CHAPTER 14
Strategy
MULTIPLE CHOICE
Choose the one alternative that best completes the statement or answers the question.
1) In a two-player simultaneous game, if player A has a dominant strategy and player B does
not, player B will
A) employ a mixed strategy.
B) choose his best strategy assuming that player A plays her dominant strategy.
C) not achieve a Nash equilibrium.
D) assume that player A does not choose her dominant strategy.
Answer: B
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2) In a two-player simultaneous game where neither player has a dominant strategy,
A) there is never a Nash equilibrium.
B) there is only one Nash equilibrium.
C) the actual outcome can be unpredictable.
D) the actual outcome will not be a Nash equilibrium.
Answer: C
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Figure 14.1
3) Figure 14.1 shows the payoff to two airlines, A and B, of serving a particular route. If the two
airlines must decide simultaneously, which one of the following statements is true?
A) Firm A does not have a dominant strategy.
B) Firm B does not have a dominant strategy.
C) Neither firm entering is a Nash equilibrium.
D) The outcome of the game is unpredictable.
Answer: B
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4) Figure 14.1 shows the payoff to two airlines, A and B, of serving a particular route. If the two
airlines must decide simultaneously, which one of the following statements is true?
A) Firm A has a dominant strategy.
B) Firm B has a dominant strategy.
C) Neither firm entering is a Nash equilibrium.
D) The outcome of the game is unpredictable.
Answer: A
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5) Figure 14.1 shows the payoff to two airlines, A and B, of serving a particular route. If the two
airlines must decide simultaneously, which one of the following statements is true?
A) Only firm A will enter the market.
B) Only firm B will enter the market.
C) Neither firm entering is a Nash equilibrium.
D) The outcome of the game is unpredictable.
Answer: A
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6) Figure 14.1 shows the payoff to two airlines, A and B, of serving a particular route. If the two
airlines must decide simultaneously, which one of the following statements is true?
A) Since firm B has no dominant strategy, its decision is unpredictable.
B) Since firm B's decision is unpredictable, firm A's decision is unpredictable.
C) Neither firm entering is a Nash equilibrium.
D) Firm B will not enter because it knows firm A will.
Answer: D
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7) Figure 14.1 shows the payoff to two airlines, A and B, of serving a particular route. If the two
airlines must decide simultaneously, what will happen if the government offers a $30 subsidy
to airlines that serve this route?
A) Both firms will enter profitably.
B) Firm A will decide not to enter since firm B will.
C) Firm B is still better off not entering.
D) Neither firm will have a dominant strategy.
Answer: A
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8) Figure 14.1 shows the payoff to two airlines, A and B, of serving a particular route. If the two
airlines must decide simultaneously, how many Nash equilibria are there?
A) 0
B) 1
C) 2
D) It cannot be determined.
Answer: B
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9) Figure 14.1 shows the payoff to two airlines, A and B, of serving a particular route. If the two
airlines must decide simultaneously, what happens if the government imposes a $20 per firm
tax on firms that service this route?
A) Neither firm has a dominant strategy.
B) Not entering is a dominant strategy for both firms.
C) Neither firm entering is a Nash equilibrium.
D) Only firm A will enter.
Answer: A
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10) Figure 14.1 shows the payoff to two airlines, A and B, of serving a particular route. If the two
airlines must decide simultaneously, and the government imposes a $20 per firm tax on firms
that service this route, which of the following maximizes the firms' joint profits?
A) Neither firm services the route.
B) Firm A offers firm B $20 to not enter.
C) Both firms will service this route.
D) Firm B offers firm A $30 to not enter.
Answer: B
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Figure 14.2
11) Figure 14.2 shows the payoff to two gasoline stations, A and B, deciding to operate in an
isolated town. If firm A chooses its strategy first, then
A) firm A will not enter.
B) firm B's entry is blockaded.
C) both firms will enter.
D) firm A will enter and firm B will not.
Answer: C
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Topic: Preventing Entry: Sequential Decisions
12) Figure 14.2 shows the payoff to two gasoline stations, A and B, deciding to operate in an
isolated town. Suppose a $60 fee is required to enter the market. If firm A chooses its
strategy first, then
A) firm A will not enter.
B) neither firm will enter.
C) both firms will enter.
D) firm A will enter and firm B will not.
Answer: D
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Topic: Preventing Entry: Sequential Decisions
13) Figure 14.2 shows the payoff to two gasoline stations, A and B, deciding to operate in an
isolated town. Suppose a $30 fee is required to enter the market. If firm A chooses its
strategy first, then
A) firm A will not enter.
