CFA Level I · CFA Level I Exam · The Firm and Market Structures
Two firms in a duopoly each choose to keep a high price or cut price. If both keep high prices, each earns 10. If both cut, each earns 4. If one cuts while the other keeps high, the cutter earns 14 and the other earns 2. The Nash equilibrium is most likely:
The Nash equilibrium is both firms cutting price. Cutting is each firm's best response whatever the rival does, since it pays 14 rather than 10 and 4 rather than 2. Both therefore cut and earn 4, which is worse than the cooperative outcome of 10 each.
- Aboth firms keep the high price
- Bone firm cuts and the other keeps the high price
- Cboth firms cut priceCorrect
Explanation
If the rival keeps high, cutting yields 14 versus 10, so cutting is better. If the rival cuts, cutting yields 4 versus 2, so cutting is better. Cutting is dominant, so both cut and earn 4 each, even though both would be better off at 10.
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