In an hour, Kim can produce 50 pies or 400 cakes, and Liam can produce 150 pies or 300 cakes.

1. If Kim and Liam spend 30 minutes of each hour producing pies and 30 minutes producing cakes, how many pies and cakes does each of them produce?
2. Who has a comparative advantage in producing pies, and in producing cakes?
3. If Kim and Liam specialise and trade, what is the highest price of a pie at which Kim and Liam would agree to trade pies and cakes? What are the gains from trade?

Question 4

Suppose that United Airlines and American Airlines are the only air carriers that serve between New York and Boston. Each currently earns a profit of $6,000 per flight on this route. If United increases its advertising spending in this market by $1,000 per flight, and American spends no more on advertising than it does now, United's profit will rise to $8,000 per flight and American's will fall to $2,000. If both spend $1,000 more on advertising, each will earn an economic profit of $5,500 per flight. These payoffs are symmetric, so that if United spends the same amount on advertising while American increases its spending by $1,000, United's economic profit will fall to $2,000 per flight and American's will rise to $8,000.

1. Develop the payoff matrix.
2. Does each player have a dominant strategy?
3. What are the potential equilibriums?
4. Is this game a prisoner's dilemma? Explain

Answers:

Question 1

In order to maximise the profit, the pizza seller would produce a quantity where there is intersection of marginal revenue and marginal cost. Since the price is $ 2.5, the MR and MC would tend to intersect at Q = 500. Hence, the equilibrium quantity in the given case would be 500 pizzas.

Profit = (Unit Price – Unit total cost )*Units = (2.5-2.25)*500 = $ 125 per day

Question 2

1. It is essential to note that Xbox console and the Xbox game are complements. With there is reduction in price of Xbox console, there would be an increased demand for Xbox. Further, the demand for Xbox games would also increase owing to the complementary nature of the product. This is indicated below.

The demand curve for Xbox moves to the right and is denoted by D₁. As a result, the equilibrium price and equilibrium quantity for Xbox games tend to increase.

1. Considering that PS3 and Wii are substitutes of Xbox, hence the fall in prices of these consoles would lead to increase in demand for these consoles and corresponding decrease in demand for Xbox console. This would imply that the demand for Xbox games would also decrease which is indicated below.

It is apparent that the demand curve for Xbox games tends to shift to the left causing a decrease in the price coupled with decrease in equilibrium quantity.

1. Due to increase in the cost of programmers, the overall cost would go up for Xbox games and hence there would be a negative impact on the supply. Hence, there would be a decrease in the supply which is represented using the following diagram.

There is a shift in the supply curve from S to S1. This leads to increase in the equilibrium price (P to P1) and corresponding decrease in the equilibrium quantity for Xbox games (Q to Q1).

Question 3

1. It is known that in an hour, Kim can produce 50 pies.  Also, in an hour, Kim can produce 400 cakes

In half an hour, Kim would produce (50/2) = 25 pies

In half an hour, Kim would produce (400/2) = 200 cakes

It is known that in an hour, Liam can produce 150 pies.  Also, in an hour, Kim can produce 300 cakes

In half an hour, Liam would produce (150/2) = 75 pies

In half an hour, Liam would produce (300/2) = 150 cakes

1. To determine the comparative advantage, the opportunity cost for the two products need to be determined.

For Kim, opportunity cost of pie = (400/50) cakes or 8 cakes

For Liam, opportunity cost of pie = (300/150) cakes or 2 cakes

Since, the opportunity cost of pie is lower for Liam, then for production of pie, Liam has the comparative advantage.

For Kim, opportunity cost of cake = (50/400) pies or 0.125 pies

For Liam, opportunity cost of cake = (150/300) pies or 0.5 pies

Since, the opportunity cost of cake is lower for Kim, then for production of cake, Kim has the comparative advantage.

Considering the above competitive advantage, it is apparent that Liam would specialise at production of pie while Kim would specialise at cake production.

Case 1: No trade specialisation – Half an hour to each product by each individual

Total production of pies = 25+75 = 100 pies

Total production of cakes = 200 + 150 = 350 cakes

Case 2: Trade and specialisation

Liam devotes 1 hour to production of pie and is able to produce 150 pies.

Kim devotes 1 hour to production of cake and is able to produce 400 cakes.

Hence, the gains from trade amount to 50 cakes and 50 pies as the total production is increased by this amount owing to specialised production based on lower opportunity cost and trading.

Question 4

1. The payoff matrix is given below.

ADV indicates the strategy for the concerned airline to increase the advertising spend by $ 1,000 per flight

NO ADV indicates the strategy for the concerned airline not to increase the advertising spending.

Based on the above payoff matrix, it is apparent that it is symmetric. Also, it is evident that American airlines has a dominant strategy which is to increase the advertising spend. Similarly, United airlines would also have the same dominant strategy, As a result, each of the players would be having a dominant strategy owing to the symmetric nature of the payoff matrix obtained above.

In the event that both the given firms tend to implement their dominant strategy, then there would exist equilibrium and it would provide a profit of $ 5,500 per flight to each of the players as both would choose to do advertising in the fear of lowering the profit if the other firm decides to go ahead with advertising.

Yes, this is a classic case of prisoner dilemma. This is because the equilibrium under dominant strategy yields a lower profit for each of the firms than the existing equilibrium. It is apparent that their mutual interest would be served better if both decided not to advertise and the respective payoffs would be more. However, since they are not sure about the move by the other airlines and also no collusion or cooperation exists, each airline plays safe and thereby choses an strategy which leads to sub-op