Ch.

17
Problems and applications
2. a. If there were many suppliers of diamonds, price would equal marginal cost ($1,000), so the quantity
would be 12,000.
b. With only one supplier of diamonds, quantity would be set where marginal cost equals marginal
revenue. The following table derives marginal revenue:

With marginal cost of $1,000 per diamond, or $1 million per thousand diamonds, the monopoly will
maximize profits at a price of $7,000 and a quantity of 6,000. Additional production beyond this point
would lead to a situation where marginal revenue is lower than marginal cost.
c. If Russia and South Africa formed a cartel, they would set price and quantity like a monopolist, so
the price would be $7,000 and the quantity would be 6,000. If they split the market evenly, they would
share total revenue of $42 million and costs of $6 million, for a total profit of $36 million. So each would
produce 3,000 diamonds and get a profit of $18 million. If Russia produced 3,000 diamonds and South
Africa produced 4,000, the price would decline to $6,000. South Africas revenue would rise to $24 million,
costs would be $4 million, so profits would be $20 million, which is an increase of $2 million.
d. Cartel agreements are often not successful because one party has a strong incentive to cheat to
make more profit. In this case, each could increase profit by $2 million by producing an extra 1,000
diamonds. However, if both countries did this, profits would decline for both of them.
5.

a. The payoffs are:

b. The likely outcome is that both of you will shirk. If your classmate works, youre better off shirking,
because you would rather have 30 units of happiness rather than 15. If your classmate shirks, you are
better off shirking because you would rather have 10 units of happiness rather than 5. So your dominant
strategy is to shirk. Your classmate faces the same payoffs, so he or she will also shirk.
c. If you are likely to work with the same person again, you have a greater incentive to work, so that
your classmate will work, and you will both be better off. In repeated games, cooperation is more likely.
d. The payoff matrix would become:

Work is a dominant strategy for this new classmate. Therefore, the Nash equilibrium will be for you to
shirk and your classmate to work. You would get a B and thus would prefer this classmate to the first.
However, he would prefer someone with a dominant strategy of working as well so that he could get an A.
6. a. Synergy does not have a dominant strategy. If Synergy believes that Dynaco will go with a large
budget, it will also choose a large budget. However, if Synergy believes that Dynaco will go with a small
budget, it will want a small budget as well.
b. Yes, Dynaco has a dominant strategy of going with a large budget. It is the best strategy for Dynaco
to follow no matter what Synergy chooses.
c. The Nash equilibrium is that both firms will choose a large budget. Dynaco will follow its dominant
strategy so Synergy will choose a large budget as well.
7.

a. The playoff matrix for this game is:

b. Taking the drug will be a dominant strategy for each player as long as X is less than 5,000.

c. Making the drug safer (lowering X) raises the likelihood of taking the drug because it increases the
payoff.
8.

a. The decision box for this game is:

b. If Braniff sets a low price, American will set a low price. If Braniff sets a high price, American will
set a low price. So American has a dominant strategy to set a low price.
If American sets a low price, Braniff will set a low price. If American sets a high price, Braniff will set a low
price. So Braniff has a dominant strategy to set a low price.
Because both have a dominant strategy to set a low price, the Nash equilibrium is for both to set a low price.
c. A better outcome would be for both airlines to set a high price; they would both get higher profits.
That outcome could only be achieved by cooperation (collusion). If that happened, consumers would lose
because prices would be higher and quantity would be lower.
10. a. If Kona enters, Big Brew would want to maintain a high price. If Kona does not enter, Big Brew
would want to maintain a high price. Thus, Big Brew has a dominant strategy of maintaining a high price.
If Big Brew maintains a high price, Kona would enter. If Big Brew maintains a low price, Kona would not
enter. Kona does not have a dominant strategy.
Because Big Brew has a dominant strategy of maintaining a high price, Kona should enter.
b. There is only one Nash equilibrium. Big Brew will maintain a high price and Kona will enter.
c. Little Kona should not believe this threat from Big Brew because it is not in Big Brews interest to
carry out the threat. If Little Kona enters, Big Brew can set a high price, in which case it makes $3 million,
or Big Brew can set a low price, in which case it makes $1 million. Thus the threat is an empty one, which
Little Kona should ignore; Little Kona should enter the market.
d. If the two firms could successfully collude, they would agree that Big Brew would maintain a high
price and Kona would remain out of the market. They could then split a profit of $7 million.