AP_Krugman_Textbook

Tackle the Test:

Multiple-Choice Questions

1. a


2. e


3. d


4. e


5. b

Tackle the Test:

Free-Response Questions

2. a.The first major reason is that cartels are illegal in the
   United States. The second major reason is that cartels set
   prices above marginal cost, which creates an incentive for
   each firm to cheat on the cartel agreement in order to
   make more profit. This incentive to cheat tends to cause
   cartels to fall apart.
   b.Under the Cournot model, each firm treats the produc-
   tion of other firms as fixed and chooses the quantity
   that will maximize profit. This type of quantity competi-
   tion results in relatively low production levels and posi-
   tive economic profit. Under the Bertrand model, firms
   undercut the prices of their rivals until price equals
   marginal cost. This type of price competition results
   in normal profit (zero economic profit), as under per-
   fect competition.

Module 65

Check Your Understanding

1. a.A Nash equilibrium is a set of actions from which neither
   side wants to deviate (change actions), given what the
   other is doing. Both sides building a missile is a Nash
   equilibrium because neither player wants to deviate from
   the decision to build a missile. To switch from building to
   not building a missile, given that the other player is
   building a missile, would result in a change from −10 to
   −20 utils. There is no other Nash equilibrium in this
   game because for any other set of actions, at least one
   side is not building a missile, and would be better off
   switching to building a missile.
   b.Their total payoff is greatest when neither side builds a
   missile, in which case their total payoff is 0 + 0 =0.
   c.This outcome would require cooperation because each
   side sees itself as better off by building a missile. If
   Margaret builds a missile but Nikita does not, Margaret
   gets a payoff of +8, rather than the 0 she gets if she
   doesn’t build a missile. Similarly, Nikita is better off if he
   builds a missile but Margaret doesn’t: he gets a payoff of
   +8, rather than the 0 he gets if he doesn’t build a missile.
   Indeed, both players have an incentive to build a missile
   regardless of what the other side does. So unless Nikita
   and Margaret are able to communicate in some way to
   enforce cooperation, they will act in their own individual
   interests and each will pursue its dominant strategy of
   building a missile.


2. a.Future entry by several new firms will increase competi-
   tion and drive down industry profits. As a result, there is
   less future profit to protect by behaving cooperatively

today. This makes each oligopolist more likely to behave

noncooperatively today.

b.When it is very difficult for a firm to detect if another

firm has raised output, it is very difficult to enforce coop-

eration by playing “tit for tat.” So it is more likely that a

firm will behave noncooperatively.

c.When firms have coexisted while maintaining high prices

for a long time, each expects cooperation to continue. So

the value of behaving cooperatively today is high, and it is

likely that firms will engage in tacit collusion.

Tackle the Test:

Multiple-Choice Questions

1. b


2. b


3. c


4. a


5. c
   Tackle the Test:
   Free-Response Questions


6. 
   

Module 66

Check Your Understanding

1. a.This is evidence of tacit collusion. Firms in the industry
   are able to tacitly collude by setting their prices according
   to the published “suggested” price of the largest firm in
   the industry. This is a form of price leadership.
   b.This is not evidence of tacit collusion. Considerable varia-
   tion in market shares indicates that firms have been
   competing to capture each other’s business.
   c.This is not evidence of tacit collusion. These features
   make it less likely that consumers will switch products in
   response to lower prices. So this is a way for firms to
   avoid any temptation to gain market share by lowering
   price. This is a form of product differentiation used to
   avoid direct competition.
   d.This is evidence of tacit collusion. In the guise of dis-
   cussing sales targets, firms can create a cartel by designat-
   ing quantities to be produced by each firm.
   e.This is evidence of tacit collusion. By raising prices
   to-gether, each firm in the industry is refusing to under-
   cut its rivals by leaving its price unchanged or lowering

Firm A

Firm B

high high

high low

high low

low low

High P

High P

Low P

Low P

SOLUTIONS TO AP REVIEW QUESTIONS S-41