Recall the prisoner’s dilemma between the two firms:

Now suppose the U.S. government has stepped into the market and threatened a penalty of $1.5b if either firm becomes a monopolist. Continue to assume that both firms cooperate, they each earn 2, and if they both defect, they each earn 1 (payoffs are in billions of dollars). However, if one firm cooperates, the other can defect, but now the defection payoff is reduced to 1.5, while the other firm continues to earn 0.

1. Write down the new payoff matrix.

2. Suppose this is a one-shot game with no enforcement. Solve for any Nash equilibria.

3. Is mutual cooperation a Nash equilibrium? Why? Does that mean cooperation will happen no matter what?

4. Which equilibrium is payoff dominant? And which equilibrium is risk dominant? Explain.

5. If one firm has no idea what the other will do, what is that firm’s dominant strategy?

6. What is the degree of belief (i.e. the probability) either firm must have that the other firm will cooperate?

7. What are some lessons you can take away from this game?