Consider an industry in which two firms are producing a product. Assume that the two firms are current "colluding together" to set price so to maximize the industry profit. At this collusive price, the industry profit is $100 million - and that profit is split evenly between the two firms. Assume also that if one firm were to cut their price, then the industry profit would fall to $80 million and the firm that cut the price would take 75% of the market. Finally, if both firms cut there price the industry profit would fall to $50 million - and that profit would be split evenly.
(1) Is game theory is an appropriate tool for analyzing this competitive situation? If so, why?
(2) Would you recommend that a firm cut its price or hold to the current price? Why?
(3) How, if at all, does this relate to the notion of a "prisoner's dilemma"?
(4) If the two parties initiated a "meeting competition clause" (e.g. "we will meet or beat or competitors price"), how would that change the strategic nature of the pricing decision.
(5) If these two firms were expected to be competing in this market for many years - that is, if they would revisit their pricing decision several times might that effect your recommendation? If so, why and how?