Aplia: Student Question 12/14/21, 2:22 PM

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1. Characteristics of oligopoly

An oligopolistic market structure is distinguished by several characteristics, one of which is either similar or identical products. Which of the following
are other characteristics of this market structure? Check all that apply.

Market control by many small firms

Neither mutual interdependence nor mutual dependence

Mutual interdependence

Market control by a few large firms

Difficult entry

Points: 1/1

Explanation: Close Explanation

An oligopolistic market structure has the following characteristics:

• A few large sellers

• Either similar or identical products

• Mutual interdependence

• Difficult entry

In an oligopolistic market structure, a few large sellers control the market for either similar or identical products. Each firm is a price maker or a
price searcher but engages in strategic behavior, since decisions by one firm significantly affect the prices and profits of other firms (mutual

interdependence). Finally, market entry is typically difficult (as existing firms can deter entry by new firms) but not impossible.

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Aplia: Student Question 12/14/21, 2:23 PM

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2. Breakdown of a cartel agreement

Consider a town in which only two residents, Clancy and Eileen, own wells that produce water safe for drinking. Clancy and Eileen can pump and sell

as much water as they want at no cost. For them, total revenue equals profit. The following table shows the town's demand schedule for water.

Price Quantity Demanded Total Revenue

(Dollars per gallon) (Gallons of water) (Dollars)

6.00 0 0

5.50 45 $247.50

5.00 90 $450.00

4.50 135 $607.50

4.00 180 $720.00

3.50 225 $787.50

3.00 270 $810.00

2.50 315 $787.50

2.00 360 $720.00

1.50 405 $607.50

1.00 450 $450.00

0.50 495 $247.50

0 540 0

Suppose Clancy and Eileen form a cartel and behave as a monopolist. The profit-maximizing price is $3.00 per gallon, and the total
output is 270 gallons. As part of their cartel agreement, Clancy and Eileen agree to split production equally. Therefore, Clancy's profit is
$405.00 , and Eileen's profit is $405.00 .

Points: 1/1

Explanation: Close Explanation

Examining the table, you can see that the price and quantity that maximize profit are $3.00 per gallon and 270 gallons of water. Therefore,

when Clancy and Eileen collude, they each produce 135 gallons of water and charge $3.00 for each gallon.

Profit is equal to price times quantity. Therefore, total profit is $810.00 when 270 gallons are produced:

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Aplia: Student Question 12/14/21, 2:23 PM

Profit = Total Revenue − Total Cost

= Price × Quantity − Total Cost
= $3.00 per gallon × 270 gallons − $0
= $810.00

So when each person produces 135 gallons, each earns a profit of $405.00.

Suppose that Clancy and Eileen have been successfully operating as a cartel. They each charge the monopoly price and sell half of the monopoly
quantity. Then one night before going to sleep, Clancy says to himself, "Eileen and I aren't the best of friends anyway. If I increase my production to

45 gallons more than the cartel amount, I can increase my profit even though her profit goes down. I will do that starting tomorrow."

After Clancy implements his new plan, the price of water decreases to $2.50 per gallon. Given Eileen and Clancy's production

levels, Clancy's profit becomes $450.00 and Eileen's profit becomes $337.50 .

Points: 1/1

Explanation: Close Explanation

When Clancy and Eileen collude, each produces 135 gallons of water (for a total of 270 gallons) and charges $3.00 per gallon. If Clancy decides

to cheat and produce 180 gallons—45 gallons more than his collusive output—they will produce a total of 315 gallons, driving the price down to
$2.50 per gallon. The following calculations summarize how to compute profit in this case:

Clancy 's Profit = Total Revenue − Total Cost

= Price × Quantity − Total Cost
= $2.50 per gallon × 180 gallons − $0
= $450.00

Eileen 's Profit = Total Revenue − Total Cost

= Price × Quantity − Total Cost
= $2.50 per gallon × 135 gallons − $0
= $337.50

As a check, notice that the combined profit is equivalent to the total revenue reported in the initial table at a price of $2.50.

