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IAI Actuarial Core Principles · Business Economics · Profit maximisation under imperfect competition

In a one-shot simultaneous game, two airlines each choose between a high fare and a low fare. Each airline earns more by choosing the low fare whatever the rival does, yet both would earn more if both chose the high fare. What is the Nash equilibrium of this game?

Both airlines choose the low fare. Low is a dominant strategy for each, so (low, low) is the Nash equilibrium, even though both would earn more at the high fare. This is the classic prisoners' dilemma outcome in a one-shot game.

  1. ABoth choose the high fare, because joint profit is highest there
  2. BBoth choose the low fare, because it is each firm's dominant strategyCorrect
  3. COne airline chooses high and the other low, alternating each period
  4. DBoth firms randomise equally between the two fares
  5. No equilibrium exists because the outcome is not jointly optimal

Explanation

A dominant strategy is best whatever the rival does. Since low is best for both, (low, low) is the Nash equilibrium. This is the prisoners' dilemma: the jointly better high-high outcome is not stable because each firm gains by undercutting.

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