Problem: Consider an industry in which two firms are producing a product. Assume that the two firms are current "colluding together" to set price so to maximize the industry profit. At this collusive price, the industry profit is $100 million - and that profit is split evenly between the two firms. Assume also that if one firm were to cut their price, then the industry profit would fall to $80 million - and the firm that cut the price would take 75% of the market. Finally, if both firms cut there price the industry profit would fall to $50 million - and that profit would be split evenly.
Question 1: Is game theory is an appropriate tool for analyzing this competitive situation? If so, why?
Question 2: Would you recommend that a firm cut its price or hold to the current price? Why?
Question 3: How, if at all, does this relate to the notion of a "prisoner's dilemma"?
Question 4: If the two parties initiated a "meeting competition clause" (e.g. "we will meet or beat or competitors price"), how would that change the strategic nature of the pricing decision.
Question 5: If these two firms were expected to be competing in this market for many years - that is, if they would revisit their pricing decision several times - might that effect your recommendation? If so, why and how?