The matrix in Figure 1 shows payoffs based on the strategies chosen by two firms. If they collude and hold prices at $10, each firm will earn profits of $5 million. If A cheats on the agreement, lowering its price, but B does not, A will get 75 percent of the business and earn profits of $8 million and B will lose $2 million. Similarly, if B cheats and A does not, B will earn $8 million and A will lose $2 million. If both firms cut prices, they will end up with $2 million each in profits. 

Which strategy minimizes the maximum potential loss for A and for B? If you were A, which strategy would you choose? Why? If A cheats, what will B do? If B cheats, what will A do? What is the most likely outcome of such a game? Explain.

Transcribed Image Text:

Figure 1 Stand by agreement A's Strategy Cheat Stand by agreement B's Strategy B's profit = $5 million A's profit= $5 million B's profit= -$2 million A's profit= $8 million Cheat B's profit= $8 million A's profit = -$2 million B's profit = $2 million A's profit = $2 million