5 Steps to a 5 AP Microeconomics, 2014-2015 Edition

Use of the previous game matrices assumes that both players in the game make simul-

taneous choices. Many games involve a series of stages where one player moves first. The

second player observes the choice made by the first and then reacts to it. These sequential

games are typically seen as a game tree rather than a game matrix.

Let’s convert the previous game to a sequential game where gas station X gets to move

first, as shown in Figure 9.16. Station Y sees the choice of station X and then sets the price

high or low. Payoffs are given at the end of the tree.

136 › Step 4. Review the Knowledge You Need to Score High

X sets

price

High

Low

Y now

sets price High

Low

Low

High

X: $2,000

Y: $2,000

X: $500

Y: $3,000

X: $3,000

Y: $500

X: $1,000

Y: $1,000

Figure 9.16

Can you see how this game will play out? Gas station X knows that its rival, station Y,

still has a dominant strategy of setting a low price. No matter what the initial decision of

station X, station Y would always see that a low price beats a high price. Because station X

knows this about its rival, it will select a low price at the beginning of the game. In 2007,

the AP Microeconomics exam included simple game theory on the free-response section for

the very first time. You should expect this area of microeconomics to be tested again in the

future, and I predict that the degree of difficulty will gradually increase.

Collusive Pricing

Explicit collusivebehavior between direct competitors is an illegal business practice, but it

does happen (surprise!) from time to time. More common is a kind of tacit, or understood,

collusion. Two competitors over time figure out that repeated attempts to undercut the

price of their rivals is counterproductive. Eventually they understand that if both set the

price high, both firms win. When one cheats on this “understanding,” the other inflicts

punishment with a retaliatory price cut.

Cartelsare more organized forms of collusive oligopoly behavior. Cartels are groups of

firms that create a formal agreement not to compete with each other on the basis of price,

production, or other competitive dimensions. The general idea of the cartel is that rather than

act independently to maximize individual profits, they collectively operate as a monopolist to

maximize their joint profits. Each cartel member agrees to a limited level of output, and this

results in a higher cartel price. Joint profits are maximized and distributed to each member.

In addition to the pesky illegality of forming cartels, these entities face three challenges

that are completely unrelated to the Attorney General:

1. Difficulty in arriving at a mutually acceptable agreement to restrict output. Have you
   ever tried to order pizza or rent a movie with more than two other friends? If so, you
   get the idea.

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