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CMA Foundation · Fundamentals of Business Economics and Management · Forms of Market

In a duopoly, firm A earns Rs 50 lakh and firm B Rs 50 lakh if both keep prices high. If A cuts price while B keeps it high, A earns Rs 80 lakh and B Rs 20 lakh, and the same holds in reverse. If both cut, each earns Rs 30 lakh. Each firm chooses independently, without agreement. What is the likely outcome?

Both firms cut prices and earn Rs 30 lakh each. Cutting is a dominant strategy for each, since it pays more whatever the rival does (80 over 50, and 30 over 20), even though both would gain more by keeping prices high.

  1. ABoth keep prices high, earning Rs 50 lakh each
  2. BBoth cut prices, earning Rs 30 lakh eachCorrect
  3. CA cuts and B keeps high, earning Rs 80 lakh and Rs 20 lakh
  4. DB cuts and A keeps high, earning Rs 80 lakh and Rs 20 lakh

Explanation

If B keeps high, A gains by cutting (80 against 50). If B cuts, A still gains by cutting (30 against 20). So cutting is a dominant strategy for A, and by symmetry for B. Both cut and earn Rs 30 lakh each, even though both would be better off at Rs 50 lakh. This is the prisoner's dilemma, and option A would need a binding agreement.

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