B) neither firm will enter.
C) both firms will enter.
D) firm A will enter and firm B will not.
Answer: C
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14) If only one firm operates in a market, and a potential entrant is blockaded from
entering the market, then the incumbent firm must
A) have acted to prevent entry.
B) be pricing where price equals marginal cost.
C) be a natural monopoly.
D) be the Stackelberg leader.
Answer: C
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15) An incumbent's threat to retaliate after a potential competitor enters the market will be taken
seriously by potential competitors if
A) the incumbent can still earn a profit after carrying out the threat.
B) the incumbent earns greater profit carrying out the threat than by accommodating entry.
C) the potential entrant cannot earn a profit if the threat is carried out.
D) the potential entrant's profit exceeds the incumbent's if the threat is carried out.
Answer: B
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Topic: Preventing Entry: Sequential Decisions
16) With regard to preventing entry, if identical firms act simultaneously,
A) they cannot credibly threaten each other.
B) they will all incur losses.
C) only one firm will enter the market.
D) none of them would enter the market.
Answer: A
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17) In the Stackelberg model, the leader has a first-mover advantage because it
A) has lower costs than the follower.
B) commits to producing a larger quantity.
C) reacts to the follower's decision.
D) differentiates its output.
Answer: B
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18) If a Cournot duopolist announced that it will double its output
A) it becomes the leader.
B) the other firm does not view the announcement as credible.
C) the other firm will shut down.
D) the other firm will double output also.
Answer: B
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19) If a Cournot duopolist announced that it will double its output, the other firm does not view
the announcement as credible because
A) the announcing firm's profits will fall if it carries out the threat.
B) the other firm's profits will fall if the announcing firm carries out the threat.
C) the other firm's profits will rise if the announcing firm carries out the threat.
D) the other firm will double output also.
Answer: A
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20) If an incumbent faces an identical potential entrant with no costs of entry, the incumbent will
A) produce the Cournot duopolist level of output.
B) produce the Stackelberg leader level of output.
C) set price equal to marginal cost.
D) shut down.
Answer: B
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21) If an incumbent cannot commit and faces an identical potential entrant with relatively high
fixed costs that are below the level where entry is blockaded, the incumbent will
A) produce the Cournot duopolist level of output.
B) produce the Stackelberg leader level of output.
C) set price equal to marginal cost.
D) produce a level of output that is greater than the Stackelberg leader level of output.
Answer: D
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22) One firm previously operated as a monopoly. Now, one potential entrant exists.
Consumers would prefer
A) entry, and the firms to split the output equally.
B) no entry, and for the incumbent to produce the Stackelberg leader level of output.
C) entry, and for the incumbent to produce the Stackelberg leader level of output.
D) no entry, and the monopoly to continue.
Answer: C
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23) Incumbents are unaffected by fixed costs of entry while potential entrants are affected by
them because
A) for potential entrants the cost is avoidable, while for the incumbent, it is not.
B) fixed costs will be greater for the potential entrant than for the incumbent.
C) fixed costs are zero for the incumbent.
D) incumbents will act to prevent entry at all costs.
Answer: A
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24) Regarding fixed costs of entry,
A) both incumbents and potential entrants are affected by them.
B) potential entrants are affected by them while incumbents are not.
C) neither incumbents nor potential entrants consider them.
D) incumbent's decisions are affected by them, while the potential entrant ignores them.
Answer: B
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Figure 14.3
25) Figure 14.3 shows the payoff matrix facing an incumbent firm and a potential entrant. The
potential entrant cannot earn a profit if the incumbent
A) chooses the Cournot level of output.
B) chooses the Stackelberg leader level of output.
C) shuts down.
D) deters entry.
Answer: D
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26) Figure 14.3 shows the payoff matrix facing an incumbent firm and a potential entrant.
Assuming a fixed cost of entry, the incumbent will deter entry because
A) it is more profitable than accommodating entry.
B) it increases consumer surplus.
C) the potential entrant winds up with zero profit.
D) the incumbent would earn zero profit if it accommodated entry.
Answer: A
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Topic: Preventing Entry: Sequential Decisions
27) Figure 14.3 shows the payoff matrix facing an incumbent firm and a potential entrant.
Assuming a fixed cost of entry, the outcome will be that the incumbent
A) deters entry.
B) chooses the Stackelberg leader level of output but the potential entrant does not enter
anyway.
C) chooses the Stackelberg leader level of output and the potential entrant enters.
D) deters entry and earns zero profit.
