Problem 8 Philip Morris and R.J. Reynolds ... [FREE SOLUTION] (2024)

Expert verified

The concept of a Nash Equilibrium is crucial in game theory and is a situation where, in a strategic game like the one Philip Morris and R.J. Reynolds are involved in, no player can benefit from changing their strategy if the other player keeps theirs unchanged. It's an indication of predictable behavior in competitive situations.

In the tobacco advertising game, the Nash Equilibrium occurs when both firms choose to advertise, each earning a profit of \(1.5 million\). Even though advertising results in lower profit than if neither advertised (\(2 million\)), neither firm can unilaterally improve its payoff by changing its strategy, because the other would then have a higher payoff, which would not be equitable. The firms are essentially 'stuck' in this equilibrium if they act in their self-interest without an enforceable contract to cooperate.

A cooperative game is a scenario in which players can form binding commitments or contracts to adopt coordinated strategies. In economics, this principle is often applied to scenarios where cooperation can lead to a more favourable outcome for all parties involved, compared to what they would achieve by acting alone.

The cooperative solution to the advertising problem facing Philip Morris and R.J. Reynolds would be for both firms to agree not to advertise, thus saving on advertising costs and each earning the higher profit of \(2 million\). This outcome can only be assured if there is an enforceable contract to prevent either firm from breaking the agreement and unilaterally choosing to advertise to gain an advantage.

Microeconomics principles help explain the decisions made by individuals and firms and the allocation of resources. In this tobacco advertising predicament, key principles such as opportunity cost, incentives, and profit maximization come into play.

The opportunity cost of not advertising for either firm is the lost potential profit if the rival firm decides to advertise. These companies also respond to incentives: for instance, the potential to gain higher profits influences their decision to advertise, despite the cost. Lastly, both firms aim to maximize profits, whether through advertising or by cooperating to eliminate advertising costs altogether.

Oligopoly strategies are employed by firms in a market where a few large sellers dominate. The actions of any one firm can significantly impact the others. In oligopolies, firms might engage in strategic behavior such as setting prices, controlling supply, or—in our example—advertising.

Philip Morris and R.J. Reynolds face a classic oligopoly scenario. They can either choose to compete aggressively through advertising (non-cooperative strategy) or collude implicitly or explicitly to refrain from advertising (cooperative strategy). In reality, without legally binding agreements, firms tend to default to non-cooperative strategies, as predicted by the Nash Equilibrium, to ensure they are not at a disadvantage relative to their competitors.