Applied Business Economics - Assignment Example

Question 3 Consider two firms, A and B, each with the option to pollute at high or low levels. Suppose their respective payoffs (in millions of dollars) are: B Low Pollution High Pollution A Low Pollution 100 100 -30 120 High Pollution 120 -30 40 40 a. Describe the table above. The table shown above is the Payoff Matrix depicting the strategic outcome of the individual companies depending on the actions considered by each other. This matrix is a decision analysis tool which is used to sum up the different possible combinations of the actions which these two firms can consider and the respective return or payoff. In the table above, the two firms A and B have two possible alternatives. They independently, can either adhere to the option of low pollution or can resort to the alternative of polluting high. However, the possible payoffs or the returns for the choice that any company will make are affected by the choice of the other company. If Company A, selects the option of polluting less, then the payoff for this choice will either be 100 million dollars when B also resorts to the choice of Low Pollution or, on the contrary, it would be a negative payoff or loss of 30 million dollars if B chooses the option of High Pollution. Moreover, if A adheres to option of High Pollution, then there again can be two possible returns depending on the option chosen by B. The return for A will be 120 million dollars if B resorts to Low pollution and returns for A will be 40 million dollars if B also adheres to High Pollution. Similarly, the matrix can be considered from the perspective of B. If B resorts to Low Pollution then it can have return of 100 million dollars if A also chooses option of Low Pollution. On the contrary B will have a negative payoff or loss or 30 million dollars if A resorts to High Pollution. Moreover, if B adheres to High Pollution, then it can reap a return of 120 million dollars when A adopts option of Low Pollution. Going further, B will also enjoy same return of 40 million dollars if A adopts option of High Pollution. b. What is the Nash Equilibrium? Discuss the implication of this in Free Market, with no government intervention. The given case presents a typical instance strategic interaction of organizations in an economic or socio-economic arena. Thus it can be considered as a strategic game having all the three necessary elements i.e. players, course of action for each player and associated payoff for each action (Harsanyi & Reinhard, 1998). Now in order to predict the outcome of such strategic interactions, the concept of Nash equilibrium can be applied which in fact is a fundamental concept in the theory of games (Nash, 1950). To achieve this objective, it is needed first determine the dominant strategy of each firm i.e. A’s best possible choice to all of B’s actions and vis-a-versa. It is evident from the payoff matrix that A’s best possible choice when B is resorting to Low Pollution is to go for High Pollution (Higher of the returns among 100 million dollars and 120 million dollars). Similarly, A’s best option if B chooses High Pollution, is also to go for High Pollution (returns of 40 million dollar against loss of 30 million dollars). Thus the dominant strategy of A is to opt for High Pollution, irrespective of the choice made by B. Further, B’s best option when A opts for Low Pollution is go ahead for High Pollution (Higher return among 100 million dollars and 120 million dollars). Similarly, B’s best option when A opts for High Pollution is also to go for High Pollution (Return of 40 million dollars as against loss of 30 million dollars). As such, B also has dominant strategy to opt for High Pollution. Thus this game has a pure strategy Nash equilibrium i.e. a unique Nash equilibrium where both the firms will resort to option of High Pollution and will be benefited by the returns of 40 million dollars each. B High Pollution A High Pollution 40 40 Analyzing the situation, points to a very amazing outcome which resembles with the game of ‘Prisoner’s Dilemma’ (King and Mankiw, 2008). Both the firms will resort to High Pollution however, they would have been better off in case both would have opted for Low Pollution i.e. both out have benefited with return of 100 million dollars as against 40 million dollars presently. In such practical situation, the application of the concept of Nash equilibrium can be affected by the availability of information to any player about the preferences, beliefs and rationality of the others. This situation is often depicted by firms operating in free markets or unregulated markets with no government intervention. In game theory, such cases suitably highlight that existence of a Nash equilibrium need not result in a Pareto optimum (Eric, 1999) and can be called as sub-optimal solution. The point emphasized here is that in a free market, there is hardly any platform to coordinate the choice of options by the interacting players. In absence of any such coordinating platform, the firms would be better off only if they could trust each other and coordinate their efforts anticipating similar action by other. Thus it can be inferred that a coordinating platform by way of governmental intervention is highly desirable in such situation so as to reach an optimal situation. c. How might the government intervene in this situation? There can be various ways in which governmental intervention can be envisaged in such cases which need to have welfare optima to reach a sustainable optimal solution. The government with a motive to keep pollution level low must put in place some kind of cap on the level of pollution emitted. This can be translated in form of a pollution standard which all the firms need to follow. The arrangement of pollution standard will help like a coordinating platform which will help both the firms to reach the conclusion that independently, the other firm will probably choose option of Low Pollution. Thus the dominating strategy for both the firms will be adopting the choice of Low Pollution which also will be a Nash Equilibrium and also be the Pareto’s Optima. B Low Pollution A Low Pollution 100 100 Further there can be more modified intervening ways like giving incentive in terms of tax rebates to the firms which can bring down the level of pollution or emission to a certain minimum level. This will also encourage the firms to unilaterally adopt the choice of Low Pollution resulting in a more rational way to anticipate the choices made. Thus the overall payoff for the entire