Question

Let two oil firms, A and B, in a duopoly be choosing their production decisions. For simplicity, assume they can choose two production levels: HI and LO. If both firms chooose LO, they each earn $3 billion. If both firms choose HI, they each earn $2 billion. If one firm chooses HI while the other chooses low, the HI firm earns $4 billion and the LO firm earns $1 billion. What is the strategy that optimizes the payoffs to both firms if they collude?

		A chooses LO, B chooses LO
		A chooses HI, B chooses LO
		A chooses LO, B chooses HI
		A chooses HI, B chooses HI

Answer 1

Payoff Matrix of the above game could be written as:

		FIRM B
		LO	HO
FIRM A	LO	$3 billion, $3 billion	$1 billion, $4 billion
	HO	$4 billion, $1 billion	$2 billion, $2 billion

As can be seen from the above given payoff matrix, the strategy that optimises the payoffs to both firms if they collude are A chooses LO, B chooses LO. By choosing this strategy both the firms earn $3 billion each which is greater than the payoffs which their strategy could result in case of non-collusion.

Hence, first option is correct