EC1301 Tutorial 5

1. In a small New Zealand town, there are only two restaurants, G restaurant and K
restaurant. Each restaurant has to decide whether to clean up its act or continue to ignore
health code violations. Each restaurant currently makes $7,000 a year in profit. If they
both tidy up a bit, they will attract more patrons but must bear the (substantial) cost of the
cleanup; so they will both be left with a profit of $5,000. However, if one cleans up and
the other doesn’t, the influx of diners to the cleaner restaurant will more than cover the
costs of the cleanup; the cleaner restaurant ends up with $12,000, and the grubbier
restaurant incurs a loss of $3,000.

a. Write out the payoff matrix for this game, clearly labelling strategies and payoffs
to each player.

Answer:
K restaurant
Clean up Don't Cleanup

5,000 -3,000
Clean up

5,000 12,000

G restaurant

12,000 7,000
Don't
Cleanup
-3,000 7,000
b. What is each player’s dominant strategy?

Answer: Both G and K have a dominant strategy: to clean up.

c. What will be the outcome of the game?

Answer: If G and K act independently, they’ll both clean up and earn $5,000.

d. Suppose the two restaurants believe they will face the same decision repeatedly.
How might the outcome differ? Why?

Answer: When facing the same decision repeatedly, G and K might decide to
cooperate. By both agreeing to not clean up, they can increase their income to
$7,000 each.

e. Assume that if one cleans up and one stays dirty, the cleaner restaurant makes
only $6,000 in profit. All other payoffs are the same as before. What will the
outcome of the game be now without cooperation? With cooperation?

Answer: The restaurants no longer have dominant strategies. For example,

G’s best action now depends on what K chooses. Without cooperation, we
would need a more sophisticated analysis to predict an outcome. With
cooperation, however, the firms will decide not to clean up, and each will earn
$7,000.

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2. Assume that Dell and HP are the only sellers of laptops in Singapore. They are
deciding how much to charge for their laptops. The two choices are “High” (H) and
“Outrageously High” (OH). Dell’s payoffs are in the lower left of each cell in the
payoff matrix below:

a. Do both companies have dominant strategies? If so, what are they?

Answer: Dell has a dominant strategy to go “high.” HP does not have a

dominant strategy.

b. What will be the outcome of the game?

Answer: HP knows that Dell will choose to play its dominant strategy: “high”, so it
chooses “high” as well (because choosing high as opposed to choosing
“outrageously high” allows HP to earn a greater profit).

So both players choose “high”. HP earns $500,000 and Dell earns $1 million.

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3. The following table shows the quantities of bottled water demanded and supplied per
week at different prices in a particular city:

Price Quantity Demanded Quantity Supplied

$1.10 8,000 0
$1.15 7,000 1,000
$1.20 6,000 2,000
$1.25 5,000 3,000
$1.30 4,000 4,000
$1.35 3,000 5,000
$1.40 2,000 6,000
$1.45 1,000 7,000
$1.50 0 8,000

a. Draw the supply and demand curves for this market, and identify the equilibrium
price and quantity.

Answer:
Price
Market Consumer
S
1.50
1.45
1.40
1.35
P* = 1.30
Market Producer Surplus
1.25
1.20
1.15

1.10
D

1000 2000 3000 5000 6000 7000 8000 Quantity

Q*= 4000

The market equilibrium price is $1.30 and equilibrium quantity is 4000.

b. Using your graph, calculate the dollar value of gains from trade to the consumers
and gains from trade to the producers, and the total gains in the market at
equilibrium.

Answer: The dollar value of consumer gains is = ((1.50 - $1.30) x 4000)/2 = $400.
The dollar value of producer gains is = ((1.30 - $1.10) x 4000)/2 = $400. The total
gains in the market at equilibrium = $400 + $400 = $800.