Burger King and Mac Donald’s are situated on opposite corners of a downtown inte
ID: 1251715 • Letter: B
Question
Burger King and Mac Donald’s are situated on opposite corners of a downtown intersection. Burger King and Mac Donald’s compete on the basis of the prices they set for their burger, fry, and soda combination meals. Every Monday, Burger King and Mac Donald’s simultaneously choose their combo meal prices, which will remain in effect for the rest of the week.
Burger King and MacDonald’s consider only two possible prices: a low price of $3.50 or a high price of $4.50 for their combination meals. The weekly profit from each of the four possible combinations of decisions is given in the following table:
Burger King’s price
Low ($3.50)
High ($4.50)
Mac Donald’s
price
Low ($3.50)
A
$3,000, $5,500
B
$6,500, $5,000
High ($4.50)
C
$2,000, $9,000
D
$5,000, $8,000
Payoffs in dollars of weekly profit.
Explain the statements below.
a. The pricing decision facing Burger King and Mac Donald’s is a prisoners’ dilemma.
b. Cooperation between Burger King and Mac Donald’s occurs in cell D of the payoff table. The noncooperative outcome occurs in cell A.
c. Cell B represents cheating by McDonald’s, while cell C represents cheating by Burger King.
d. If Burger King and Mac Donald’s make their pricing decision just one time, they will likely end up in cell A.
e. Burger King can credibly threaten to punish MacDonald’s with a retaliatory price cut.
f. MacDonald’s can credibly threaten to punish Burger King with a retaliatory price cut.
A news magazine offers students a discount on the regular subscription rate. The total number of subscriptions is optimal, and, at the current prices, the marginal revenue from the last subscription sold to a student is $6, while the marginal revenue from the last subscription sold to a regular customer is $10.
a. What could the magazine do in order to maximize profit? Explain.
b. How would profit be affected if the magazine sells one more subscription to a regular customer and one less subscription to a student? Explain.
Burger King’s price
Low ($3.50)
High ($4.50)
Mac Donald’s
price
Low ($3.50)
A
$3,000, $5,500
B
$6,500, $5,000
High ($4.50)
C
$2,000, $9,000
D
$5,000, $8,000
Payoffs in dollars of weekly profit.
Explanation / Answer
Explain the statements below. a. The pricing decision facing Burger King and Mac Donald’s is a prisoners’ dilemma. The pricing decision works in the same way the prisoner's dilemma works in that there is one outcome (high, high) where cooperation makes both players better off than the non-cooperative outcome (low,low), but each player could do a little better than the cooperative outcome by cheating. If the players agree to cooperate than one player will choose high and if the other player cheats he can choose low and make a higher profit in that period. In the prisoner's dilemma, the cooperation outcome ends in a little jail time for each player, but less than the non-cooperative outcome where both prisoner's talk. b. Cooperation between Burger King and Mac Donald’s occurs in cell D of the payoff table. The non-cooperative outcome occurs in cell A. If the players choose to cooperate, they can each choose high prices (high, high)--cell D. In this scenario, the players will both benefit from the cooperation because both will make more than if they do not cooperate. The non-cooperative outcome occurs at low, low because if I am Burger King and do not know how Mac Donald's will set prices, I have a dominant strategy to choose low. Since the same is true for Burger King, the non-cooperative outcome is the result of the dominant strategies of choosing low and will be (low,low)--Cell A c. Cell B represents cheating by McDonald’s, while cell C represents cheating by Burger King. If both players agree to the cooperative outcome (cell D), then one player can cheat and choose low, while the other chooses high and earn a higher profit in that period than they would have earned at the cooperative outcome. d. If Burger King and Mac Donald’s make their pricing decision just one time, they will likely end up in cell A. As explained, cell A is the Nash Equilibrium of the game where no cooperation is possible because both players have a dominant strategy to choose low. That means that if one player does not know what another player will do, he will be better off choosing low, so the result of the game will be (Low, Low)--Cell A. e. Burger King can credibly threaten to punish Mac Donald’s with a retaliatory price cut. Burger King will have to threaten to punish Mac Donald's if there is to be cooperation, otherwise Mac Donald's will choose low while Burger King chooses high in order to move from a pay-off of $5,000 at cell D, to $6,500 at cell B. If that happens, Burger King will make $5,000 instead of the $8,000 at cell D, but more importantly, less than the $5,500 Burger King would have made at cell A (non-cooperation). Since Mac Donald's cheating makes Burger King less well off than not cooperating, Burger King will have a credible threat. f. Mac Donald’s can credibly threaten to punish Burger King with a retaliatory price cut. Mac Donald's will have to threaten to punish Burger King for cheating if there is to be cooperation, otherwise, Burger King will choose low while Mac Donald's chooses high in order to move from a pay off of $8,000 at cell D, to $9,000 at cell C. If that happens, Mac Donald's will make $2,000 instead of the $5,000 at cell D, but more importantly, less than the $3,000 it would have made at cell A (non-cooperative). Since Burger King's cheating makes Mac Donald's less well off than not cooperating, Mac Donald's will have a credible threat. A news magazine offers students a discount on the regular subscription rate. The total number of subscriptions is optimal, and, at the current prices, the marginal revenue from the last subscription sold to a student is $6, while the marginal revenue from the last subscription sold to a regular customer is $10. a. What could the magazine do in order to maximize profit? Explain. If possible, it could sell more subscriptions at the regular price instead of the discount rate. If it is possible to sell more subscriptions at the regular rate, and therefore, fewer at the discount rate, it may also be possible to reduce the amount of the discount since a lower quantity is to be sold anyway (move to the left on the demand curve for discount subscriptions). b. How would profit be affected if the magazine sells one more subscription to a regular customer and one less subscription to a student? Explain. Profit will increase. At current prices, marginal revenue will increase by ($10-$6) $4 for every magazine that is sold at the regular price instead of the discount price.
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