and low levels of rivalry between existing firms.
The U.S. Passenger airline industry has low barriers to entry, high customer
bargaining power, high supplier power, several substitutes, and a high level of
rivalry.
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Salvatore Chapter 11:
A)Discussion Question 11: Do the duopolists in a Cournot equilibrium face a prisoner’s
dilemma? Explain.
Yes¸the duopolists in a Cournot equilibrium face a prisoner’s dilemma. In the
Cournot model, each firm, while trying to maximize profits, assumes that the
other duopolist holds its output constant at the existing level. The result is a cycle
of moves and countermoves by the duopolists until each sells one-third of the
total industry output (if the industry were organized along perfectly competitive
lines). The prisoner’s dilemma refers to a situation in which each firm adopts its
dominant strategy but each could do better by cooperating. Firms in a duopoly
face the prisoner’s dilemma because each firm will charge the low price and earn
a smaller profit because if it charges the higher price, it cannot trust its rival to
also charge the higher price.
Discussion Question 12: How did the 1971 law that banned cigarette advertising on
television solve the prisoners’ dilemma for cigarette producers? Note: Explain first the
prisoners' dilemma for cigarette producers before 1971 law. Use table 11-4, replace Low
Price with Advertise, and High Price with Don't Advertise. You would see this is similar
to the prisoners' dilemma.
Before the 1971 law that banned cigarette advertising on television was passes,
cigarette producer’s faced the prisoner’s dilemma. The prisoner’s dilemma arose
from the choice to advertise or not to advertise. If a cigarette producer chose to
advertise, there profits were higher. If they choose not to advertise, their profits
were lower. In this case, each firm would adopt its dominant strategy of
advertising and would earn a profit of 2. However, both firms could do better by
not advertising because they would then earn the higher profit of 3. Before the
1971 law, cigarette producers faced the prisoner’s dilemma of choosing to not
advertise and earn higher profits because, unless both producers, choose not to
advertise, one would come out much stronger than the other. When the law passed
in 1971 banning cigarette advertisement on television, this solved the prisoner’s
dilemma for the cigarette producers. After 1971, neither company was allowed to
advertise, putting both firms in the ‘don’t advertise’ box of the matrix, which has
higher profits. The 1971 law that banned cigarette advertising on television not
only solved the prisoner’s dilemma, but also increased profits for cigarette
producers.
Cigarette Producer B
AdvertiseDon’t Advertise
Advertise(2, 2)(5, 1)
Cigarette Producer A
Don’t advertise(1, 5)(3, 3)
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B)Problem 2: From the following payoff matrix, where the payoffs are the profits or losses
of the two firms, determine (a) whether firm A has a dominant strategy, (b) whether firm
B has a dominant strategy, (c) the optimal strategy for each firm, and (d) the Nash
equilibrium, if there is one.
Firm B
Low PriceHigh Price
Low Price(1, 1)(3, -1)
Firm A
High Price(-2, 3)(4, 2)
(a)Firm A does not have a dominant strategy.
(b)Firm B does have a dominant strategy of charging a low price.
(c)The optimal strategy for Firm A is to charge a high price if firm A charges a
high price. The optimal strategy for Firm B is to charge a low price if Firm A
charges a high price.
(d)The Nash equilibrium is low price for both firms. The payoff for both would
then by 1.
Problem 6: Explain why the payoff matrix in Problem 1 indicates that firms A and B face
the prisoner’s dilemma.
Firm B
Low PriceHigh Price
Low Price(1, 1)(3, -2)
Firm A
High Price(-2, 3)(2, 2)
The above payoff matrix indicates that firms A and B face the prisoner’s dilemma.
The prisoner’s dilemma refers to a situation in which each firm adopts its
dominant strategy but each could do better by cooperating. In the case above, both
firms could double their profits if they cooperated to use the strategy of (high,
high) instead of using their dominant strategy of (low, low).
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Problem 10: Given the following payoff matrix, (a) indicate the best strategy for each
firm. Note: The strategies for firm A are low price and high price and the strategies for
firm B are enter and don't enter. What is the best (optimal) strategy for each firm? (b)
Why is the entry-deterrent threat by firm A to lower the price not credible to firm B?
