Question

Question 4 (a) Consider the following game: Mercedes-Benz and Honda are the only two firms in the market for automobiles. Each firm has two strategies: produce high-grade vehicles or produce low-grade vehicles. The first entry in the bracket is the payoffs (in $billion) of Mercedes-Benz and the second entry is the payoffs of Honda. Honda's Decision Low-grade High-grade Mercedes- Low-grade (4, 5) (5, 4) Benz's Decision High-grade (8, 6) (6, 2) What is the dominant strategy of Mercedes-Benz? ii. What is the dominant strategy of Honda? iii. What is the Nash equilibrium of this game? i. (5 marks) (5 marks) (2 marks) (b) GoGo Pizza is producing at the profit-maximizing level of output in a monopolistically competitive market. i. Show GoGo Pizza's profit-maximizing level of output, selling price, and a positive profit in a diagram. Briefly explain. ii. (8 marks) Does GoGo Pizza have an incentive to produce at the level of output that maximizes the social welfare? Explain with the diagram in part (i). (5 marks)

Answer 1

When Honda chooses low grade, MB must choose high grade When Honda chooses high grade, MB must choose high grade Thus, dominant strategy of Mercedes Benz is High grade When MB chooses low grade, Honda must choose low grade When MB chooses high grade, Honda must choose low grade Thus, dominant strategy of Honda is Low grade Nash: (MB: High Grade; Honda: Low grade) i.e. (8,6) b) Profit maximization for a monopolistically competitive firm can be seen as below:

/MC supernormal profit AC DEAR MR 01 Since the firm sets price at the point MR = MC, the price charged will be P1 and the grey colored area represents profits. ii) No. these firms do not have the incentive to produce at the output level which maximizes social welfare as it would mean lower profits and these firms operate only to maximize profits. However, in the long run, these firms end up producing at the perfectly competitive outcome level because of free entry and exit of firms.