Because Clancy has deviated from the cartel agreement and increased his output of water to 45 gallons more than the cartel amount, Eileen decides
that she will also increase her production to 45 gallons more than the cartel amount.

After Eileen increases her production, Clancy's profit becomes $360.00 , Eileen's profit becomes $360.00 , and total profit (the
sum of the profits of Clancy and Eileen) is now $720.00 .

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Aplia: Student Question 12/14/21, 2:23 PM

Points: 1/1

Explanation: Close Explanation

When Clancy and Eileen are in a cartel, each produces 135 gallons of water (for a total of 270 gallons of water) and charges $3.00 per gallon.
When both decide to cheat and produce 180 gallons each, they will produce a total of 360 gallons, driving the price down to $2.00 per gallon.
Thus, each of them will earn a profit of $360.00:

Each Person's Profit = Total Revenue − Total Cost

= Price × Quantity − Total Cost
= $2.00 per gallon × 180 gallons − $0
= $360.00

And you can compute total profit in the following way:

Total Profit = Clancy 's Profit + Eileen 's Profit

= $360.00 + $360.00
= $720.00

As a check, notice that the combined profit is equivalent to the total revenue reported in the initial table at a price of $2.00.

True or False: Based on the fact that both Clancy and Eileen increased production from the initial cartel quantity, you know that the output effect was
smaller than the price effect at that quantity.

True

False

Points: 1/1

Explanation: Close Explanation

The output effect refers to revenue gained from the sale of additional units of output when production is increased. When price is above

marginal cost, the output effect positively affects profits because the revenue obtained from selling one more unit of output exceeds the cost of
producing it. The price effect refers to the decline in price of each unit sold when output is increased. Thus, the price effect negatively affects
profits on all previous units sold. Producers choose to increase output when the output effect is greater than the price effect, and to reduce

output when the price effect is greater than the output effect. Given that the producers deviated from the cartel quantity, the output effect must
have been larger (or it would not have been in either's best interest to increase production).

Note that Clancy and Eileen started by behaving cooperatively. However, once Clancy decided to cheat, Eileen decided to cheat as well. In other words,
Eileen's output decisions are based on Clancy's actions.

This behavior is an example of a tit-for-tat strategy .

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Aplia: Student Question 12/14/21, 2:23 PM

Points: 1/1

Explanation: Close Explanation

A player follows a tit-for-tat strategy if he or she cooperates until his or her opponent defects (cheats) and then continues defecting until the
opponent cooperates again. In other words, this strategy starts out collusive in nature, penalizes uncooperative behavior, and then forgives that
behavior if appropriate.

In this case, Clancy and Eileen started as a cartel, and each earned half of a monopolist's profit. However, Clancy decided to cheat, so Eileen
decided to cheat as well. This left each of them with less than half of a monopolist's profit.

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Aplia: Student Question 12/14/21, 2:23 PM

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3. Solving for dominant strategies and the Nash equilibrium

Suppose Bob and Cho are playing a game in which both must simultaneously choose the action Left or Right. The payoff matrix that follows shows the

payoff each person will earn as a function of both of their choices. For example, the lower-right cell shows that if Bob chooses Right and Cho chooses
Right, Bob will receive a payoff of 7 and Cho will receive a payoff of 6.

Cho

Left Right

Left 4, 3 6, 4
Bob
Right 6, 7 7, 6

The only dominant strategy in this game is for Bob to choose Right .

Points: 1/1

Explanation: Close Explanation

A dominant strategy, if it exists, is a strategy that is best for a player, regardless of the strategies chosen by the other players. In this game,

only Bob has a dominant strategy. If Cho chooses Left, Bob should choose Right (because a payoff of 6 is better than 4). If Cho chooses Right,
Bob still should choose Right (because a payoff of 7 is better than 6). Choosing Right is, therefore, a dominant strategy for Bob.

Cho does not have a dominant strategy, because Cho's choice depends on Bob's strategy. Cho should choose Right if Bob chooses Left, but Left
if Bob chooses Right.

