Question 5 a) The two big fast food chains, Cafe de Coral and Fairwood, occupy a

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Question 5

a) The two big fast food chains, Cafe de Coral and Fairwood, occupy a very large share in the Chinese fast food market in Hong Kong. Suppose these two fast food chains try to form a cartel to charge higher prices for their food. Each fast food chain can choose to charge high prices (H) or low prices (L). The payoffs to each of the fast food chains are summarized in the following matrix:

Fairwood’s payoffs

Fairwood’s payoffs

Note: The first entry is Cafe de Coral’s payoffs and the second entry is Fairwood’s payoffs.)

i The cartel agreement is for each fast food chain to charge high prices (H). What are the payoffs to the two fast food chains if the agreement is observed?

ii Explain why an individual fast food chain has no incentive to charge high prices as specified in the agreement.

b Why do economists say that a monopolistically competitive firm is producing too little output from an efficiency point of view? Briefly explain with a diagram.

Fairwood’s payoffs

Fairwood’s payoffs

L H Cafe de Coral’s payoffs L (2,2) (12,0) Cafe de Coral’s payoffs H (0,12) (10,10)

Explanation / Answer

I) When both the fastfood companies charge are high price, both of them will earn a payoff of 10 each

Ii) This is because when one firm is charging a high price, then if the other firm charges a low price, then it will earn higher payoff of 12, which incentivses it to defect from the agreement.

Iii) This is because a monopolistically competitive firm produces till the point MR=MC. This output level is much less than the perfectly competitive and efficient output level of P=MC

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