Define the terms “Dominant Strategy” and “Nash equilibrium”. Does the pay off matrix (above) indicate that Nash equilibrium exists? Explain your answer.
A strategy is said to be dominant if regardless of what other player does, the strategy is capable to earn the player a larger payoff or profit than any other. Dominant strategy is always preferable than any other strategy. Nash Equilibrium refers to a term which is used effectively in game theory as an equilibrium situation where the strategy of each player is maximum when the strategies of all other firms are given. The payoff matrix does not indicate a Nash equilibrium as one firm tends to gain while changing the strategy from price $4 to $3 (Economics.fundamentalfinance.com, 2015).
Define Collusion. Does the above situation provide an incentive to collude? Why are collusive arrangements often unstable? Explain your answer.
In economic terms, collusion can be defined as an agreement between two or more parties to restrict open competition by deceiving, misguiding or tends to gain an unfair market advantage (Google Books, 2015). It is an arrangement among the firms to divide the market, set the prices or limit production activities and thus avoid pressure from competitors. The above diagram represents that there is an incentive to collide as when both the firms to fix the price at $4, they will tend to gain more profit. Reducing the price may lead to increase in competition among the firms and reduce profit which is shown in the fourth cell of the matrix, which they would like to avoid.
Collusive agreements are often unstable as each member of the agreement can make more profit by breaking the agreement than it could by abiding by the agreement. If monitoring whether the firms are abiding by the agreement or not is difficult this gives the firm opportunity to get away and make higher profits for longer. So members are more prone to cheat and the agreement tends to become unstable (Google Books, 2015).