Chapter 13 – Applied Problems

1. When McDonald’s Corp. reduced the price of its Big Mac by 75 percent if customers also purchased french fries
and a soft drink, The Wall Street Journal reported that the company was hoping the novel promotion would revive
its U.S. sales growth. It didn’t. Within two weeks sales had fallen. Using your knowledge of game theory, what do
you think disrupted McDonald’s plans?

As we all know, MC Donald is known for their hygienic burgers, which is their core competency. If they want
to attract customers by reducing the price, they have to do it strategically so that it doesn’t harm their market
share.
Here in question, they are offering a reduction of 75% on the price of burgers if the consumer also buys
French fries and a soft drink along with the burger. From an economic point of view this strategy is not a
good strategy, because if consumer doesn’t want to have the extra items they are providing along, and are
being charged unnecessarily for that, then in this case they definitely will not buy. Even if they buy that too,
no doubt the consumer would get less to pay on burger, but for attached foods they would end up paying
more. This is the reason consumers didn’t turn up with the scheme.
So, they have to formulate strategy in such way so that it benefits both ways and also, it should be a win-win
situation on all sides.

2. The well-known nationally syndicated columnist David Broder reported the recent findings of two academic
political scientists. These scholars found that voters are quite turned off by “negative campaigns” of politicians.
Many people went as far as not voting because of this. Nevertheless, the political scientists noted it is futile to urge
candidates to stay positive. The damage from staying positive is heaviest when the opponent is attacking. Explain
the dilemma in terms of strategic behavior.

Negative campaigning is the vilification of opponent among mass in order to incite them to do untoward things and
get them disqualified or by less, promoting things that has the negatively impact on the minds of voters. In these
circumstances suppose there are two political parties, each one is contesting to win over the public. If there are two
political parties fighting for a seat, and if party A wants to grab power by attacking the party B, and if the party B does
not react and took a positive stance, then it will incur a heavy loss. No doubt rational requires remaining positive in
approach, but if the opponent is always in constant bricking in order to defeat its opponent then it’s quite challenging
for the party to hold on. Positive approach sometime signals the general masses that what is being circulated was
actually true. As a result, party has to suffer losses. Party B decision is strategically correct but politically incorrect. So,
they have to plan and formulate strategies in such a manner so that opponent attack doesn’t stand any chance of
influence and party doesn’t get affected. The dilemma here for party B is whether to answer the attack or not, if they
take positive approach, voters will come out to vote, but then wrong information will be passed among the mass. If
they defend themselves vocally like that of attacking party, they will able to restrict the wrong information to bypass
but voters will be dejected and will not vote.

3. Dell Computer Corp., the world’s largest personal-computer maker, is keenly aware of everything its rival PC
manufacturers decide to do. Explain why Dell usually reacts more quickly and more substantially to pricing, product
design, and advertising decisions made by Hewlett-Packard and Gateway than when these same types of decisions
are made by Apple Computer.

Dell computer is strong and largest company in an IT industry. They are any players who are a part of an IT industry.
So, if anyone changes their price or changes their product specifications and if that is strongly liked by consumers than
all company in that industry has to follow otherwise, they may affect their market share. So, in this case when HP had
made a change in their pricing and product specification, being into same industry and competitor Dell has reacted
immediately so that they their existing and potential customer may not switch to HP which will hamper their market
share and that too is not good for Dell.
4. Some states have had laws restricting the sale of most goods on Sunday. Consumers, by and large, oppose such
laws because they find Sunday afternoon a convenient time to shop. Paradoxically, retail trade associations
frequently support the laws. Discuss the reasons for merchants’ supporting these laws.

The prisoner’s dilemma is a speculative game set up showing a situation where people won’t like to work together
even when it’s favorable to do so.