The outcome reflecting the unique Nash equilibrium in this game is as follows: Bob chooses Right and Cho chooses Left .

Points: 1/1

Explanation: Close Explanation

A Nash equilibrium is a set of strategies (one for each player) in which each player's strategy is the best option for that player given the

chosen strategy of the player's opponent. In this game, Cho's best option is to choose Left if Bob chooses Right. The fact that Bob's best option

is to always choose Right makes the choice of Right by Bob and Left by Cho a Nash equilibrium. As you can verify, for any other cell in the
payoff matrix, one of the players could do better by switching strategies even if the other player continues to use the same strategy.

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Aplia: Student Question 12/14/21, 2:24 PM

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4. Using a payoff matrix to determine the equilibrium outcome

Suppose there are only two firms that sell tablets: Padmania and Capturesque. The following payoff matrix shows the profit (in millions of dollars)

each company will earn, depending on whether it sets a high or low price for its tablets.

Capturesque Pricing

High Low

High 11, 11 2, 15
Padmania Pricing
Low 15, 2 8, 8

For example, the lower-left cell shows that if Padmania prices low and Capturesque prices high, Padmania will earn a profit of $15 million, and

Capturesque will earn a profit of $2 million. Assume this is a simultaneous game and that Padmania and Capturesque are both profit-maximizing
firms.

If Padmania prices high, Capturesque will make more profit if it chooses a low price, and if Padmania prices low, Capturesque will make more
profit if it chooses a low price.

Points: 1/1

Explanation: Close Explanation

Suppose Padmania prices high. If Capturesque prices high, it will earn a profit of $11 million (upper-left cell). If Capturesque prices low, it will
earn a profit of $15 million (upper-right cell). Therefore, when Padmania prices high, Capturesque’s profit will be higher if it chooses a low price.

Suppose Padmania prices low. If Capturesque prices high, it will earn a profit of $2 million (lower-left cell). If Capturesque prices low, it will earn
a profit of $8 million (lower-right cell). Therefore, when Padmania prices low, Capturesque’s profit will be higher if it chooses a low price.

If Capturesque prices high, Padmania will make more profit if it chooses a low price, and if Capturesque prices low, Padmania will make more
profit if it chooses a low price.

Points: 1/1

Explanation: Close Explanation

Suppose Capturesque prices high. If Padmania prices high, it will earn a profit of $11 million (upper-left cell). If Padmania prices low, it will earn
a profit of $15 million (lower-left cell). Therefore, when Capturesque prices high, Padmania’s profit will be higher if it chooses a low price.

Suppose Capturesque prices low. If Padmania prices high, it will earn a profit of $2 million (upper-right cell). If Padmania prices low, it will earn

a profit of $8 million (lower-right cell). Therefore, when Capturesque prices low, Padmania’s profit will be higher if it chooses a low price.

Considering all of the information given, pricing low is a dominant strategy for both Padmania and Capturesque.

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Aplia: Student Question 12/14/21, 2:24 PM

Points: 1/1

Explanation: Close Explanation

A dominant strategy, if one exists, is a strategy that is best for a player regardless of the strategies chosen by the other players. Regardless

of Padmania’s pricing scheme, Capturesque is better off choosing a low price. Similarly, regardless of Capturesque’s pricing scheme, Padmania

earns more profit when it chooses a low price. Therefore, pricing low is a dominant strategy for both Padmania and Capturesque.

If the firms do not collude, what strategies will they end up choosing?

Padmania will choose a high price, and Capturesque will choose a low price.

Padmania will choose a low price, and Capturesque will choose a high price.

Both Padmania and Capturesque will choose a low price.

Both Padmania and Capturesque will choose a high price.

Points: 1/1

Explanation: Close Explanation

Regardless of what the other firm does, each firm has the incentive to price low, because $8 million is more than $2 million, and $15 million is

more than $11 million. Because pricing low is a dominant strategy for both firms, without colluding, both firms will end up choosing a low price.

True or False: The game between Padmania and Capturesque is not an example of the prisoners’ dilemma.

