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Decision Making in Oligopoly Markets: Burger King vs. McD's

Burger King and McDonald's are situated on opposite corners of a downtown intersection. Burger King and McDonald's compete on the basis of the prices they set for their burger, fry, and soda combination meals. Every Monday, Burger King and McDonald's simultaneously choose their combo meal prices, which will remain in effect for the rest of the week.
Burger King and McDonald's consider only two possible prices: a low price of $3.50 or a high price of $4.50 for their combination meals. The weekly profit from each of the four possible combinations of decisions is given in the following table:

Burger King's price
Low ($3.50) High ($4.50)
price Low ($3.50) A $3,000, $5,500 B $6,500, $5,000
High ($4.50) C $2,000, $9,000 D $5,000, $8,000

Payoffs in dollars of weekly profit.

Explain the statements below.
a) The pricing decision facing Burger King and McDonald's is a prisoners' dilemma.
b) Cooperation between Burger King and McDonald's occurs in cell D of the payoff table. The non-cooperative outcome occurs in cell A.
c) Cell B represents cheating by McDonald's, while cell C represents cheating by Burger King.
d) If Burger King and McDonald's make their pricing decision just one time, they will likely end up in cell A.
e) Burger King can credibly threaten to punish McDonald's with a retaliatory price cut.
f) McDonald's can credibly threaten to punish Burger King with a retaliatory price cut.

Solution Preview

a) If they could trust each other, both restaurants could get a higher payoff by charging a high price and settling in cell D. However, neither restaurant can trust the other to abide by an agreement to charge a high price, so they will end up in cell A and both be worse off.
b) If they ...

Solution Summary

This solution uses game theory to analyze how Burger King and McDonald's set their prices.