It’s well known fact that Sunday is a time when consumer gets time to do their purchasing. However, due to law
enforcement their purchase is restricted and same is agreed by the retailers too. The reason for that might be that as
more people wish to buy the restricted product, sellers might not able to provide the customers with them. Secondly
if all consumers’ starts purchasing that restricted product on Sunday then it might be that the sellers operating cycle
gets affected, and as a result it creates some discrepancies in logistics part.

The retailers were in a prisoners' dilemma. They all wanted to close on Sunday to save money and not lose sales, but
the temptation to cheat was high. Those who stayed closed while others were open would lose a great deal of sales.
The law essentially imposed a very costly deterrent to cheating. Thus, it is the reason why merchants would support
such laws.

5. Thomas Schelling, an expert on nuclear strategy and arms control, observed in his book The Strategy of Conflict
(Cambridge, MA: Harvard University Press, 1960), “The power to constrain an adversary depends upon the power
to bind oneself.” Explain this statement using the concept of strategic commitment.

Strategic commitment requires strict principle and adherence to stance that the individual took.

By posturing, it creates an impression that loyalty cannot be compromised. It has long-run impact and is difficult to
revers. The competitor not only required to read the mind of its adversary but also strategically able to manipulate its
action. The quotation implies that to be effective, one need to be loyal and should be binding on its action. The
aggressiveness would be reflected in the action what it proclaimed it to do. In this way, it will constraint the adversary
from undertake any adventure.

6. Many economists argue that more research, development, and innovation occur in the oligopolistic market
structure than in any other. Why might this conclusion be true?

Oligopolistic market consists of few powerful firms and each one of them is interdepend with respect to price and
output. If one changes price in a downward direction, other will follow suits, so that they don’t lose their market share
to price changing firm. However, none would rise price their price independently, because there are no incentives to
do so. So in order to compete in the market for survival firms need to be innovative, and they required investing in
R&D. R&D gives firm an edge over specification with regards to other firms in the industry, and able to retain loyal
customers and attract potential customers at the same time.

The degree of competition in the industry has led firms to invest in research and innovation in a significant amount,
because they know that the conventional strategies are not influential enough in profit generation, it is the only
through research that it could able to achieve competitive advantage.
7. In the 2000 U.S. presidential contest, Al Gore was advised by his strategists to wait for George W. Bush to
announce his vice-presidential running mate before making his own decision on a running mate. Under what
circumstances would Gore be better off giving Bush a head start on putting together his presidential ticket? What
kind of strategic situation is this?

The question is trying to highlight the sequential decision-making process. In sequential game, there are two players
more players, and their moves depend on the pay-off they get, considering the action taken by other player prior to
its action. Highest the pay-off better will be the move. In analogy, in the run of vice-presidential nomination, Al Gore
strategist thinks that the second move is more advantageous and pay-off is quite greater than the first move. If Al Gore
waits for the move taken by Bush, then it will have advantage of knowing the action of his opponent and at the same
time able to assess expected pay-off.

8. When he retired as CEO of American Airlines, a position he held for 18 years, Robert Crandall was described in a
Newsweek article (June 1, 1998) as “one tough [expletive].” Other nicknames Crandall garnered during his career
included Fang, Bob the Butcher, and Wretched Robert. Newsweek noted that Crandall’s “salty language and brass
knuckle, in-your-face” style of dealing with employees and rival airlines is now out of style in the executive suites
of U.S. corporations. In strategic decision-making situations, why might Crandall’s style of management have been
advantageous to American Airlines?

The firm AA is well known for its brand. When Mr. Crandall was its CEO his approach of managing the firm was quite
hard. His tough stand had earned him a few good names in the industry. From economic perspective, it’s a good
approach in dealing with rival firms. Since AA hold a giant share in the industry, rough stand would have complemented
in restraining the rivals from taking action that might had hurt the company’s market share. At the same time,
disciplined behavior might have also earned few more clients in the industry. Actually, disciplined behaviours create a
perception of non-comprisable among the rivals and because of this, to certain extent it able to restrict the action to
an insignificant level.