True

False

Points: 1/1

Explanation: Close Explanation

When each firm acts in its own self-interest and prices low to maximize its individual profit, each firm earns a profit of $8 million. However, both

firms would be better off if they both chose a high price because each would earn $11 million. Just as in the prisoners’ dilemma, the firms would
be better off if they both chose the alternative option (in this case, a high price); however, each firm has the individual incentive to choose a low
price instead. Therefore, this statement is false.

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Aplia: Student Question 12/14/21, 2:24 PM

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5. To advertise or not to advertise

Suppose that Creamland and Dairy King are the only two firms that sell ice cream. The following payoff matrix shows the profit (in millions of dollars)

each company will earn depending on whether or not it advertises:

Dairy King

Advertise Doesn't Advertise

Advertise 8, 8 15, 2
Creamland
Doesn't Advertise 2, 15 11, 11

For example, the upper right cell shows that if Creamland advertises and Dairy King doesn't advertise, Creamland will make a profit of $15 million,

and Dairy King will make a profit of $2 million. Assume this is a simultaneous game and that Creamland and Dairy King are both profit-maximizing
firms.

If Creamland decides to advertise, it will earn a profit of $8 million if Dairy King advertises and a profit of $15 million if Dairy King does
not advertise.

Points: 1/1

Explanation: Close Explanation

If both Creamland and Dairy King decide to advertise, each firm will earn a profit of $8 million. This outcome is represented by the upper left
cell of the payoff matrix. If Creamland decides to advertise and Dairy King decides not to advertise, Creamland will earn a profit of $15 million
(and Dairy King will earn a profit of $2 million). This outcome is represented by the upper right cell of the payoff matrix.

If Creamland decides not to advertise, it will earn a profit of $2 million if Dairy King advertises and a profit of $11 million if Dairy King

does not advertise.

Points: 1/1

Explanation: Close Explanation

If Creamland decides not to advertise and Dairy King decides to advertise, Creamland will earn a profit of $2 million (and Dairy King will earn a
profit of $15 million). This outcome is represented by the lower left cell of the payoff matrix. If both Creamland and Dairy King decide not to

advertise, each firm will earn a profit of $11 million. This outcome is represented by the lower right cell of the payoff matrix.

If Dairy King advertises, Creamland makes a higher profit if it chooses to advertise .

Points: 1/1

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Aplia: Student Question 12/14/21, 2:24 PM

Explanation: Close Explanation

Suppose Dairy King advertises. If Creamland chooses to advertise, it will earn a profit of $8 million (and Dairy King's profit will be $8 million). If
Creamland chooses not to advertise, it will earn a profit of $2 million (and Dairy King's profit will be 15 million). Therefore, when Dairy King

advertises, Creamland earns a higher profit if it chooses to advertise.

If Dairy King doesn't advertise, Creamland makes a higher profit if it chooses to advertise .

Points: 1/1

Explanation: Close Explanation

Suppose Dairy King doesn't advertise. If Creamland chooses to advertise, it will earn a profit of $15 million (and Dairy King's profit will be $2

million). If Creamland chooses not to advertise, it will earn a profit of $11 million (and Dairy King's profit will be $11 million). Therefore, when

Dairy King doesn't advertise, Creamland earns a higher profit if it chooses to advertise.

Suppose that both firms start off not advertising. If the firms act independently, what strategies will they end up choosing?

Creamland will choose not to advertise and Dairy King will choose to advertise.

Both firms will choose to advertise.

Creamland will choose to advertise and Dairy King will choose not to advertise.

Both firms will choose not to advertise.

Points: 1/1

Explanation: Close Explanation

A dominant strategy, if it exists, is a strategy that is best for a player, regardless of the strategies chosen by the other players. Regardless of
what the other firm does, each firm has the incentive to advertise, because $8 million is more than $2 million and $15 million is more than $11

million. This means that advertising is the dominant strategy for both firms. So, without colluding, both firms will end up advertising.

Again, suppose that both firms start off not advertising. If the firms decide to collude, what strategies will they end up choosing?

Both firms will choose not to advertise.