Answer: A
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28) Figure 14.3 shows the payoff matrix facing an incumbent firm and a potential entrant. If the
fixed cost of entry were to increase, which of the following would occur?
A) The incumbent chooses the Cournot level of output.
B) The incumbent shuts down.
C) The entry-deterring level of output rises.
D) The entry-deterring level of output falls.
Answer: D
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Topic: Preventing Entry: Sequential Decisions
29) For an incumbent, investing in plant and equipment that reduces marginal cost while raising
total cost makes sense if
A) the incumbent's profit from producing the entry-deterring level of output after making the
investment exceeds the profit the firm would earn if it didn't make the investment and entry
occurred.
B) the incumbent's profit from producing the entry-deterring level of output after making the
investment is positive.
C) the potential entrant cannot enter the market profitably after the incumbent makes the
investment and produces the entry-deterring level of output.
D) the potential entrant would not enter the market anyway.
Answer: A
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Topic: Creating and Using Cost Advantages
30) "Learning by doing" allows an incumbent firm to deter entry because
A) it raises the incumbent's marginal cost.
B) it lowers the incumbent's marginal cost.
C) it shifts the demand for the good rightward.
D) it is only available to incumbents and not future entrants.
Answer: B
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31) An incumbent's gain from "learning by doing" is diminished if learning is rapid because
A) the incumbent gets too quick a head start.
B) future entrants can catch up quickly.
C) the incumbent will not bother to learn cost-saving techniques.
D) other firms would not enter anyway.
Answer: B
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32) An incumbent's gain from "learning by doing" is diminished if learning is slow because
A) the incumbent gets too quick a head start.
B) future entrants cannot catch up.
C) the incumbent will not bother to learn cost-saving techniques.
D) the early cost reduction enjoyed by the incumbent is very small.
Answer: D
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Topic: Creating and Using Cost Advantages
33) Which of the following would not represent an incumbent's strategy to deter entry?
A) building excess capacity
B) limit pricing
C) patents
D) restricting output
Answer: D
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Topic: Creating and Using Cost Advantages
34) Recently, the American Institute of Certified Public Accountants changed the educational
requirements for certification from 120 college credits to 150 college credits. This policy
change represents
A) an increased cost to potential entrants.
B) a reduction in costs for incumbents.
C) an increased cost for incumbents.
D) accommodated entry.
Answer: A
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35) An incumbent firm lobbying government officials to require any new firms that
enter the market to include costly pollution-reducing devices, is an example of
A) learning by doing.
B) raising all firms' costs.
C) raising rivals' costs.
D) limit pricing.
Answer: C
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36) The monopoly can shift the demand for its product rightward by
A) accommodating entry.
B) advertising new uses for its product.
C) moving along the learning curve.
D) All of the above.
Answer: B
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Topic: Advertising
37) A firm will increase its spending on advertising until
A) it has monopolized the market.
B) it has deterred all future entry.
C) the marginal benefit of advertising is zero.
D) the marginal benefit of advertising equals the marginal cost of advertising.
Answer: D
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Topic: Advertising
38) If identical firms sell an undifferentiated product, advertising is likely to be
A) used to attack the rivals' products.
B) collectively undertaken by the industry group.
C) strategically aimed at deterring entry.
D) focused on secret ingredients.
Answer: B
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Topic: Advertising
39) A firm's advertising can help rivals
A) if it focuses on a general problem that the product addresses.
B) if it focuses on a secret ingredient that only this firm possesses.
C) if rivals do not advertise.
D) if rivals advertise.
Answer: A
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40) In a duopoly, if advertising only takes customers from rivals rather than attracting new
customers, then
A) neither firm will advertise.
B) there is no dominant strategy.
C) the result is similar to the prisoners' dilemma.
D) only one firm will advertise.
Answer: C
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Topic: Advertising
41) In a duopoly, if advertising only takes customers from rivals rather than attracting new
customers, then
A) the Nash equilibrium does not maximize the joint payoff.
B) the Nash equilibrium maximizes the joint payoff.
C) firms need not collude to maximize their joint payoff.
D) there is no dominant strategy.
Answer: A
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Topic: Advertising
42) In a duopoly, if advertising only takes customers from rivals rather than attracting new
customers, then
A) the Nash equilibrium maximizes the joint payoff.
B) firms must collude to maximize the joint payoff.
C) the Nash equilibrium is that neither firm advertises.
D) there is no dominant strategy.
Answer: B
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Topic: Advertising
43) In a duopoly, if advertising only takes customers from rivals rather than attracting new
customers, joint profits are maximized when
A) both firms advertise.
