Assignment
1. United Airlines and Frontier Airlines compete as duopolists in the Denver airport. Frontier is the column player in the payoff matrix below. It has three strategy options: Left (lots of low-priced flights), Middle (smaller number of medium-priced flights), and Right (a few high-priced flights). United is the row player, and has four strategy options: Top (many high-priced flights), High (a few high-priced flights), Low (many low-priced flights), and Bottom (many medium-priced flights). What strategy choices do you think each airline will make? Explain carefully the logical steps you use in arriving at your answer.
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Frontier Airlines
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United Airlines
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Left
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Middle
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Right
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Top
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4 , 5
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3 , 0
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6 , 4
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High
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3 , 1
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2 , 3
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12 , 2
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Low
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5 , 6
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4 , 5
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9 , 7
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Bottom
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2 , 2
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5 , 4
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10 , 3
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2. Your sister is the mayor of Napflio. She awards you the monopoly franchise rights to provide cable TV services to citizens of Napflio. As such, you are the only provider and as long as you have no competition, the discounted present value of your economic profit stream is 40,000,000€. Trouble looms on the horizon, however, because a satellite TV company is considering entering your market. Your monopoly franchise rights only apply to hard-wired cable TV, and do not apply to satellite signals and rooftop satellite dishes. If entry occurs and you share the market with a competitor, your discounted present value of economic profits will fall to 18,000,000€. If you contest entry and fight a price "war," the discounted present value of economic profits is -2,000,000€.
You announce publicly that if entry occurs, you will fight. In preparation to fight a price war, you decide to add capacity to your system which enables you to offer additional channels that your competitor could not. The cost of adding such capacity in preparation to fight for customers is 24,000,000€. Only if entry occurs will you find it necessary to utilize this capacity.
(a) Is your threat to fight a price war credible? Why or why not?
(b) Was your decision to make such a commitment to deter entry a good one? Explain why or why not. It would help if you draw the decision tree for this sequential-move game.
3. You live on a small island in the Aegean Sea. The island has considerable tourist potential, except that it only gets ferry service once a week. You have done research on tourism for similar Greek islands, and you have estimated that demand for hotel rooms on this island would be Q = 10 - P, if only the ferry came every day instead of once per week. Q is the number of hotel rooms demanded by tourists each night, and P is the price per room. Assume that marginal costs are constant at 2 per room per night (MC=AC=2).
a) Suppose that the Blue Star Ferry Line announces that it will begin providing daily service to your island. If you could be guaranteed a monopoly position in this market (not outside the realm of possibility since the island governing council is dominated by your close relatives), how big of a hotel would you build, i.e. how many rooms? Hint: calculate the profit maximizing price and quantity. What would your profits be?
b) Now suppose that the island governing council decides to grant operating licenses to two hotels, yours and one proposed by your cousin. You have never been able to fully trust your cousin, and now you are aligned against him in a simultaneous-move game-you both have to decide how much capacity (how many rooms) to build into your hotels. You have narrowed your viable choices to 2, 3, or 4 rooms. Your cousin has the same options in building his hotel. The following payoff matrix lays out the possible strategies and payoffs:
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You
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Your cousin
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Q = 2
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Q = 3
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Q = 4
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Q = 2
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8, 8
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5, 9
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4, 8
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Q = 3
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9, 5
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6, 6
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3, 4
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Q = 4
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8, 4
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4, 3
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0, 0
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If you and your cousin each have to make your capacity choice simultaneously, what will be the likely outcome of this game? Explain your reasoning.
c) Instead of you and your rival moving simultaneously, suppose instead that your cousin is getting his MBA in the U.S.A. and won't be home to start his hotel for another year. So you have the opportunity to make your capacity choice and build your hotel before he gets back, and then he will make his capacity decision second after you have made the first move. Based on the information in the above payoff matrix, write out the game tree for this sequential-move game. What will be the outcome of the game? Briefly explain.
d) Draw the profit possibilities frontier for this market in the diagram, where your cousin's profits are measured on the vertical axis and your profits are measured on the horizontal axis. Illustrate the three possible outcomes you have just analyzed in your diagram.