(b) Currently, firm I has a monopoly in a market, from which it earns annual profits
of $2million, all of which it would lose if it exited the market (so it will not be
exiting the market). Firm E is considering entering the market. If it enters it will
incur annual non-recoverable fixed costs of $300,000. If E does enter, I can either
"accommodate" E, or choose to fight a price war. E could then decide whether to
stay in the industry, or to exit. Firm E figures out the payoff matrix for both firms
given the various possible sequence of actions and responses (the payoffs in each
cell are (E payoff, I payoff) in millions of dollars/year):
Firm E's actions
Stay
Exit
Accommodate
0.1, 1.5
-0.3, 2.0
Firm I's actions
Price-war
-0.2, 1.0
-0.3, 2.0
(i)
Draw the sequential game tree for this situation.
(5 marks)
(ii) Explain why Firm I's dominant strategy is to accommodate, if Firm E
(5 marks)
enters.