B) neither firm advertises.
C) the Nash equilibrium is achieved.
D) each firm plays its dominant strategy.
Answer: B
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44) In a duopoly, if advertising only takes customers from rivals rather than attracting
new customers, the two firms would prefer
A) the Nash equilibrium level of advertising.
B) to advertise more than the current level.
C) to not change the level of advertising.
D) an advertising ban.
Answer: D
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Topic: Advertising
TRUE/FALSE/EXPLAIN
1) In a simultaneous game where both players prefer doing the opposite of what the opponent
does, a Nash equilibrium does not exist.
Answer: False. There are two Nash equilibria. In each, the two players are doing the opposite
of one another. The problem is, it is difficult to know which equilibrium is achieved without
some form of collusion.
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2) If an incumbent threatens to retaliate against entry, but its profits are greater under
accommodated entry than under the proposed threat, potential entrants will ignore the threat.
Answer: True. The threat is not credible since the incumbent firm is better off
accommodating entry than retaliating.
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Topic: Preventing Entry: Sequential Decisions
3) Fixed costs of entry create an advantage for potential entrants since incumbents have already
made these expenditures while potential entrants can avoid these costs.
Answer: False. The advantage is to the incumbent. The incumbent ignores the fixed entry
cost since it is a sunk cost. For the potential entrant, the fixed entry cost can be avoided if
entry does not occur. Thus, the fixed entry cost is an added expense to entrants.
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4) Investments that lower a firm's marginal cost discourage entry.
Answer: True. By lowering marginal cost, a firm commits to producing large levels of
output. Thus, the incumbent's threat to retaliate against entry is credible.
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5) Since a monopoly faces no competitors, it need not advertise.
Answer: False. The monopoly benefits from advertising because advertising can shift the
demand for its product rightward.
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Topic: Advertising
PROBLEMS
Figure 14.1
1) Figure 14.1 shows the payoffs to two airlines, A and B, of serving a particular route. Is there
a Nash equilibrium? What is it? Explain.
Answer: Firm A entering and firm B not entering is the Nash equilibrium. Entering is firm
A's dominant strategy. It will enter no matter what firm B does. Firm B does not have a
dominant strategy but is always better off doing the opposite of firm A. Put in another way,
given firm A's decision, if firm B enters, it will incur a loss.
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Topic: Preventing Entry: Simultaneous Decisions
Figure 14.4
2) Suppose two firms, A and B, are simultaneously considering entry into a new market. If
neither enters, both earn zero. If both enter, they both lose 100. If one firm enters, it gains 50
while the other earns zero. Set up the payoff matrix for this game and determine if any Nash
equilibria exist. Can you predict the outcome? What if firm A gets to decide first?
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Answer: See Figure 14.4. There are two Nash equilibria; either firm A is a natural monopoly
or firm B is a natural monopoly. It is difficult to predict the outcome since the firms decide
simultaneously. If firm A has the opportunity to choose first, it will enter, and firm B will
not.
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3) Explain why to some game theorists the idea of mixed strategies is appealing and to
others it is implausible.
Answer: Sometimes the pure Nash equilibria call for identical firms to use different
strategies. With mixed strategies where firms choose between possible actions with given
probabilities, identical firms may use the same strategies, which is logically appealing.
However, some theorists do not agree with the assignment of probabilities, and claim that
mixed strategies are implausible because firms do not randomly select strategies. They
suggest that a firm may use some information that its rival does not observe to choose a pure
strategy.
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Topic: Preventing Entry: Simultaneous Decisions
Figure 14.2
4) Figure 14.2 shows the payoffs to two firms deciding to open a gasoline station in an isolated
town. If firm A decides first, what will happen? If there is a $60 fee to enter this market, what
will happen?
Answer: If firm A decides first, it will enter. Entering is also a dominant strategy for firm B,
so it will enter also. With a $60 fee, firm A still enters and earns $40. Firm B will not enter,
since it will incur a $10 loss doing so.
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Figure 14.3
5) Figure 14.3 shows the payoff matrix facing an incumbent firm. Assuming a fixed cost of
entry, will the incumbent deter entry? Why?
Answer: It will deter entry. The profit from deterring entry exceeds the profit from
accommodating entry.
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Topic: Preventing Entry: Sequential Decisions
6) How can a firm be made better off by limiting its options?
Answer: By limiting its options, the firm commits to a certain strategy. The strategy is now
viewed as credible by potential competitors. For example, an oversized plant commits the
firm to a large level of output. Its threat to overproduce in the face of entry is now viewed as
credible.