Creamland will choose to advertise and Dairy King will choose not to advertise.

Both firms will choose to advertise.

Creamland will choose not to advertise and Dairy King will choose to advertise.

Points: 1/1

Explanation: Close Explanation

Collusion refers to an agreement among agents in a game about which strategies to implement to prevent competitive pricing and thereby
maximize economic profits. In this scenario, each firm knows that if one firm advertises, the other will also advertise to minimize the decline in
profit that results when the other advertises. However, if both firms advertise, the outcome will be suboptimal, as each will earn only $8 million.

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Aplia: Student Question 12/14/21, 2:24 PM

On the other hand, if the two firms agree not to advertise (i.e., they collude), each can avoid the low-profit outcome of the upper left cell and

maximize its profit, with each earning $11 million.

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6. Game theory terminology

Select the term that best describes each definition listed in the following table.

Tit-for- Prisoners'
Nash Dominant tat Payoff Dilemma
Definition Equilibrium Strategy Collusion Strategy Matrix Game

A set of strategies (one for each player) in which each player's

strategy is the best option for that player, given the chosen
strategy of the player's opponents

The event that occurs when agents in a game form an agreement

about which strategies to implement

A visual representation of a game showing all possible strategies

for each player and all potential outcomes and payoffs

A strategy in which a player cooperates until the other player

defects and then defects until the other player cooperates again

Points: 1/1

Explanation: Close Explanation

A Nash equilibrium is a set of strategies (one for each player) in which each player's strategy is the best option for that player, given the
chosen strategy of the player's opponent. Economics uses game theory, the study of how people behave in strategic situations, to solve for such
an equilibrium.

A dominant strategy, if it exists, is a strategy that is best for a player, regardless of the strategies chosen by the other players.

Collusion refers to an agreement among agents in a game about which strategies to implement. A typical application is an agreement among
firms in a market about what quantities to produce or what prices to charge. A cartel is one possible outcome of collusion. Once a cartel is

formed, the market is effectively served by a monopoly.

A player follows a tit-for-tat strategy if he or she cooperates until his or her opponent defects (cheats) and then defects until the opponent
cooperates again. In other words, this strategy starts out collusive in nature, penalizes uncooperative behavior, and then forgives that behavior

if appropriate.

A payoff matrix is a diagram used to describe all the elements of a game. It displays all the players involved in the game, all their potential

strategies, and all possible payoffs to each player that may occur, depending on which strategies are chosen. A payoff matrix is examined via
game theory techniques to help predict the outcome of the game.

A particularly important game under the umbrella of game theory is the prisoners' dilemma. This game, defined by a certain payoff structure

and an inability of players to collude, provides insight into the difficulty of maintaining cooperation. The story of the prisoners' dilemma contains
a more general lesson that applies to any group of individuals or firms trying to maintain cooperation among its members without enforceable

punishments.

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7. Individual Problems 15-4

After graduation, you enter salary negotiations for your first job. Suppose the potential employer (employer A) has two choices: to offer you a high

salary or to offer you a low salary. You may then accept or reject whatever offer is made. The payoffs, as well as the decision tree, are depicted in the
following figure.

Employee Accept
Employee: 96
Employer A: 76

High Offer Employee Reject

Employee: 0
Employer A: 0

Employer Employee Accept

Employee: 76
Employer A: 96

Low Offer

Employee Reject
Employee: 0
Employer A: 0

Assume this is a sequential game.

If employer A offers a low salary, you, as the employee, are best served by accepting the offer. In this case, you would earn a payoff of 76 ,

and employer A would earn a payoff of 96 . Alternatively, if employer A offers a high salary, you are best served by accepting the offer. In
this case, you would earn a payoff of 96 , and employer A would earn a payoff of 76 . With this information, employer A will choose to make a

low offer, since it will yield a higher payoff for her, based on what you (the employee) will subsequently choose.

