Dominick Salvatore Schaums Outline of Microeconomics, 4th edition Schaums Outline Series 2006

CHAP. 12] GAME THEORY AND OLIGOPOLISTIC BEHAVIOR 281
Table 12.10 shows that in the first period, firm A sets a high price (i.e., cooperates) and so does firm B (so that each
firm earns a profit of 2). If in the second period firm B does not cooperate and sets a low price while firm A is still
cooperating and setting a high price, firm B earns a profit of 3 and firm A incurs a loss of 1. In the third period, firm A
retaliates and also sets a low price. As a result, each firm earns a profit of only 1 in period 3. In period 4, firm B
cooperates again by setting a high price. With firm A still setting a low price, firm A earns a profit of 3 while
firm B incurs a loss of 1. In the fifth period, firm A also cooperates again and sets a high price. Since both firms
are now setting a high price, each earns a profit of 2.
STRATEGIC BEHAVIOR
12.18 Given the payoff matrix of Table 12.11 (a) indicate the best strategy for each firm. (b) Why is the entrydeterrent
threat by firm A to lower price not credible to firm B? (c) What could firm A do to make its
threat credible without building excess capacity?
Table 12.11
Firm A
Firm B
Enter Don’t Enter
Low Price 3, 21 3, 1
High Price 4, 5 6, 3
(a)
(b)
(c)
From the payoff matrix of the problem, we see that firm A adopts its dominant strategy of charging a high
price and firm B enters the market and also charges a high price. Thus, firm A earns a profit of 4 and firm
B earns a profit of 5.
The threat by firm A to lower price should not discourage firm B from entering the market because the threat is
not credible. The reason is that firm A earns a profit of 3 if it charges the low price and a profit of 4 if it charges
the high price.
Short of building excess capacity, firm A can make its threat credible by cultivating a reputation for aggressively
fending off entry into the market by lowering price (and thus imposing a loss on the potential entrant),
even if this means lower profits.
12.19 Show how the payoff matrix in the table of Problem 12.17 might change for firm A to make a credible
threat to lower price by building excess capacity to deter firm B from entering the market.
Table 12.12 shows that by building excess capacity, firm A can make a credible threat to lower price, which would
deter firm B from entering the market.
Table 12.12
Firm A
Firm B
Enter Do Not Enter
Low Price 3, 21 3, 1
High Price 2, 5 5, 3
The payoff matrix of Table 12.12 is the same as in Problem 12.18, except that firm A’s profits are now lower when it
charges a high price because idle or excess capacity increases firm’s A costs without increasing its sales. On the
other hand, we assume that charging a low price would allow firm A to increase sales and utilize its newly built
capacity so that costs and revenues increase leaving firm A’s profits the same as in Problem 12.18 (i.e., the
same as before firm A expanded capacity). Building excess capacity in anticipation of future need now becomes
a credible threat because with excess capacity, firm A will charge a low price and earn a profit of 3 instead of a
profit of 2 if it charged the high price. Firm B would then incur a loss of 1 if it entered the market and would
thus stay out. Entry deterrence is now credible and effective.