Question

A booming airline industry is known to be running under a duopoly form of market. On New Years day, both firms are considering to acquire either 5 or 10 Airbus planes. Their profits (in millions of USD) would depend also on the other firm's decision. The possible profits are depicted in a matrix below:

		Firm A
		5 planes	10 planes
Firm B	5 planes	100, 100	80, 140
	10 planes	140, 60	80, 80

a. Explain why it is possible for these firms to earn more by buying fewer planes together. Is it Pareto optimal?

b. Explain why both firms will end up buying more planes. Is it good for the travelers?

c. Discuss how these two firms can achieve a sustainable cooperative outcome over a long-run horizon. Explain why such strategy is effective.

Answer 1

(a) The payoff matrix suggests that both the firms will earn a profit of 100 units upon buying 5 planes each and if you both the firms buy the 10 planes then each firm will earn a profit of 80 units each. Therefore, it is suitable for both firms to buy fewer planes

Yes, it is Pareto optimal. In Pareto optimal condition nobody can be better off without making someone worse off. Any deviation from 5,5 planes will reduce the profit of at least one of the firm therefore there no available option in which some people can be better off without making nobody worse off

(b) In the independent noncooperative game, the firms will reach Nash equilibrium. Each firm has an option of increasing planes from 5 to 10 since it will yield extra profit from 100 units to 140 units. This force drives each firm to buy 10 planes and game theory name this concept as Nash equilibrium.

Yes, indeed, it is good for travellers because the increased supply of planes will reduce the price of travelling and increase availabilities of travel through the air

(c) In the second option, each firm end up buying 10 planes because the strategy is formed in isolation of other firms means no cooperation.

The collusion as a mode of cooperation among competitors can yield a higher return than non-cooperation. The cooperative strategy will result in each firms buying only 5 planes.

This strategy is effective over a long time horizon because the victim firm can retaliate if the other party broke the agreement through strategies like Tit-for-Tat((the punishment continues as long as the other player defects), Tit-for-two Tats(a more forgiving variant of tit for tat) or Grim trigger strategy(the punishment continues indefinitely after the other player defects just once)

Good Luck!!

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