AF2601 INTRODUCTION TO ECONOMICS

Problem set 4 written report

TANG, Siu Hung Victor 10520732d

School of Accounting and Finance

Problem Set 4 Written Report
AF2601 Introduction to Economics
Semester 1, 2011/2012
Problem set 4:
Question 5.5, Question 6.1

TANG, Siu Hung Victor___________

Student Name

10520732d
Student Number

LEC001
Lecture Number

Dr. Zhang Eric

Name of Lecturer

TUT002
Tutorial Number

Dr. Zhang Eric

Name of Tutor

17th November 2011_______________

Due Date
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AF2601 INTRODUCTION TO ECONOMICS

Problem set 4 written report

TANG, Siu Hung Victor 10520732d

Topic 5 Market Structure

5.5a) Explain the essence of game theory and why it is only applied to oligopoly market
but not perfect competition and monopoly.
Solution: The essence of game theory should be included: 1. Understanding the action of
the independence rivals. 2. The intention or interesting to obtain the profit maximum and
the biggest market sharing. 3. Considering and estimating their rivals or competitors
possible action before marking their own decision. 4. Performing the action in the payoff
matrix 5. Determining two types of games: either cooperate (collude) or non-cooperate.
In order to understand why game theory only applied to oligopoly market but not perfect
competition and monopoly, we have to understanding the characteristics of these market
structures:
1. Perfect competition market structure describes markets such that no participants are
large enough to have the market power to set the price of a homogeneous product: Firstly,
under perfect competition, there have many sellers and buyers. All sellers are selling
identical products to buyers and since all information are opened to the public and can be
obtained very easily, so that all sellers and buyers have perfect knowledge about products
specification, prices and also the market operation mode. Moreover, firms are free to enter
or exit to the market under perfect competition since it is not require a large amount of
capital and technology investment to enter to the market. Under perfect competition, all
sellers and buyers are insignificant relative to the market, they cannot affect the others
decision and products price, so that sellers in perfect competition are all price takers.
From this, all sellers under perfect competition need not to consider the rivals action.
Therefore, game theory cannot apply in perfect competition market.
2. Monopoly market structure exists when a specific person or enterprise is the only
supplier of a particular commodity: Firstly, under the monopoly market structure, there
has only one seller in the market. Secondly, product sold or supplied by monopolist is
unique and with no close substitutes, e.g. The Hong Kong Electricity Company (The only
one electricity supplier in Hong Kong Island). In addition, there has barrier to limit
companies freely to enter to monopoly market since monopoly industries need a large
amount of investment in both capital and technology. Moreover, monopoly market
sometimes required license or approval in operation from government or regulatory
bodies, so that it is very difficult to entry to the market. Moreover, in the monopoly
market structure, there has no rival can affect monopolys decision and monopolists only
need to consider the profit-maximizing output. Therefore, game theory cannot apply in
the monopoly.
3. Oligopoly market structure form in which a market or industry is dominated by a small
number of sellers (oligopolists): Firstly, oligopoly market dominated by a few large
sellers since there have many barriers to limit firms to enter to the market. All firms in
oligopoly market are mutually dependence. Secondly, products sold in oligopoly market
can be either differentiated or identical. Moreover, oligopolists have some influence over
the selling price (facing downward sloping demand curve), so that oligopolists are price
searcher (price maker) but the power is limited by the possible action of its competitors
(rivals), so that they need to consider rivals decision and choose the best marketing
strategies to obtain maximum profit. Therefore, the game theory can be applied in the
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AF2601 INTRODUCTION TO ECONOMICS

Problem set 4 written report

TANG, Siu Hung Victor 10520732d

oligopoly market structure.

5.5b) ABC Ltd. is a small company composed of three persons: the owner Mr. Smart, and
two salesmen, Peter and Paul. In order to show his appreciation for the good effort of the
two salesmen, Mr. Smart has designed a reward scheme as follows. He is going to offer
Peter and Paul the following choices: (a) give oneself $10,000 of bonus, and (b) give the
other salesman $30,000 of bonus. Mr. Smart tells Peter and Paul that they are only
allowed to select either choice (a) or (b) but not both.
(i) The following is the payoff matrix of Peter and Paul:
The first figure in each cell denotes Peters payoff and the second figure denotes the
payoff to Paul. Complete the above payoff matrix by filling in the blanks.
Solution:
Pauls Choice
Give oneself $10,000 Give the other salesman
bonus
$30,000 bonus
Peters Choice

Give oneself $10,000

bonus

10,000/10,000

40,000/0

Give the other salesman

$30,000 bonus

0/40,000

30,000/30,000

(ii) What is the best choice for Peter and Paul if they can communicate and collude before
making their choices? Explain.
Solution:
Pauls Choice
Give oneself $10,000 Give the other salesman
bonus
$30,000 bonus
Peters Choice

