WEEK 7_Tutorial Solutions
1. A negative externality is created by
A) cleaning up the sidewalk on your block.
B) graduating from university.
C) repainting the house you live in to improve its appearance.
D) keeping a junked car parked on your front lawn.
2. When does a negative externality exist?
A) When there are quantity controls in a market.
B) When there are price controls in a market.
C) When the marginal social cost of producing a good or service exceeds the private
cost.
D) When the marginal private cost of producing a good or service exceeds the social
cost.
3. Which of the following represents the true economic cost of production when firms
produce goods that cause negative externalities?
A) The private cost of production
B) The social cost of production
C) The external cost of production
D) The explicit cost of production
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Figure 11.3
Figure 11.3 shows a market with an externality. The current market equilibrium output
of Q1 is not the economically efficient output. The economically efficient output is
Q2.
4. Refer to Figure 11.3. Suppose the current market equilibrium output of Q1 is not
the economically efficient output because of an externality. The economically
efficient output is Q2. In that case, the diagram shows
A) the effect of a positive externality in the production of a good.
B) the effect of a negative externality in the production of a good.
C) the effect of an external cost imposed on a producer.
D) the effect of an external benefit such as a subsidy granted to consumers of a good.
5. Refer to Figure 11.3. If, because of an externality, the economically efficient
output is Q2 and not the current equilibrium output of Q1, what does S1 represent?
A) The market supply curve reflecting external cost
B) The market supply curve reflecting implicit cost
C) The market supply curve reflecting social cost
D) The market supply curve reflecting private cost
6. Refer to Figure 11.3. If, because of an externality, the economically efficient
output is Q2 and not the current equilibrium output of Q1, what does S2 represent?
A) The market supply curve reflecting private cost
B) The market supply curve reflecting social cost
C) The market supply curve reflecting external cost
D) The market supply curve reflecting implicit cost
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Answers
1. D
2. C
3. B
4. B
5. D
6. B
Short-answer Questions
Question 1
What is meant by the term ‘internalising an externality’? How does a Pigovian tax or
subsidy internalise an externality?
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Answer: Internalising an externality refers to transferring the external benefit or cost
to the producer or consumer that generates the externality. A Pigovian tax transfers a
negative externality in production back to the producer, which reduces the supply of
the product and results in an efficient level of output. A Pigovian subsidy transfers a
positive externality in consumption back to the consumer, which increases the demand
for the product and results in an efficient level of output.
Question 2
Give brief definitions of the following concepts:
a. Game theory
b. Cooperative equilibrium
c. Non-cooperative equilibrium
d. Dominant strategy
e. Nash equilibrium
Solution: a. Game theory is the study of how people make decisions in
situations in which attaining their goals depends on their interactions with
others.
b. A cooperative equilibrium is one in which players in a game cooperate
to increase their mutual payoff.
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c. A non-cooperative equilibrium is one in which players don’t cooperate
but pursue their own self-interest.
d. A dominant strategy is one that is best for a player, no matter what
strategies other players use.
e. A Nash equilibrium is a situation in which each player chooses the best
strategy, given the strategies chosen by the other player or players.
Question 3
Bob and Tom are two criminals who have been arrested for burglary. The police put
Tom and Bob in separate cells. They offer to let Bob go free if he confesses to the
crime and testifies against Tom. Bob is also told that he will serve a 15-year sentence
if he remains silent while Tom confesses. If he confesses and Tom also confesses,
they will each serve a 10-year sentence. Separately, the police make the same offer to
Tom. Assume that if Bob and Tom both remain silent, the police only have enough
evidence to convict them of a lesser crime and they will serve three-year sentences.
a. Use this information to write a payoff matrix for Bob and Tom.
b. Does Bob have a dominant strategy? If so, what is it?
c. Does Tom have a dominant strategy? If so, what is it?
d. What sentences do Bob and Tom serve? How might they have avoided
this outcome?
Solution: a.
b. Confessing is a dominant strategy for Bob.
c. Confessing is a dominant strategy for Tom.
d. They will both confess and serve 10-year sentences. This outcome is
difficult to avoid because both Bob and Tom have a strong incentive to confess,
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but if they had both refused to confess, they each would have served only three-
year sentences. For many years, organised criminals practised a ‘code of
silence’ under which any member of the organisation knew that if he testified
against another member, he was likely to be killed. In game theory terms, the
code of silence helped criminal organisations to avoid the prisoner’s dilemma
when their members were arrested.
