ECON20005 Competition and Strategy Tutorial 4
1 Fast food entry/exit and price competition
McDonald’s (MD) and Hungry Jack’s (HJ) are contemplating opening stores in Ararat,
Victoria. After doing some market research, MD found it would realize a monopoly
profit of 10 if it had the only restaurant in the market, while HJ found it would realize a
monopoly profit of 8 if it had the only restaurant in the market. If a firm does not enter
the market, then it realizes a profit of 0.
If MD and HJ both enter the market, they have two possible (discrete) pricing choices:
charge high prices PH and low prices PL . If they both choose PH , then they each earn
profits of 6. If they both choose PL , then they each earn profits of 3. If one firm charges
PH and the other chooses PL , then the firm charging PH earns a profit of 2 and the firm
charging PL earns a profit of 7. Assume that MD and HJ set their prices simultaneously
in the case that they have both entered the market.
(a) Consider first the equilibrium of the pricing game assuming (for the moment) that
both MD and HJ have entered the market. Write down the game table/normal
form for this simultaneous pricing game. Find all pure strategy NE of this game.
(b) Depict the extensive form and the pure strategy NE of the pricing game if both
firms have entered the market.
(c) Now consider a two-period entry game. In the first period MD and HJ simultane-
ously choose to either enter the market (ENTER) or not enter the market (NOT
ENTER). Upon seeing the period one entry decisions of both firms, in period two
MD and HJ simultaneously choose their prices if they are both in the market. If a
firm is the sole entrant, it simply earns its monopoly profit. If a firm does not enter
the market, it earns a profit of 0.
Characterize all the pure strategy SPNE of this game. That is, state the SPNE
strategies, the SPNE path, and the SPNE payoffs. Also depict the extensive form
of the game and illustrate the SPNE strategies.
(d) Suppose that if a firm does not enter the market then it instead realizes a profit of
4 (say from investing the money that it would have otherwise spent on opening a
restaurant). Characterize all the pure strategy SPNE of this game (i.e., state the
SPNE strategies, path, and payoffs). Also depict the extensive form of this game
and the SPNE strategies.
2 Corretto / Papa Gino’s and Collusion
Consider the following price setting game between Corretto and Papa Gino’s, two restau-
rants on Lygon Street. Firms set their prices simultaneously. The cost of a pizza for each
restaurant is c = $4. Market research has shown that when Papa Gino’s charges price
PP and Corretto’s charges price PC , the number of customers QP and QC are given by
QP = 25 − 2PP + PC
ECON20005 Competition and Strategy Tutorial 4
QC = 25 − 2PC + PP
Suppose that, instead of competing, Corretto and Papa Gino’s colluded in setting
their prices PP and PC . As part of the collusive agreement, Corretto and Papa Gino’s
agree to share the total profits earned from their collusive agreement equally.
(a) Write down the total profit function under the two firms’ collusive arrangement.
(b) Derive Corretto and Papa Gino’s collusive prices PC∗ and PP∗ . Calculate the corre-
sponding profits and quantities realized by the two firms under the collusive pricing
arrangement.
(c) Show graphically and algebraically that Papa Gino’s price under collusion, PC∗ , is
not consistent with a NE. (Hint: use Corretto’s best-response function.)
3 Finding Mixed Strategy NE
Consider the following Extensive Form game:
1
L R
2 2
l r l r
(5, 5) (8, 2) (9, 1) (6, 4)
(a) Present this game in Normal Form.
(b) Find all pure strategy NE of this game.
(c) Find the mixed strategy NE of this game.
(d) Let p be Player 1’s probability of playing L and q be Player 2’s probability of
playing ℓ in the mixed strategy NE. Plot Player 1’s and Player 2’s best-response
correspondences in (p, q) space. Indicate the location of any pure strategy and
mixed strategy NE in your figure.
ECON20005 Competition and Strategy Tutorial 4
4 Bistro Game
The bistro game defines the demand functions for Xavier’s bistro as Qx = 44 − 2Px + Py
and for Yvonne’s bistro as Qy = 44 − 2Py + Px , where Px and Py are the prices chosen
by Xavier and Yvonne, respectively. Profits for each bistro depend, in addition, on their
costs of serving each customer. Suppose that Xavier’s incurs a cost of $8 per customer,
while Yvonne’s is able to reduce its costs to $6 per customer.
(a) Derive the bistros’ best-response functions and solve for their NE prices.
(b) Graph the best-response curves. How does the best-response curve shift when the
costs per customer change?