Scenario: Contiguous states often use tax policy to attract residents, firms, and economic activity. These "tax competitions" between states can be modeled with game theory. Suppose New Jersey currently has a state sales tax of 7 percent and Pennsylvania has a state sales tax of 6 percent. The game shown below models the effect of a reduction in each state's sales tax rate to 3 percent on each state's sales tax revenue. Assume the motivation of each state is to maximize tax revenue. The first number in a cell is the payoff to New Jersey; the second number is the payoff to Pennsylvania.

(Source: John Greenwald, "A No-Win War Between the States," Time, April 8, 1996, 44-45.
-Refer to the scenario above.Is there a dominant strategy equilibrium?
A) No.
B) Yes, New Jersey lowers its sales tax rate to 3 percent and Pennsylvania maintains its sales tax rate.
C) Yes, both New Jersey and Pennsylvania maintain their sales tax rates.
D) Yes, both New Jersey and Pennsylvania lower their sales tax rates to 3 percent.

Question

Scenario: Contiguous states often use tax policy to attract residents, firms, and economic activity. These "tax competitions" between states can be modeled with game theory. Suppose New Jersey currently has a state sales tax of 7 percent and Pennsylvania has a state sales tax of 6 percent. The game shown below models the effect of a reduction in each state's sales tax rate to 3 percent on each state's sales tax revenue. Assume the motivation of each state is to maximize tax revenue. The first number in a cell is the payoff to New Jersey; the second number is the payoff to Pennsylvania.
  
(Source: John Greenwald, "A No-Win War Between the States," Time, April 8, 1996, 44-45.
-Refer to the scenario above.Is there a dominant strategy equilibrium?
A) No. 
B) Yes, New Jersey lowers its sales tax rate to 3 percent and Pennsylvania maintains its sales tax rate. 
C) Yes, both New Jersey and Pennsylvania maintain their sales tax rates. 
D) Yes, both New Jersey and Pennsylvania lower their sales tax rates to 3 percent.

Quizplus · Accepted Answer

Both New Jersey and Pennsylvania have a dominant strategy to lower their sales tax rates to 3 percent. This results in a Nash equilibrium where neither state can improve its payoff by changing its strategy, given the other state's strategy. Both states would see a decrease in tax revenue, but not as much as if they maintained their high tax rates while the other state lowered theirs. Therefore, the best choice for both states is to lower their sales tax rates to 3 percent.

Scenario: Contiguous States Often Use Tax Policy to Attract Residents