9. The secretary-general of OPEC, Ali Rodriquez, stated that it would be easier for OPEC nations to make future
supply adjustments to fix oil prices that are too high than it would be to rescue prices that are too low. Evaluate this
statement.

The Secretary of OPEC highlights that instead of targeting price directly it would be better and much more efficient if
future oil supply is adjusted. It appears that the cartel must be facing inefficiency or probably loss due to price volatility
in energy market. and their policy in stabilizing the price directly does not seems to work. So by adjusting the future
oil accordingly it will give them flexibility in setting the price and also helps stabilizing the market.

10. A church signboard offers the following advice: “Live every day as if it were your last.” Taken literally, could this
advice encourage “bad” behavior? Explain.

“Live every day as if it were yours last” is very subjective phrase, and behavior depends on person to person. If a person
is spiritual and always believe in doing good deeds, he would prefer the same everyday irrespective of the day. As for
the person who is individualistic and selfish, he would definitely put forward his own interest on top of others, so this
category would end up doing bad things.
11. In 1999 Mercedes-Benz USA adopted a new pricing policy, which it called NFP (negotiation-free process), that
sought to eliminate price negotiations between customers and new-car dealers. An article in The New York Times
(August 29, 1999) reported that a New Jersey Mercedes dealer who had his franchise revoked is suing Mercedes,
claiming that he was fired for refusing to go along with Mercedes’ no-haggling pricing policy. The New Jersey dealer
said he thought the NFP policy was illegal. Why might Mercedes’ NFP policy be illegal? Can you offer another reason
why the New Jersey dealer might not have wished to follow a no-haggling policy?

Company M caters to an elite class category of consumers. It produces high quality products and thus follows a proper
code of conduct for its business operations. When the company adopts the policy to remove any sort of negotiation
between its dealers and customers then it is implied that all dealers should follow the same. If this policy is not followed
by any of the dealers knowingly or unknowingly, it will affect the reputation as well as business operations of the
company. People will rush to those dealers who negotiate on the car prices, leading to an increase in demand at that
outlet because of a fall in price. Other dealers would then follow suit and find it profitable to set negotiable prices in
order to attract more consumers and profits. As a result, the whole policy would collapse and prove to be a failure for
the company. The dealer might have thought that the policy was illegal as it would only lead to a fall in the demand
for the company’s products, and that is why the company would never adopt such a policy. The dealer might not have
wished to follow the NFP policy in order to earn higher profits due to higher sales.

12. Suppose the two rival office supply companies Office Depot and Staples both adopt price-matching policies. If
consumers can find lower advertised prices on any items they sell, then Office Depot and Staples guarantee they
will match the lower prices. Explain why this pricing policy may not be good news for consumers.

If two companies claim to provide any item, they sell at the lowest possible price consumers can find, then it means
that they will definitely alter the quality of their product in order to satisfy and lure more consumers. If the companies
produce at a cost of $5 and some other company produces and sells at a price of $3, the consumer would go to the
first two companies demanding a price of $3 for their product. In order to meet those demands, the companies would
then have no other option but to use cheap quality inputs to bring down their production costs. Eventually, it will be
the consumer who will be at loss because of the low-quality product he will be sold.

13. Recently one of the nation’s largest consumer electronics retailers began a nationwide television advertising
campaign kicking off its “Take It Home Today” program, which is designed to encourage electronics consumers to
buy today rather than continue postponing a purchase hoping for a lower price. For example, the “Take It Home
Today” promotion guarantees buyers of new plasma TVs that they are entitled to get any sale price the company
might offer for the next 30 days.

a. Do you think such a policy will increase demand for electronic appliances? Explain.

b. What other reason could explain why this program is offered? Would you expect the other large electronics stores
to match this program with one of their own? Why or why not?

