Question

Firm B Enter Enter Do Not Enter 50 0 Firm A 50 100 1001 0 Do Not Enter 0 0 The above 3) figure shows the payoffs to two firms deciding to open a gasoline station in an isolated town. If firm A decides first, what will happen? If there is a $60 fee to enter this market, what will happen? 4) You are party and one of your guests lights up a cigar without asking. Explain why this creates an externality. What having a are two possible actions to increase welfare of guests?

Answer 1

3) If firm A decides to enter first, it will be able to capture the entire market share of 100. However, if there are no entry barriers, firm B may enter later and the market share will get shared equally, 50 - 50.

If there is an entry fee of $60, it will only make sense to enter if the other firm can be prevented from entering. For example, if only firm A enters, its total payoff will be 100 - 60 = 40. Now if firm B also enters, both will end up with a payoff of (-10). Thus, firm A will have to prevent firm B from entering.

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4) Lighting up of the cigar will create smoke, which will impact the welfare of the other guests. The other guests, who are bystanders, have to face inconvenience, for no fault of theirs.

One option is to ask the smoker to either stop smoking or leave the party. The other option is to ask the smoker to compensate the other guests, in any way that is equivalent to their inconvenience faced.