microeconomics book solution 15

C since pepsi can raise its revenue by 100000 from

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c. Since Pepsi can raise its revenue by $100,000 (from $700,000 without advertising to $800,000 with advertising), it should be willing to spend at most $100,000 on an advertising campaign. 9. Philip Morris and R.J. Reynolds spend huge sums of money each year to advertise their tobacco products in an attempt to steal customers from each other. Suppose each year Philip Morris and R.J. Reynolds have to decide whether or not they want to spend money on advertising. If neither firm advertises, each will earn a profit of $2 million. If they both advertise, each will earn a profit of $1.5 million. If one firm advertises and the other does not, the firm that advertises will earn a profit of $2.8 million and the other firm will earn $1 million. Price of Pepsi Quantity of Pepsi demanded (per can) (millions of cans) $0.10 5 0.20 4 0.30 3 0.40 2 0.50 1 C H A P T E R 1 5 O L I G O P O LY S-217 S209-S220_Krugman2e_PS_Ch15.qxp 9/16/08 9:23 PM Page S-217
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Solution Solution a. Use a payoff matrix to depict this problem. b. Suppose Philip Morris and R.J. Reynolds can write an enforceable contract about what they will do. What is the cooperative solution to this game? c. What is the Nash equilibrium without an enforceable contract? Explain why this is the likely outcome. 9. a. See the accompanying payoff matrix. b. Each firm should not advertise, since this would maximize joint profits. Each firm then earns a profit of $2 million. c. Each firm will consider what its best action is depending on the action of the other firm. If R.J. Reynolds advertises, Philip Morris should as well, since it will earn $1.5 million instead of $1 million. If R.J. Reynolds does not advertise, Philip Morris should advertise, since $2.8 million is better than $2 million. So no matter what R.J. Reynolds does, the best action for Philip Morris is to advertise. The same logic applies to R.J. Reynolds. As a result, each firm will advertise, yielding profit of $1.5 million for each firm. This is a prisoners’ dilemma situation. 10. Over the last 30 years the Organization of Petroleum Exporting Countries (OPEC) has had varied success in forming and maintaining its cartel agreements. Explain how the following factors may contribute to the difficulty of forming and/or main- taining its price and output agreements. a. New oil fields are discovered and increased drilling is undertaken in the Gulf of Mexico and the North Sea by nonmembers of OPEC. b. Crude oil is a product that is differentiated by sulfur content: it costs less to refine low-sulfur crude oil into gasoline. Different OPEC countries possess oil reserves of different sulfur content. c. Cars powered by hydrogen are developed. 10. a. With the discovery of new oil by nonmembers of OPEC, there is increased compe- tition. This will lead to a fall in market price and make the cartel agreement hard- er to maintain. b. The OPEC countries sell a differentiated and complex product. This complicates the decision about what prices to set for what types of oil and makes enforcement of a cartel agreement more difficult. Much of the conflict within OPEC rests on the price differential that is set between high- and low-quality oils.
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