The policy “take it home today” will definitely increase the demand for electronic appliances. A lot of consumers
postpone buying an expensive appliance in the hope of a fall in price of the product in the future. This sometimes leads
to consumers not buying the product ever when the price does not fall over a long period of time. However, such an
advertising tactic by the company will increase the sale of its products as such consumers would come and buy the
products they were waiting to buy, as in such a case they will be able to get the product today at a sale price which
takes place later on.

This program is offered so that the number of footfall in their store increases and so do sales. Sometimes people come
to buy one product but end up buying many. This will result in higher sales and profits to the company. It is possible
that other large electronics stores might copy this program in order to increase their sales. It is also possible that they
might introduce other offers and schemes to attract more consumers. This is because companies are only concerned
with higher sales and profits, be it through any way.
14. When Advanta Corp. decided that it wished to begin charging a fee to holders of its credit cards for periods
during which the card is not used and for closing the account, it first “signaled” its intentions to hike fees by publicly
announcing its plans in advance. The company notified its cardholders that it wouldn’t begin charging the fees right
away but would reserve the right to do so. One worried cardholder told The Wall Street Journal, “I hope the other
credit card companies don’t follow suit.” Apparently, cardholders had good reason to worry, according to one credit
card industry analyst: “Everyone is considering (raising fees), but everyone’s afraid. The question is, who’ll be daring
and be second? If there’s a second, then you’ll see a flood of people doing it.”

a. If Advanta believes raising fees is a profitable move, then why would it delay implementing the higher fees, which
could reduce the amount of profit generated by higher fees?

Raising fees is not profitable, but the company feels that if it tries to implement this policy then existing defaulters
might pay back their amount otherwise, they will have to pay huge penalties. So, the main idea behind it is not to earn
extra profit, but to get back payments from their defaulters. This is the reason why they are postponing the
implementation of these policies as they fear to lose out on their new customers and also may not get their amount
back.

b. Are rivals waiting for Advanta to implement its fee hikes before they do in order to secure a second-mover
advantage? Explain. Is there any other reason rivals might wait to raise their prices?

Yes, other companies are waiting for Company A to implement its fee hike as they might want to check how this
strategy works and whether it will reduce the number of defaulters or not. They would also want to check whether it
will enhance their customers or reduce them because if the strategy fails, then it will affect their sales relative to their
rivals.

c. Could Advanta Corp. be trying to establish itself as the price leader in the consumer credit card industry?

Yes. Company A is trying to implement a new and different strategy in which it may become a leader in the pricing
industry. They are planning to initiate with a process through which they can charge a person who doesn’t pay back
their outstanding amount on team. It will be a helpful initiative and would even encourage others to follow it and
reduce their defaulters as well.
15. Economists believe terrorists behave rationally: If country A (America) increases security efforts while country
B (Britain) remains complacent, terrorists will focus their attacks on targets in the relatively less well-protected
country B. Suppose the following payoff table shows the net benefits for the United States and Great Britain
according to their decisions either to maintain their annual spending levels at the optimal levels (when both
countries spend proportionately equal amounts) or to increase annual spending by 10 percent. The payoffs in the
table measure net benefits (in dollars) from antiterrorism activities, that is, the value of property not destroyed and
lives not lost due to reduced terrorism minus spending on antiterrorism.

a. Antiterrorism policy analysts believe allies in the war against terror face a prisoners’ dilemma concerning how
much each country chooses to spend on activities that reduce the incidence of terrorist attacks on their own nation’s
people and property. In the payoff table, make up your own values for payoffs in cells B and C that will create a
prisoners’ dilemma situation.

A prisoner’s dilemma is a game that shows how the two players do not cooperate with each other in the game, even
though it is in their best interest to do so. In order to make the given game a prisoner’s dilemma, the following values
can be filled as below:

Britain’s Antiterrorism Spending

$100 $110
America’s Antiterrorism $100 1000, 1000 1200, 900
Spending $110 900, 1200 800, 800

This game shows that although it is better for both the countries to increase their antiterrorism spending, both of
them end up not increasing their expenditure, as the Nash equilibrium turns out to be ($1000, $1000).

b. “When all nations spend more and more preventing terrorist acts, they may actually all end up worse off for their
efforts.” Evaluate this statement using the payoff table you created in part a.

