BUSI 620 QUESTIONS FOR CRITICAL THINKING

Questions for Critical Thinking 5

Salvatore’s Chapter 10:

Discussion Questions: 2 and 8.

2. (a) What are the advantages of the Herfindahl index over concentration ratios in measuring the degree of concentration in an industry? (b) What is the disadvantage of both?

The Herfindahl Index (H) is given by the sum of the squared values of the market shares of all the firms in the industry. The higher the H, the greater is the degree of concentration in the industry (Salvatore, 2011, pg. 415).

It was developed to provide an alternative measure of the relative market control of the largest firms to that found with the four-firm and eight-firm concentration ratios. The Herfindahl index is named after Orris C. Herfindahl, the economist first credited with using it to analyze industry concentration. The degree by which an industry is dominated by a few large firms is meansured by concentration ratios (Salvatore, 2011, pg. 415). These ratios give the percentage of total industry sales of the 4, 8, or 12 largest firms in the industry.

8. In what way does OPEC resemble a cartel? How successful is it?

• Advantages:
• –H is advantageous, as it applies the information of all firms, rather than the 4, 8, or 12 largest firms.
• -Higher H, greater degree of concentration in industry.
• -By squaring the market share of each firm, H appropriately gives much larger weight to larger firms rather than smaller firms.
• -Concentration ratios give percentages of total industry sales of the 4, 8, or 12 largest firms.
• -With concentration ratios, the four-firm concentration ratio for most manufacturing industries in the US, for example, is close to 100 is oligopolistic and are between 20 and 80 percent.
• -Industries in which this ratio is higher than 50 to 60 percent are also likely to be oligopolistic.
• (b)Disadvantages:
• –H has difficulty in finding numbers, meaning, while a 4 firm concentration ratio of 61.25% indicates that the top 4 firms in the industry account for 61.25% of total industry sales. Therefore H has no intuitive meaning.
• -There is no specific reason, theoretically or otherwise, to square market share for each firm. Squaring does not give greater importance to firms with larger market shares, as these shares could easily be cubed or raised to the 4th, 5th, or 6th power.
• –H requires a substantial amount of information versus the information required for concentration ratios. When calculating a 4 firm concentration ratio, the only information that is taken is from the top 4 firms.
• -To calculate H, the market share for every firm in the industry is needed rather than the top 4, 8, or 12 firms. Since some of these firms are oligopolistic, industries also have a few large firms, and dozens, even hundreds of smaller firms. Therefore, obtaining the needed information can be quite a chore.

A cartel is a group of firms that behave and act as a single firm, with all decisions made jointly in a way that will maximize profit(s) for the entire group. The Organization of the Petroleum Exporting Countries (OPEC)consists of 12 oil producing and exporting countries, spread over America, Asia and Africa. The OPEC decides how much crude oil will be supplied, to those in OPEC, in a way that will keep prices stable, as well as maintain prices that the profits of the oil, exported to other nations, will not suffer.

Basically this means that with higher cartel prices, less oil is demanded, which is why OPEC assigns specific output quotas. So far, it has been fairly successful as OPEC has greatly raised the prices of oil products for consumers and in turn, the profits increased significantly.

Problems: 1 and 5.

Herfindahl Index = Sum of Squared Shares

• Find the Herfindahl index for industry composed of (a) three firms – one with 70 percent of the market, and the other two with 20 and 10 percent of the market respectively; (b) one firm with a 50 percent share of the market and 10 other equal-sized firms; (c) 10 equal-sized firms.

HHI = 702+202+102= 5400

• 3 Firms:

HHI= 502+52+52+52+52+52+52+52+52+52+52 = 2750

• 1 Firm:

5. Starting with the reaction functions of duopolists A and B from Problem 4, find the Cournot solution algebraically.

• 10 Equal Sized Firms:
• HHI = 102+102+102+102+102+102+102+102+102+102 = 1000

Duopolist A: QA = (12-QB)/2
Duopolist B: QB = (12-QA)/2

Substituing equation 1 into equation 2:

QB= (12-(12-QB)/2)/2→ QB= 12/5 = 2.4

If the value of QB, found in equation 1 is placed in equation 1:

QA= (12-(12/5))/2 → QA= 24/5 = 4.8

Therefore, the Cournot Solution is:

QA = 4.8 and QB = 2.4

Froeb and McCann’s Chapter 10:

Individual problems: 10-4.

10.4. Examine the U.S. Passenger airline industry using the Five Forces. Is this an attractive industry? Why or why not?

The Five Forces Industry Analysis include: bargaining power of suppliers, bargaining power of customers, threat of new entrants, threat of substitute products, and competitive rivalry within an industry.

Threat of New Entrants include:

-Industry involves quite considerable investment

-Very tightly regulated by authorities

-Difficult to break brand of loyalty by those already loyal

-Very highly congested areas in major airports

Threat of Substitues:

-Road

-Rail

-Marine

Bargaining Power of Customers/Buyers:

-Industry faces strong bargaining power of customers because of technology

-Deregulation is another bargaining of power of customers

-Already existing loyalty from customers

Bargaining Power of Suppliers

-Dependent on limited suppliers and high barriers to entry

-Cost that is associated with switching from one supplier to another is rather high

-Various types of aircrafts may potentially be provided supplies by very few suppliers/product differentiation

Competitve Rivalry within Industry:

-This aspect is fairly high

-Slower growth rate

-Rather high fixed costs

-Low marginal costs

(Source: Khorasani, R., Garcia, G., Casiano, E., &Vrzal, E. (2009). Airline industry. Retrieved from http://www.slideshare.net/rayk47/airline-industry.)

