EXERCISE 4 (GAME THEORY AND MARK UP PRICING)

PART 1 GAME THEORY

Assume a market with a monopolist and a new entrant. The new entrant is
aware that if the monopolist sets a low price after it comes in, the new
entrant will lose money. If the monopolist continues to charge a high
price, the new entrant will make a profit. These possible outcomes are
shown in the pay-off matrix below.

MONOPOLIST

Price High
Price Low

NEW ENTRANT
Enter
20, 10
5, -10

Dont Enter
50, 0
10, 0

a) Does either player have a dominant strategy? (2 points) Explain briefly. (3

points)
b) Is there a Nash equilibrium in this game? (2 points) Explain briefly. (3 points)
c) How could the monopolist make the threat to set a low price after the new
entrant comes in credible? (3 points)
PART 2 MARKUP PRICING
1. Given each of the following price elasticities, calculate the optimal
markup above cost. Show your solution. (2 points each):
a)
b)
c)
d)
e)

-5
-1
-0.5
-16
-9

2. Assume that a firm has a constant marginal cost of 20 pesos. The current price
of the product is 25 pesos. At that price, it is estimated that the price elasticity of
demand is -3.0.
a) Is the firm charging the optimal price for the product? (1 point) Why or why
not? (4 points)
b) Should the price be changed? (1 point) If so, by how much? (4 points). If not,
why not?
(4 points)