If all countries start spending more, then it will eventually end up worsening off all their efforts because terrorists will
then become used to it and would start devising new ways through which they can enter and harm these economies.
As a result of this, all the economies would face equal risk of being attacked by these terrorists.
16. The two largest diner chains in Kansas compete for weekday breakfast customers. The two chains, Golden Inn
and Village Diner, each offer weekday breakfast customers a “breakfast club” membership that entitles customers
to a breakfast buffet between 6:00 a.m. and 8:30 a.m. Club memberships are sold as “passes” good for 20 weekday
breakfast visits. Golden Inn offers a modest but tasty buffet, while Village Diner provides a wider variety of breakfast
items that are also said to be quite tasty. The demand functions for breakfast club memberships are:

QG = 5,000 – 25PG + 10PV

QV = 4,200 – 24PV + 15PG

where QG and QV are the number of club memberships sold monthly and P G and PV are the prices of club
memberships, both respectively, at Golden Inn and Village Diner chains. Both diners experience long-run constant
costs of production, which are:

LACG = LMCG = $50 per membership

LACV = LMCV = $75 per membership

The best response curves for Golden Inn and Village Diner are, respectively,

PG = BRG (PV) = 125 + 0.2PV

PV = BRV (PG) = 125 + 0.3125PG

a. If Village Diner charges $200 for its breakfast club membership, find the demand, inverse demand, and marginal
revenue functions for Golden Inn. What is the profit-maximizing price for Golden Inn given Village Diner charges a
price of $200? Verify mathematically that this price can be obtained from the appropriate best-response curve given
above.

Given the VD charges $200, the GI demand, inverse demand and marginal revenue functions will be:

Demand Function:
QGI = 5000 – 25PGI + 10PVI = 5000 – 25PGI + 2000 = 7000 – 25PGI

Inverse Demand Function:

QGI = 7000 – 25PGI
PGI = (1/25)(7000 – QGI) = 280 – 0.04QGI

Marginal Revenue Function:

R = PGI x QGI
dR/dQGI = {d [(280 – 0.04QGI)QGI]}/{dQGI}
MRGI = 280 – 0.08QGI

The profit maximising price is where marginal revenue is equal to marginal cost. Hence,

MRGI = LMCGI = 50
280 – 0.08QGI = 50
QGI = 2,875

Therefore, the price is,

PGI = 280 – 0.04QGI = 280 – 0.04 (2,875) = $165

The best response function for GI is,

PGI = BRGI (PVI) = 125 + 0.2PVI = 125 + (0.2 x 200) = 165

Hence, this proves that the price can be obtained by the best response function.
b. Find the Nash equilibrium prices for the two diners. How many breakfast club memberships will each diner sell
in Nash equilibrium? How much profit will each diner make?

The Nash equilibrium price is the price at which both the chains are at equilibrium and neither have an incentive to
deviate from that price.

The best response function is,

PGI = 125 + 0.2PVI

PVI = 125 + 0.2PGI

Solving them simultaneously, you get the equilibrium price, which is 156.25.

The number of memberships each diner will sell are,

QGI = 5000 – 25PGI + 10PVI = 5000 – 25(156.25) + 10(156.25) = 2656.25

QVI = 4200 – 42PVI + 15PGI = 4200 – 42(156.25) + 15(156.25) = 2793.75

The profit that each diner will make is,

πGI = R – C = (PGI x QGI) – (QGI x LACGI) = (156.25 x 2656.25) – (2656.25 x 50) = 282,226.25

πVI = R – C = (PVI x QVI) – (QVI x LACVI) = (156.25 x 2793.75) – (2793.75 x 75) = 226,992.18

c. How much profit would Golden Inn and Village Diner earn if they charged prices of $165 and $180, respectively?
Compare these profits to the profits in Nash equilibrium (part c). Why would you not expect the managers of Golden
Inn and Village Diner to choose prices of $165 and $180, respectively?