Salvatore’s Chapter 11:

Discussion Questions:12and 13.

12. How did the 1971 law that banned cigarette advertising on television solve the prisoners’ dilemma for cigarette producers?

When the 1971 law that banned cigarette advertising on television went into effect, cigarette companies were searching for ways to still bring in profits. However, this ban actually increased the profits for cigarette companies. It helped solve the prisoners’ dilemma for cigarette producers because it allowed and made way for the outcome to be increasing profits, despite a decrease in advertising. This is because cigarette companies were spending less and less on adversiting and instead earning higher profits.

13. (a) What is the meaning for tit-for-tat in game theory? (b) What conditions are usually required for tit-for-tat strategy to be the best strategy?

Problems: 2, 6, and 10.

• Tit-for-tat in game theory basically means do to your opponent what he or she has done to you. To further explain, one player begins by cooperating and continues to cooperate as long as their opponent cooperates in return. If the opponent betrays the other players, then the next move the player makes against their opponent will entail them betraying him or her in return. This cycle can repeat.
• The best strategy for each player is repeated games. This implies that a players will respond or make a move based on the previous move of their opponent. Each player of a game will cooperate with any other oppononets who are cooperative as well, or in some cases will betray any opponents who betray them. The stipulations of the repeated game strategy is the fact that the moves of cooperation or betrayal are repeated indefinitely. If each player in the game cooperates with one another, then the end result is successful and happy one. On the contrary, if the players of the game knew when their opponents were going to be cooperative versus being rebels, then each player in the game would have the inclination to repeat the same behavior.

6. Explain why the payoff matrix in Problem 1 indicates that firms A and B face the prisoners’ dilemma.

• From the following payoff matrix, where the payoffs that are profits or losses of the two firms, determine (a) whether firm A has a dominant strategy, (b) whether firm B has a dominant strategy, (c) the optimal strategy for each firm, and (d) the Nash equilibrium, if there is one.
• When Firm B chooses to charge a low price, Firm A will also charge a low price and in turn earn a higher payoff. When Firm B decides to charge a high price, Firm A should consider charging a high price as well. Firm A is dependent on Firm B’s strategy. Therefore, Firm A does not have a dominant strategy.
• Based on the matrix and the answer from (a), Firm B does indeed have a dominant strategy of low price. When Firm A chooses to charge a low price, Firm B will choose to charge a low price too and in return earn a higher payoff.
• The optimal strategy for Firm A would be to charge a high price if Firm B is charging a high price and the same goes for a low price.
• For Firm B, the optimal strategy would be to charge a low price, period.
• The Nash Equilibrium is low price for both Firm A and Firm B. The payoff for both firms is (1,1).

The prisoners’ dilemma is a situation in which each firm adopts a dominant strategy, but each could do better by cooperating. If cooperation was exercised in this situation, then both Firms A& B would have not been in such a predicament.

In the problem, both Firm A& Firm B would have been better off if they both could have come together and decided on a strategy. Both firms knew that if they charge high prices, then they could both make high profits. However, if Firm A kept prices high and Firm B kept prices low, then Firm A would ultimately suffer a decrease in profit. The same applies to Firm B keeping a high price and Firm A keeping a low price. If both firms keep their prices low, then they will suffer losses. This is what is referred to as Prisoner’s Dilemma.

10. Given the following payoff matrix, (a) indicate the best strategy for each firm. (b) Why is the entry-deterrent threat by firm A to lower the price not credible to firm B? (c) What could firm A do to make its threat credible without building excess capacity?

(a) The best strategy for both Firm A and Firm B would be low price.

(b) The entry-deterrent threat is decreasing the payoff and it will actually be a negative payoff if Firm B will not lower the price.

(c) For Firm A to make its threat credible, without building excess capacity, they should keep a low price.

Froeb and McCann’s Chapter 15:

Individual problems: 15-4 and 15-5.

15-4. The following represents the potential outcomes of your first salary neogotiation after graduation: Assuming this is a sequential move game with the employer moving first, indicate the most likely outcome. Does the ability to move first give the employer an advantage? If so, how? As the employee, is there anything you could do to realize a higher payoff?

15-5. Every year, management and labor renegotiate a new employment contract by sending their proposals to an arbitrator who chooses the best proposal (effectively giving one side or the other $1 million). Each side can choose to hire, or not hire, an expensive labor lawyer (at a cost of $200,000) who is effective at preparing the proposal in the best light. If neither hires lawyers or if both hire lawyers, each side can expect to win about half the time. If only one side hires a lawyer, it can expect to win three-quarters of the time.

Note:

• Diagram this simultaneous move game.
• What is the Nash Equilibrium of the game?
• Would the sides want to ban lawyers?

P15-5: Part of the payoff matrix looks like the following:

Submit this assignment by 11:59 p.m. (ET) on Sunday of Module/Week 5.