Points: 1/1

Explanation: Close Explanation

If employer A offered a high salary, you would accept it, since accepting it yields a higher payoff (96) than rejecting it (0). Additionally, if

employee A offered a low salary, you would also accept it, since the payoff of accepting the low offer (76) is greater than the payoff of rejecting

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Aplia: Student Question 12/14/21, 2:24 PM

it (0). In short, you would accept any offer.

With the knowledge that you will accept the offer, regardless of whether it is high or low, employer A will make her decision to maximize her

own payoff. If employer A offers a high salary, she will get a payoff of 76 when you accept. On the other hand, making a low salary offer will
yield a payoff of 96 when you accept. Thus, it is more profitable for employer A to make a low offer. The ordering of the game gives employer A

a first-mover's advantage and the equilibrium path is {low, accept}.

Suppose you have a competing job offer from employer B. Accepting this job offer gives a payoff of 86. During your negotiations with employee A, you

have the option of taking this offer from employer B, and employer A is aware of this offer (as well as the payoff to you). Given this competing offer,
the negotiation with employer A is depicted in the following figure:

Employee Accept
Employee: 96
Employer A: 76

High Offer Employee Reject

Employer A: 0
Employee: 86

Employer Employee Accept

Employee: 76
Employer A: 96

Low Offer

Employee Reject
Employee: 86
Employer A: 0

True or False: With this competing job offer, your threat to reject employer A's offer, if it is low, is now credible.

True

False

Points: 1/1

Explanation: Close Explanation

If employer A offers a low salary, you can reject her offer and accept employer B's offer, yielding a payoff of 86. Since this payoff is higher than

the payoff of accepting employer A's low salary offer, it is profitable for you to reject any low offer from employer A, making your threat
credible. Knowing you would reject any low offer, leaving her with a payoff of 0, employer A is now better off offering you a high salary (which

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Aplia: Student Question 12/14/21, 2:25 PM

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8. Individual Problems 15-6

Consider a sequential-move game in which an entrant is considering entering an industry in competition with an incumbent firm. If the entrant does

not enter (“Out”), the incumbent firm earns a payoff of 10, while the entrant earns a payoff of 0. If the entrant enters (“In”), then the incumbent can
either accommodate or fight. If the incumbent accommodates, both earn a payoff of 5. If the incumbent fights, then the entrant can either leave the
industry (“Withdraw”) or remain in it (“Stay”). If the entrant stays, both earn a payoff of –5. If the entrant withdraws, the entrant earns a payoff of –

1, and the incumbent earns a payoff of 8. The extensive form of the game is depicted in the following figure, where the payoffs are of the form

(Entrant Payoff, Incumbent Payoff).

Entrant

In Out

Incumbent

Accommodate Fight

Entrant
(5,5) (0,10)

Stay Withdraw

(-5,-5) (-1,8)

True or False: The equilibrium for this game is {In, Fight, Stay}.

False

True

Points: 1/1

Explanation: Close Explanation

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Aplia: Student Question 12/14/21, 2:25 PM

The equilibrium can be determined through backward induction: a process of determining the sequence of optimal choices by reasoning

backwards from the final choice to the first. In this case, in the final choice, you can see that the entrant would choose “withdraw” (with a payoff
of –1) rather than “stay” (with a payoff of –5). Given this information, you can now see that the incumbent, in the second to last decision, would

choose “fight” (with a payoff of 8) rather than “accommodate” (with a payoff of 5). And finally, you can see that in the initial decision of the

game, the entrant would choose to stay out of the industry (with a payoff of 0) rather than enter it (with a payoff of –1). Thus, the equilibrium
for this game is {Out}.

Notice that the outcome of the game would be different if, in the final action of the game (the first action considered in the backward induction

process), the entrant does not have the option of withdrawing. If the entrant can credibly threaten to remain in the game, regardless of the
actions taken by the incumbent, the incumbent will choose to “accommodate” (with a payoff of 5) rather than “fight” (with a payoff of –5) in the

second to last action of the game. Since the payoff to the entrant is now 5 rather than 0 (for non-entry), the entrant's outcome is improved.

Thus, one can make actually make oneself better off by eliminating one or more of one's options. An absence of options can make threats
credible.

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