The profit for GI and VI respectively are,

πGI = R – C = (PGI x QGI) – (QGI x LACGI) = (165 x 2656.25) – (2656.25 x 50) = 305,468.75

πVI = R – C = (PVI x QVI) – (QVI x LACVI) = (180 x 2793.75) – (2793.75 x 75) = 293,343.8

It is clear that by setting price higher than Nash equilibrium price both firms will increase their individual profit.
However, since they are interdependent, they are aware that if they by charging higher price than what is being
charged by rival firm, then it will backfire in terms of lower price by rival firm. So, their interdependent restrain
managers at respective Inn from charging the above-mentioned price.
17. Samsung wants to prevent Whirlpool from entering the market for high-priced, front-load washing machines.
Front-load washing machines clean clothes better and use less water than conventional top-load machines. Even
though front-load machines are more costly to manufacture than top-loaders, Samsung is nonetheless earning
economic profit as the only firm making front-loaders for upscale consumers. The following payoff table shows the
annual profits (in millions of dollars) for Samsung and Whirlpool for the pricing and entry decisions facing the two
firms.

a. Can Samsung deter Whirlpool from entering the market for front-load washing machines by threatening to lower
price to $500 if Whirlpool enters the market? Why or why not?

Samsung lowers their price level to $500, it may affect whirlpool on entering the market only if it has dominant strategy
in reducing the price to $500.

Samsung
$500 $1000
Stay Out 0, 20 0, 34
Whirlpool
Enter -5, 15 17, 17

But in the matrix above we can see that if whirlpool enters the market the best strategy for Samsung is to keep its
price at $1000 because at this price it has greater payoff of 17 than price $500, where its payoff is 15. So, Samsung will
not reduce its price. Thus, it can't deter whirlpool to enter the market. Samsung’s threat is not credible, so whirlpool
ignores it and enters the market.

Suppose the manager of Samsung decides to make an investment in extra production capacity before Whirlpool
makes its entry decision. The extra capacity raises Samsung’s total costs of production but lowers its marginal costs
of producing extra front-load machines. The payoff table after this investment in extra production capacity is shown
here:

b. Can Samsung deter Whirlpool from entering the profitable market for front-load washing machines? What must
be true about the investment in extra production capacity for the strategic move to be successful? Explain.

When Samsung increased its portfolio of production with extra capacity, it may able to stop whirlpool to enter because,
whirlpool loss level will increase from $5 to $6, just because Samsung have increased their production which will no
doubt increase their cost but it will be not be that high as compared to Whirlpool.

Samsung
$500 $1000
Stay Out 0, 16 0, 24
Whirlpool
Enter -6, 14 12, 12

Now, in the new payoff matrix, If whirlpool enters the market the best strategy for Samsung is to keep its price at $500
because at this price it has greater payoff of 14 than price $1000, where its payoff is 12. So, Samsung will reduce its
price.

In this case whirlpool payoff will be -6. So best response of whirlpool will be to stay out of the market for better payoff.
So, after new investment Samsung can deter whirlpool to enter the market by reducing its price. So, investment in
extra capacity will be successful only if Samsung reduce its prices to $ 500.
c. Construct the sequential game tree when Samsung makes the first move by deciding whether to invest in extra
production capacity. Use the roll-back technique to find the Nash equilibrium path. How much profit does each firm
earn? (Hint: The game tree will have three sequential decisions: Samsung decides first whether to invest in extra
plant capacity, Whirlpool decides whether to enter, and Samsung makes its pricing decision.)

Nash Equilibrium is a point when both enter into a market and with $1000 price which will result in gain of $12 i.e. at
(12,12) and (17,17) which will be an advantageous for both.