Give oneself $10,000

bonus
Give the other
salesman $30,000
bonus

$10,000 + $10,000 =
$20,000

$40,000 + $0 = $40,000

$0 + $40,000 = $40,000 $30,000 + $30,000 =

$60,000

If they can collude, they will prefer to make the decision which can benefit both of them
(win win situation) and obtain the highest benefit (i.e. economic surplus) for them. In
order to get the highest benefit (i.e. economic surplus) for themselves, both Peter and Paul
will choose the option of give the other salesman $30,000 bonus, so that the highest total
benefit that they can me make equal to the highest economic surplus that they can make,
which is $30,000 + $30,000 = $60,000.
(iii) Suppose Peter and Paul have agreed to collude. Explain why their collusion is likely
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AF2601 INTRODUCTION TO ECONOMICS

Problem set 4 written report

TANG, Siu Hung Victor 10520732d

to fail.
Solution: The reasons for Peter and Pauls collusion is likely to fail are: Firstly, Peter and
Paul are selfish; they only care about obtaining the best possible outcome (i.e. highest
benefit) for themselves. Secondly, they dont trust each other and they are worried that the
other parties will not maintain their promises. Finally, as they know the other choice,
there has a very high incentive for them to cheat and break the promise to get the highest
bonus for themselves ($40,000 rather than $30,000). If one of them changes his decision
after they promised to collude, their collusion will fail.
(iv) State and explain the Nash Equilibrium of the above game.
Solution:
Pauls Choice
Give oneself $10,000 Give the other salesman
bonus
$30,000 bonus
Peters Choice

Give oneself $10,000

bonus

10,000/10,000

40,000/0

Give the other salesman

$30,000 bonus

0/40,000

30,000/30,000

In game theory, Nash equilibrium is a solution concept of a game involving two or more
players, in which each player is assumed to know the equilibrium strategies of the other
players, and no player has anything to gain by changing only his own strategy
unilaterally. If each player has chosen a strategy and no player can benefit by changing
his or her strategy while the other players keep theirs unchanged, then the current set of
strategy choices and the corresponding payoffs constitute a Nash equilibrium.
If Paul chooses give oneself $10,000 bonus, Peter will choose give oneself $10,000 bonus
also. As a result, both Peter and Paul can get $10,000.
If
Each player is assumed to know the equilibrium strategies of the other players
To predict the strategy is the best response to the predicted strategies of other players
A set of strategy that no participant can improve their profit, given the other strategy of
the participant

Topic 6 Market Failure

6.1 a) Consider a monopoly facing the following demand and MC curves:
Demand: P = 12 - 0.002Q
MC: MC = 3 + 0.001Q
(i) Calculate the profit maximizing output of this monopoly.
Solution: To maximize profit, the firm should produce at the output level where marginal
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AF2601 INTRODUCTION TO ECONOMICS

Problem set 4 written report

TANG, Siu Hung Victor 10520732d

revenue equal to marginal cost (MR = MC). Since the slope of MR curve is twice the
slope of demand curve.
MR = 12 - 0.002(2) Q
MR = 12 - 0.004Q
By considering the intersection point of MC curve and MR curve.
MR = MC
12 0.004Q = 3 + 0.001Q
9 = 0.001Q + 0.004Q
Q = 1800
The profit maximizing output of this monopoly is 1800.
(ii) Calculate the socially efficient output level.
Solution: The condition for socially efficient output level is when price is equal to
marginal cost (MC). By considering the intersection point of MC curve and demand
curve:
P = MC
12 - 0.002Q = 3 + 0.001Q
9 = 0.003Q
Q = 3000
The socially efficient output level is 3000.
(iii) Suppose the government wants to adopt a price ceiling to induce this monopoly to
produce at the socially efficient output level. Explain what the level of price ceiling
should be.
(Note: When the demand curve is P = a b Q, the MR curve will be MR = a 2 b Q.)
Solution: After adopting a price ceiling, the price of the goods must not be higher the
level of price ceiling. In order to produce at the socially efficient output level, the price
should correspond to the socially efficient output level, which is found in part (ii). We
substitute the socially efficient output level Q = 3000 in the equation of demand curve:
P = 12 (0.002) (3000)
P=6
The level of price ceiling should be $6.

