Exhibit 10-6 Two-Firm Payoff Matrix

Suppose costs are identical for the two firms in Exhibit 10-6. Each firm assumes without formal agreement that if it sets the high price its rival will not charge a lower price. Under these "tit-for-tat" conditions, equilibrium will be established by:
A) Widget Co. charging the high price and Ajax Co. charging the low price.
B) Widget Co. charging the high price and Ajax Co. charging the high price.
C) Widget Co. charging the low price and Ajax Co. charging the low price.
D) Widget Co. charging the low price and Ajax Co. charging the high price.

Question

Exhibit 10-6 Two-Firm Payoff Matrix

Suppose costs are identical for the two firms in Exhibit 10-6. Each firm assumes without formal agreement that if it sets the high price its rival will not charge a lower price. Under these "tit-for-tat" conditions, equilibrium will be established by:
A) Widget Co. charging the high price and Ajax Co. charging the low price. 
B) Widget Co. charging the high price and Ajax Co. charging the high price. 
C) Widget Co. charging the low price and Ajax Co. charging the low price. 
D) Widget Co. charging the low price and Ajax Co. charging the high price.

Quizplus · Accepted Answer

In a tit-for-tat situation, each firm assumes that its rival will respond in kind to its pricing strategy. Therefore, Widget Co. will charge the high price, anticipating that Ajax Co. will charge the high price in response. This results in an equilibrium where both firms charge the high price, as neither has an incentive to deviate from this strategy.