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ECON200 – Economics: Policy Frameworks and Markets
Semester 2, 2016
This assessment piece is worth 10 marks in total. To pass, you must score a combined total of at least 5 out of 10.
PART 1 (4 Marks)
Imagine you live in a small town. In this town public transportation is limited to an unreliable public bus service and a small fleet of private taxis owned by a company called OL’ CAB. An announcement is made that a rideshare company, YUBER, will start operating in your town as of next month. You learn that whereas the companies do not offer exactly the same service they will definitely compete in the market for paid trips in your town.
- Explain what is likely to happen to the market equilibrium for paid trips in your town after YUBER enters the market (2 marks)
- Explain what is likely to happen to the demand and supply curves for taxi journeys in your town after YUBER enters the market (2 marks)
PART 2 (6 Marks)
Now, assume that OL’CAB and YUBER decide to advertise to compete for customers in the market.
If they both advertise, they would each earn $ 1 million in profit. If neither advertises, they each earn $ 2 million in profit. But if one advertises and the other doesn’t, the firm advertising earns $ 2.5 million in profit while the other earns $ 1 million in profit.
1) Create a payoff matrix to explain the choices that both firms face. (1 mark)
2) Explain which each firm’s dominant strategy is. (1 mark)
3) Find the Nash Equilibrium. (1 mark)
4) Explain what happens if OL’CAB and YUBER decide to collude. (Note: In your answer please comment on who loses from this behaviour and why). (2 marks)
ECON200 – Economics: Policy Frameworks and Markets
Semester 2, 2016
Table of Contents
- A market structure with two primary cab companies- OL’CAB and YUBER are given. The companies do not offer exactly the same service but they compete in the same market for paid trips. After YUBER enters the market, the supply of cabs for paid rides will go up. This will result in the supply curve shifting to the right, with demand remaining constant (Baumol and Blinder, 2015).Thus, the equilibrium point shifts (from e1 to e2), resulting in a higher amount of quantity supplied and a lower equilibrium price.
- Once YUBER enters the market, customers have a greater choice of cabs. They could book a private cab or choose to share a ride in a pool with YUBER. This means, the supply of cabs in the town has gone up. But the demand remains constant (Mankiw 2014). As can be seen from the Figure 1 that supply shifts from S1 to S2 thus resulting in a higher quantity (Q*2) and lower price (P*2).
- It can be gathered that each company is faced with two choices- to advertise (A) or not to advertise (NA). If both companies choose A then they both get a payoff of $1m. If both choose NA then they save the advertising cost and payoffs would be $2m for each company. However, if one firm chooses A while the other chooses NA then the payoff to the advertiser is $2.5m, while the other firm gets $1m. The payoff matrix is thus:
OL’CAB YUBER ADVERTISE (A) NOT ADVERTISE (NA) ADVERTISE (A) 1
NOT ADVERTISE (NA) 2.5
- A dominant strategy is one where regardless of what any other players do, the strategy earns the player a larger payoff than any other (Telser2016). Here it can be seen that neither OL’CAB nor YUBER is faced with any strict dominant strategy. Consider, that YUBER chooses to advertise. In this case, OL’CAB is indifferent between advertising or not since both choices fetch $1m. However, if YUBER chooses not to advertise, then OL’CAB is better off advertising as it fetches $2.5m over $2m if it doesn’t. Here, it can be found that there is no strictly dominant strategy for OL’CAB. However, a weakly dominant strategy exists in favor of advertising. Similarly, for YUBER as well, it is observed that advertising is the weakly dominant strategy.
- Nash equilibrium is where each player’s strategy is optimal and neither has any motive to change the strategy (Myerson 2013). In our example, the Nash equilibrium is advertising for both YUBER and OL’CAB. Both the companies know that they would earn a higher payoff if they didn’t advertise ($2m). At the same time, both know that if their rival advertises and they do not, then the rival company would earn a much higher pay-off ($2.5m) and it would earn only $1m. This is why both companies feel it would be better off advertising than not.
- In a monopolistic or oligopolistic market structure one often comes across collusion, where rival firms co-operate for their mutual benefit. Collusion results in an unfair market advantage, much like in the case of monopoly (Ichiishi2014).Firms under a collusion often charge a much higher price than the market equilibrium price, which is called price-fixing. They may also collude to produce a lower quantity of the good or service in order to drive up market prices. In such a scenario, the customers are adversely affected. Competition in the market is also low, since a collusion ensures that new firms are not able to enter the market freely.
Baumol, W.J. and Blinder, A.S., 2015. Microeconomics: Principles and policy. Cengage Learning.
Ichiishi, T., 2014. Game theory for economic analysis. Elsevier.
Mankiw, N.G., 2014. Principles of macroeconomics. Cengage Learning.
Myerson, R.B., 2013. Game theory. Harvard university press.
Telser, L.G., 2016. Competition, collusion and game theory. Springer.
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