The Firm and Market Structures: practice question

Freight rivals Dorbek Logistics and Sarnow Freight each choose between holding rates high or cutting rates for one period. If both hold, each earns $10 million; if one cuts while the other holds, the cutter earns $14 million and the holder earns $3 million; if both cut, each earns $6 million. The Nash equilibrium of this game is:

1. both firms hold rates high, maximizing joint profit
2. one firm cuts rates while the other holds them high
3. both firms cut rates, even though joint profit is then lower

Show answer and explanation

Correct answer: C

Explanation: Cutting is a dominant strategy for each firm: 14 beats 10 when the rival holds, and 6 beats 3 when the rival cuts, so the unique Nash equilibrium is both cutting at $6 million each. A describes the collusive outcome, which is unstable because each firm can gain $4 million by deviating alone. B cannot be an equilibrium because the firm holding high would also want to cut, given its rival's choice.