Note: Question is asking whether firm A would use the low price as a threat if firm B
enters. (c) What could firm A do to make its threat credible without building excess
cap acit y?
Firm B
EnterDon’t Enter
Low Price(3, -1)(3, 1)
Firm A
High Price(4, 5)(6, 3)
(a) The best strategy (profit-wise) for Firm A is to have a high price and for Firm B
to not enter. The best strategy for Firm B is for Firm A to have a high price and for
Firm B to enter.
(b) Although Firm A could deter Firm B by offering low prices, the threat is not
credible for Firm B because, in turn, Firm A would also lose profits.
(c) Firm A could take a loss of profits for a while in order to make its threat
credible without building excess capacity to Firm B. Firm B will likely not enter if
the prices are low because Firm B will lose profits.
The most likely outcome with the potential outcomes above is that the employer
will offer a low salary and the employee will accept. Because this is a
sequential-move game with the employer moving first, it would be in the best
interest of the employer to offer the lower salary. Due to the offer of a low salary,
and the employee’s assumed need for the job, the employee would most likely
accept the offer. The ability for the employer to move first does give the employer
ad advantage because they then have the upper-hand. By moving first, the
employer gives the employee the option to take it or leave it. Although the
employee could counteroffer and try to bargain for the higher salary, in most
cases, they will accept what is being offered because they need the job. This is an
advantage to the employer for sure. As the employee in this scenario, you could
bargain and try to explain why you are worth the extra salary without being too
pushy. Being too aggressive could cost the job altogether. However, a case could
be made as to why you are not only the best person for the position, but you are
also worth the extra pay.
QCT5 8
Froeb et al. Chapter 15:
Individual Problem 15-4: The below figure represents the potential outcomes of your
first salary negotiation after graduation. Assuming this is a sequential-move game with
the employer moving first, indicate the most likely outcome. Does the ability to move
first give the employer an advantage? If so, how? As the employee, is there anything you
could do to realize a higher payoff?
E
W
E
0 E
0
L S O
E
A
E
100 E
75
E
E
W
E
0 E
0
H S Of
E
A
E
100 E
75
QCT5 9
Individual Problem 15-5: Every year, management and labor renegotiate a new
employment contract by sending their proposals to an arbitrator who chooses the best
proposal (effectively giving one side or the other $1 million). Each side can choose to
hire, or not hire, an expensive labor lawyer (at a cost of $200,000) who is effective at
preparing the proposal in the best light. If neither hires lawyers or if both hire lawyers,
each side can expect to win about half the time. If only one side hires a lawyer, it can
expect to win three-quarters of the time. 1) Diagram this simultaneous-move game. 2)
What is the Nash equilibrium of the game? 3) Would the sides want to ban lawyers?
If neither side hires a lawyer, they each get to keep their entire $500,000.
If they both hire a lawyer, they have an equal chance at getting the extra
$1,000,000, but they both have to pay $200,000 each for fees, so their profits are
expected to only be $300,000 each.
If one side hired a lawyer and the other didn’t, the chance of winning the 1 million
dollars is 75%. 0.75*1million – 200,000 lawyer fee = $550,000 for the side that
hired the lawyer. 0.25*1million = $250,000 for the side that did not hire the
lawyer.
Nash equilibrium would be if both sides hired lawyers or if neither sides hired
lawyers. In either case, both sides would have equal profits.
It would be beneficial to both sides if they banned lawyers, assuming they still has
an equal chance at winning with no lawyers. With no lawyers, both sides stand to
make $500,000 in profits, whereas with lawyers they only stand to make
$300,000 because they are paying out $200,000 in lawyer fees. The idea of
earning $550,000 in profits if one side hires a lawyer and the other doesn’t is only
good in theory. If one side hires a lawyer, the other side will follow and hire a
lawyer as well.
Additionally, banning lawyers would eliminate the prisoner’s dilemma.
Labor No Lawyer
Lawyer
Management
No LawyerLawyer
$500,000 , $500,000$250,000 , $550,000
$550,000 , $250,000$300,000 , $300,000