Question 4
Suppose that Big W and Kmart are competing on whether to stick with barcodes or
switch to radio frequency identification (RFID) tags to monitor the flow of products.
Because many suppliers sell to both Big W and Kmart, it is much less costly for
suppliers to use one system or the other, rather than to use both. The following payoff
matrix shows the profits per year for each company resulting from the interaction of
their strategies.
a. Briefly explain whether Big W has a dominant strategy.
b. Briefly explain whether Kmart has a dominant strategy.
c. Briefly explain whether there is a Nash equilibrium in this game.
Solution: a. Big W doesn’t have a dominant strategy. If Kmart uses barcodes,
Big W earns more profit when it also uses barcodes, but if Kmart uses RFID
tags, Big W’s best strategy is to use RFID tags.
b. Kmart doesn’t have a dominant strategy. If Big W uses barcodes, Kmart
earns more profit when it uses barcodes, but if Big W uses RFID tags, Kmart
earns more by using RFID tags.
c. Recall the definition of a Nash equilibrium: a situation where each firm
chooses the best strategy, given the strategies chosen by other firms. In this
problem there are two Nash equilibria: both firms choosing barcodes or both
firms choosing RFID tags. In either of these situations, neither firm can
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increase its profits by changing its strategy, given the strategy chosen by the
other firm. An important point to note is that it is possible to have a Nash
equilibrium even when neither firm has a dominant strategy.
Question 5
Finding dominant strategies is often a very effective way of analysing a game.
Consider the following game: Microsoft and Apple are the two firms in the market for
operating systems. Each firm has two strategies: charge a high price or charge a low
price.
a. What (if any) is the dominant strategy for each firm?
b. Is there a Nash equilibrium? Briefly explain.
Solution: a. A dominant strategy is a strategy where a player is better off
playing regardless of which strategy the other player chooses. To analyse
Microsoft’s strategy: Suppose Microsoft knew that Apple was going to charge
a high price. In that case, Microsoft could also charge a high price and receive a
payoff of $1 billion, or it could choose to charge a low price, and receive a
payoff of $8 billion. Clearly, Microsoft would be better off charging a low
price if it knew Apple was going to charge a high price. Now suppose that
Microsoft knew that Apple was going to charge a low price. In that case,
Microsoft could charge a high price and receive a payoff of $10 billion, or it
could charge a low price and receive a payoff of $4 billion. Clearly, Microsoft
would be better off charging a high price if it knew Apple was going to charge
a low price. Because Microsoft’s best strategy depends upon the strategy Apple
chooses, Microsoft doesn’t have a dominant strategy.
To analyse Apple’s strategy: Suppose Apple knew that Microsoft was going
to charge a high price. In that case, Apple could also charge a high price and
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receive a payoff of $6 billion, or it could charge a low price and also receive a
payoff of $6 billion. Clearly, Apple would be indifferent between charging a
high price or charging a low price if it knew Microsoft was going to charge a
high price. Now suppose Apple knew that Microsoft was going to charge a low
price. In that case, Apple could charge a high price and receive a payoff of $2
billion, or it could charge a low price and receive a payoff of $3 billion.
Clearly, Apple would be better off charging a low price if it knew Microsoft
was going to charge a low price.
Because Apple is indifferent between strategies if Microsoft charges a high
price and better off charging a low price if Microsoft charges a low price, a
dominant strategy for Apple is to charge a low price.
b. A Nash equilibrium occurs when neither player has an incentive to
change strategies given the strategy the other player is using. In this game,
Apple always chooses to charge a low price because that is its dominant
strategy. If Apple chooses to charge a low price, then Microsoft is better off
charging a high price, so the equilibrium for this game is the outcome in the
northeast quadrant. Apple has no incentive to change its behaviour given
Microsoft is charging a high price. If Apple switched to charging a high price,
then its outcome would not improve. Microsoft has no incentive to change its
behaviour given Apple is charging a low price. If Microsoft switched to
charging a low price, then its payoff would fall from $10 billion to $4 billion,
which clearly makes it worse off.
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