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AF2601 INTRODUCTION TO ECONOMICS

Problem set 4 written report

TANG, Siu Hung Victor 10520732d

b) Discuss whether it is possible for the following markets to reach allocative efficiency
in the absence of government intervention:
Solution: To begin with, allocative efficiency refers to a theoretical measure of the
benefit or utility derived from a proposed or actual choice in the distribution or
apportionment of resources. In some situations, such as a perfectly competitive market is
able to reach allocative efficiency. In contrary, the market economy may fail to achieve
efficiency in markets such as monopoly, externalities and public goods, so that there is a
need for government intervention.
(i) Education service.
Solution: Education services can generate both the positive externalities and private
benefit: For externalities, because it causes extra benefits to society, since if more people
can receive education, there will have more educated labor force in the society. The
increased in educated labor force will result in external benefit in society as compared
with those who are not educated, people with knowledge are more capable of creating
new ideas.

For individual benefit, a more benefit or higher income can be gained when people with a
higher education background or qualification. However, since people only care for their
private benefit and private cost, they would not consider the social demand, so that they
may decide the output level based on their own benefits. As a result, without government
intervention, the private optimum will be less than the social optimum; efficiency may not
be achieved when there are externalities. Also, underproduction will be resulted.
(ii) Products which incur external cost during the production process and sold by a
monopoly.
Solution: Production process generates negative externalities means that the process
needs external cost, such as the cost of pollution. In such case, the level of the activity
will be greater than the socially optimal level.

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AF2601 INTRODUCTION TO ECONOMICS

Problem set 4 written report

TANG, Siu Hung Victor 10520732d

By considering the above diagram of monopoly, to maximize profit, output level (QPVT)
is determined by the intersection of MC and MR curve while the price (QPVT) is
determined by the demand curve. To avoid deadweight loss, the intersection point of MC
curve and demand curve is considered. Hence, the output level and market price are equal
to Qm and Pm respectively.

In this case, however, there is external cost which leads to a higher social MC curve.
Social MC = Private MC + XC, where XC is the external cost. By considering the
intersection point of social MC curve and demand curve, it is possible that the output
level is eventually equal to the quantity (QPVT) that is corresponding to profit
maximization. As a result, output level of profit maximization is equal to market output
level (QPVT = QPVT+SOC), and the price is QPVT+SOC. Therefore, private optimum is
equal to social optimum and there is no deadweight loss. Thus, it is not possible to reach
allocative efficiency without governmental intervention in this case.
c) Rivalry and Excludability are the two features of consumption of products and
services. Explain the meaning of these two terms.
Solution: Rivalry means the consumption by one person would diminish its availability
for the others. In other words, it decreases the quantity available for others. Books and
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AF2601 INTRODUCTION TO ECONOMICS

Problem set 4 written report

TANG, Siu Hung Victor 10520732d

street lights are examples of rival goods and non-rival goods respectively.
Excludability means it is possible to prevent a person from enjoying the benefits of a
good. Cable TV and air are examples of excludable goods and non-excludable goods
respectively.
d) Explain whether each of the following services has the characteristics of rival among
the consumers when consuming the services and excludable by the producer of the
services? Give your assumptions to justify the answers if necessary.
(i) Outdoor musical performance.
Solution: Outdoor musical performance can be considered as the following scenario:
Outdoor musical performance can be considered as non-rival because both the visual and
audio entertainment consumption of one person does not affect the quantity available for
the others. When a person is listening to the music or watching the visual performance,
the others can also enjoy the same quantity of entertainment (consumption).
For excludability, audio entertainment and visual entertainment should be considered
separately. Also, it depends on whether tickets are needed. If it is assumed that tickets are
needed, audio entertainment is non-excludable since the musical performance is perform
at outdoor, so that both the people in or outside the performance venue can enjoy the
same audio entertainment. However, for visual entertainment, it can only be enjoyed by
those who have bought tickets, so it is excludable. On the other hand, if tickets are not
needed, everybody can enjoy the same performance, both the audio and visual
entertainment, so it is non-excludable.
Rival
Non-rival
Excludable
No such case since the visual and Outdoor performance and
audio entertainment should always be tickets are required: For
considered as non-rival.
visual entertainment
Non-excludable No such case since the visual and Outdoor performance and
audio entertainment should always be tickets are not required: For
considered as non-rival.
both visual and audio
entertainment
(ii) Weather forecast.
Solution: Weather forecast is non-rival because all people can get the same amount of
information at the same time, the availability would not be affected. For excludability,
however, it depends on whether payment is needed to get the information. When payment
is needed, it is non-excludable whereas when money is needed, it prevents some people
from getting the information, it is excludable. Nevertheless, in case if a person who
bought the information and share the information to others, it becomes non-excludable.
Rival
Non-rival
Excludable
No such case since the weather When payment is needed to get
forecast
should
always
be the
weather
forecast
considered as non-rival.
information
Non-excludable No such case since the weather If a person who bought the
forecast
should
always
be weather forecast information
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AF2601 INTRODUCTION TO ECONOMICS

Problem set 4 written report

TANG, Siu Hung Victor 10520732d

considered as non-rival.

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and share the information to

others