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Topic: Preventing Entry: Sequential Decisions
7) Suppose market demand is p = 10 - Q. Firms have a fixed cost of 5 and no marginal cost. If
firm A is the incumbent, can it deter the entry of its rival, firm B?
Answer: Firm B's reaction function is qB= 5 - (1/2)qA. The Stackelberg leader quantity is 5
and firm B will produce 2.5. Firm A's profit is 7.5. If firm A produces 6 units for example,
firm B's best response is 2 units; however, it would incur a loss and not enter. Firm A's
profits would be 19. Thus, firm A can deter entry by overproducing.
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8) Suppose market demand is p = 10 - Q. Firms incur no cost of production. If firm A is the
incumbent, can it deter the entry of its rival, firm B?
Answer: Firm B's reaction function is qB= 5 - (1/2)qA. Knowing this, firm A's profit function
is  = 5qA- q2A/2 . The Stackelberg leader maximizes profit at a quantity of 5 and firm B will
produce 2.5. Firm A's profit is 12.5. If firm A produces more, firm B will still enter and earn
a profit. Firm B must earn a profit since it faces no costs. Firm A's profit falls as its output
increases. So, firm A cannot deter entry and is better off accommodating firm B.
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Topic: Preventing Entry: Sequential Decisions
9) Two identical firms are considering entering a new market that currently has no
suppliers. The demand is large enough for both firms to make a positive profit. There are no
fixed costs to enter. Explain how a simultaneous decision to enter on the part of the two firms
will lead to a different outcome than a sequential entry decision.
Answer: If the firms' entry decisions are simultaneous, then neither firm can issue a credible
entry prevention threat. Both firms will enter and a Cournot equilibrium will result. If one
firm can decide to enter before the other, it will enter and produce the Stackelberg leader
level of output. The other firm will also enter and produce the optimal level of output given
the leader's output.
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Topic: Preventing Entry: Sequential Decisions
10) Suppose an incumbent firm builds a plant that is so large that it produces the Stackelberg
leader output at a very high average cost, but the competitive output at a very low average
cost. What does this behavior tell potential entrants?
Answer: This tells potential entrants that the incumbent is committed to retaliate if entry
occurs.
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Figure 14.5
11) Currently, there is an incumbent monopoly in a market. A potential entrant may
enter. The incumbent can spend x dollars lobbying to require all new firms that enter the
market to use a pollution-abatement device that costs y dollars to install. If lobbying occurs,
the pollution-abatement device will be required. Draw the game tree describing this situation.
Under what conditions will the monopoly lobby?
Answer: See Figure 14.5. If both firms are in the market, then they will each earn duopoly
profits. If lobbying occurs, then the lobbying cost will apply to the incumbent and the cost of
the device will apply to the entrant. If the entrant does not enter the market, then the
incumbent will earn monopoly profits. Again, if lobbying occurred, the cost must be
subtracted from the incumbent's profit. If the profit the monopoly makes minus the cost of
lobbying is greater than the duopoly profit the incumbent would earn if entry occurs, then the
monopoly will lobby.
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Topic: Creating and Using Cost Advantages
12) A monopoly faces the following demand function: Q = 100 - p + sqrt(A), where A equals the
dollar amount spent on advertising. If the cost function is A + 10 + 2Q, what are the profitmaximizing levels of price, output, and advertising? Compare this outcome to the case where
the firm does not advertise at all.
Answer: (1)  = (100 - Q + sqrt(A))Q - 10 - 2Q - A.
(2) /Q = 100 - 2Q + sqrt(A) - 2 = 0
(3) /A = Q/2sqrt(A) - 1 = 0
From (3), sqrt(A) = Q/2. Substituting into (2) and rearranging yields Q = 65.33. So, A =
1067.32 and p = 67.33. Total revenue is (65.33 * 67.33) = 4398.67. Total costs = (10 +
2(65.33) + 1067.32) = 1207.98. Profit equals 3190.69.
Without advertising, set A = 0 in equation (2). This yields Q =49 and p = 51. Total revenue
equals 2499; total cost equals 108. Profit equals 2391. The firm is better off advertising.
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Topic: Advertising
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13) Under what conditions would firms be likely to support an industry-wide advertising ban?
Answer: If advertising only takes share away from rivals, the firms in the industry are better
off if advertising is banned. Yet, if advertising is not banned, their dominant strategy is to
advertise. This Nash equilibrium of all firms advertising, however, does not yield maximum
joint profits.
Diff: 1
Topic: Advertising
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