Big Earth and District 13 are two producers of neodymium, a rare earth. If they agree to restrict output, each firm earns $100 million per year. If both firms expand output, each firm earns $50 million per year. If one firm restricts output and the other firm expands output, the firm that expands output earns $150 million per year and the other firm earns only $30 million per year. Assume that Big Earth and District 13 will compete infinitely, with each firm following a grim trigger strategy. Which of the following statements is TRUE?
A) If d = 0.50, Big Earth is indifferent between agreeing to restrict output and expanding output.
B) If d = 0.40, Big Earth would be better off restricting output.
C) If d = 0.90, Big Earth would be indifferent between agreeing to restrict output and expanding output.
D) If d = 0.75, Big Earth would be better off by expanding output.

Question

Quizplus · Accepted Answer

The grim trigger strategy implies that if one firm cheats, the other will retaliate by expanding output forever. The discount factor (d) determines the present value of future payoffs. At d = 0.50, the present value of cooperating (restricting output) equals the present value of defecting (expanding output), making Big Earth indifferent.

Big Earth and District 13 Are Two Producers of Neodymium