system will go up and each stake holder will be individually better off also. Question 6 Take a qualitative guess in the market-level price elasticities that are plausible for each of the following goods and describe the character of the market and product that leads you to this view: a) Pharmaceuticals Often pharmaceuticals form the critical part of essential requirements and inherently, pharmaceuticals will have very low price elasticity of demand. However, by virtue of their consumption pattern which varies across the demographics, pharmaceuticals have a range of price elasticity. This range will be driven by factors like age, income level, extent of health insurance and social security provided by the government. The aged and elderly population in any country accounts for a lopsided distribution of pharmaceutical consumption. For an example in Australia, the Pharmaceutical Benefits Scheme (PBS) expenses per capita, incurred by the government, for the people aging over 65 years is almost 7 times more than for the people below 65 years (Australian Government, 2007b: Table C2). And for this elderly population, price hike will not have much effect on the necessary consumption pattern of the pharmaceuticals products. However, there might be some variation in the elasticity which can be noticed when compared an aged belonging to different income group. Like for high-income older people, the price elasticity of pharmaceuticals will be near zero (Siminski, 2008). In very high per capita income nations like Norway, where the medical expenses are almost taken care by the government and the demand of pharmaceuticals is almost inelastic to the change in the price. On the contrary, in underdeveloped nations and to an extent in developing nations, where public medical facilities are not adequately established, the elasticity will be comparatively higher. This is also evident by the fact that many people die in absence of appropriate medications in such countries (Taghreed, 2007). Figure 1: Price Elasticity of Demand There is another aspect to this issue. Broadly, pharmaceuticals can be categorized into two classes which are ‘Generic Drugs’ and ‘Branded Drugs’. Commercially, branded drugs are patented and are more costly as compared to generic drugs. Logically in situations of price hikes, the consumption shifts from branded to generic resulting in a comparatively higher price elasticity of demand for the branded drugs. b) Car repairs following an accident The price elasticity of demand for car repairs following an accident will be primarily dependent on the two critical factors. The first and the foremost is the extent of damage and the other one will be the price of new car. For example, if the car is severely damaged, then paying high for the repairs will not be a cost effective option as the durability of the repaired car will definitely be lesser. This means that in such cases, the price elasticity will be very high. However, in case of minor damage, the cost of repair will always be much less than the price of new car. In such cases, even if the repair cost goes up, the services need to be availed. Thus the price elasticity is relatively lower. There is another aspect to this issue which is related to the price of new car. If the price of new car is very high, then it would initially encourage people to opt for repair rather than replacement so that the demand for repair will be comparatively inelastic. However, the over the period of time the price elasticity for the demand for repair would decline as the old and repaired car needs to be replaced. Another connotation to this issue is the availability of car insurance. In markets, which have high level of penetration of car damage insurance, the price elasticity of demand will be lower. In this case also, one can observe a global variation in the trend of the price elasticity of demand for car repairs following accident. In developed nations, where such repairs are quite expensive because of costly labour charges, the elasticity will also be higher. However, in not so developed nations, where labour charges are quite low, the cost of repair is also relatively lower and hence the price elasticity will be accordingly lower. c) Salt The price elasticity of demand for salt presents a very unique case. In the present context where we usually consume salt in very meager quantity, and the cost of the salt is also very low, the demand is almost inelastic to the price. However, even if the price of slat would have been very high, by virtue of quantitatively smaller demand, the consumption pattern would have hardly changed. On the contrary, the consumption quantity would not go noticeably high even if the prices come drastically down. Thus salt is a case of near inelastic demand vis-s-vis price. Figure 2: Inelastic Demand Curve for Salt As a matter of fact, the inelasticity is related to the common salt or table salt used for our daily consumption. People often consume various other kinds of flavored salts also. Their demand pattern is not same as that of table salt. In case of price hike their consumption can be avoided and can be replaced by table salt. Thus the price elasticity will be comparatively higher. But even in case of these flavored salts, the quantity consumed will not go up with decrease in price. References: Adam Taghreed et al., “Achieving the MDGs for health, cost-effectiveness analysis of strategies for maternal and neonatal health in developing countries”, British Medical Journal, (10 January 2007). Australian Government, 2007a. Guide To Social Security Law Version 1.124. Retrieved from URL http://www.facs.gov.au/guides_acts/ssg/ssguide-4/ssguide-4.10/ssguide-4.10.7/ssguide-4.10.7.50.html Australian Government, 2007b. Intergenerational Report 2007. Commonwealth of Australia, Canberra. Eric Maskin, 1999, Nash Equilibrium and Welfare Optimality, The Review of Economic Studies, Vol. 66, No. 1, Special Issue: Contracts. (Jan., 1999), pp. 23-38. Gans, J., S. King and N.G. Mankiw, Principles of Microeconomics, 4th Ed. Thomson Learning, 2008. Harsanyi, John C., and Reinhard Selten. 1998. A General Theory of Equilibrium Selection in Games. Cambridge, MA: MIT Press. Nash, John F. 1950. Equilibrium Points in N-Person Games. Proceedings of the National Academy of Sciences 36 (1): 48–49. Siminski, P, The Price Elasticity of Demand for Pharmaceuticals amongst High Income Older People in Australia: A Natural Experiment, Department of Economics, University of Wollongong, 2008. Retrieved from http://ro.uow.edu.au/commwkpapers/185 Read More