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Tutorial - Topic 11 - Oligopoly - Suggested Answer

The document discusses the concept of oligopoly, emphasizing the interdependence of firms and the kinked demand curve that illustrates price elasticity in response to competitors' actions. It also explains the prisoners' dilemma in game theory, highlighting how cooperation can lead to better outcomes than individual rational strategies. Additionally, it presents various payoff matrices and Nash equilibria for different scenarios, demonstrating the implications of strategic decision-making among players.

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4 views

Tutorial - Topic 11 - Oligopoly - Suggested Answer

The document discusses the concept of oligopoly, emphasizing the interdependence of firms and the kinked demand curve that illustrates price elasticity in response to competitors' actions. It also explains the prisoners' dilemma in game theory, highlighting how cooperation can lead to better outcomes than individual rational strategies. Additionally, it presents various payoff matrices and Nash equilibria for different scenarios, demonstrating the implications of strategic decision-making among players.

Uploaded by

cuz8al0qq
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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Microeconomics – Tutorial – Topic 11 Oligopoly – Suggested Answer

1. Why are firms in oligopoly interdependent?

Since each firm has a large market share, a firm's decision will inevitably affect the
others since consumers will always search for the highest value in purchasing.
Decisions made by one firm can elicit responses from others in the industry. For
example, if a firm decides to reduce the prices of its products, other firms may
follow suit in a bid to defend their market share from being taken away by the
former.

2. Explain, with the aid of a suitable economics diagram, kinked demand curve faced
by a firm in oligopoly market.

price

P B

C
quantity
Q
Diagram 1
As shown in Diagram 1, the demand curve for an oligopolist is ABC which kinked
at point B. Assume the initial price is P and the quantity demanded for this firm is
Q. If this firm raises its price, the other firms will not follow. The firm will encounter
a large decrease in quantity demanded when price increases and its total revenue
will decrease. Thus, for the portion above P the demand curve will be elastic. If this
firm reduces its price, the other firms will follow. The firm will encounter only a
small increase in quantity demanded when price decreases and its total revenue
will decrease. Thus, for the portion below P the demand curve will be inelastic. The
kinked point at point B shows the optimal price to operate to avoid negative
consequences of losing market share or gaining only marginal benefits.
3. Describe the prisoners’ dilemma game and explain why the Nash equilibrium
delivers a bad outcome for both players.

Prisoners’ dilemma game is a concept in game theory that describes a situation


where two rational individuals, who cannot communicate or coordinate their
actions, face a decision between cooperation and betrayal.
The Nash equilibrium delivers a bad outcome for both players even though they
choose the best strategy for themselves, respectively. This is because the Nash
equilibrium does not give rise to the optimal situation for both players. In fact,
there exist another outcome which is better for them.

4. Describe how firms overcome Prisoner’s Dilemma.

To overcome the prisoner’s dilemma, there must be cooperation or collusion


among the players to stick to a specific strategy. For this collusion to hold there
must be reward for cooperation and punishment for non-cooperation. This will
requires the game to play more than once.
If the game is only played one, there will be no punishment for violating the
agreement and both players will have incentive to cheat. Only if a game is played
repeatedly that the player will know that non-cooperation will invite retaliation
from the other player in the subsequent games which will result in long term loss
and hence the players are willing to cooperate.

5. Consider a game with two players who cannot communicate, and in which each
player is asked a question. The players can answer the question honestly or lie. If
both answer honestly, each receives $100. If one player answers honestly and the
other lies, the liar receives $500, and the honest player gets nothing. If both lie,
then each receives $50.
a. Construct the payoff matrix.

Player 1
Honest Lie
Honest $100 $500
$100 $0
Player 2
Lie $0 $50
$500 $50

b. What is the equilibrium of this game?

The equilibrium of this game is when both players lie about the question.
This is because lying is the dominant strategy for both players and it is the
stable state where both players adopt their dominant strategies.
c. Compare this game to the prisoners’ dilemma. Are the two games similar
or different? Explain.

This game is the same as the prisoners’ dilemma. The prisoners’ dilemma
is a situation where the equilibrium does not give rise to the mutually
beneficial outcome, and neither player chooses that outcome in this game.
In this case, the equilibrium is both players lie but the best outcome is only
achieved when both players are honest.

6. Two students, Alice and Bob, are taking a test. They can choose to either Study
Hard or Cram Last Minute. Their payoffs depend on their combined effort.
• If both Study Hard, they both get an A grade.
• If one Studies Hard and the other Crams Last Minute, the one who studied
gets an A+, while the one who crammed gets a B.
• If both Cram Last Minute, they both get a C grade.

a. Construct the payoff matrix for Alice and Bob.

Bob
Study Hard Cram Last Minute
Study Hard A B
A A+
Alice
Cram Last A+ C
Minute B C

b. Identify the Nash Equilibrium.

The Nash equilibrium is achieved when both parties are willing to study
hard.
7. Two classmates, Chen and Mei, are caught cheating on an assignment. They are
questioned separately and cannot communicate. They can choose to Confess or
Deny.
• If both Deny, they both receive a warning.
• If one Confesses and the other Denies, the confessor gets no punishment,
while the denier gets expelled.
• If both Confess, they both receive a suspension.

a. Construct the payoff matrix for Chen and Mei.

Mei
Confess Deny
suspension Get expelled
Confess suspension No punishment
Chen
Deny No punishment warning
Get expelled warning

b. Identify the dominant strategy for each player.

Confess

c. Explain why this is a Prisoner's Dilemma.

The Nash Equilibrium is (Confess, Confess), but this is not the optimal
outcome for both players, as they would both prefer (Deny. Deny).

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