Question

Refer to the following formula for expected payoff:

Answer 1

Answer:

Step-by-step explanation:

From the given information:

The price reduction = 98% = 0.98

$Then \ the \ expected \ payoff \ = \[(probability \ of \ matching \ price \ reduction \ * \ size \ of \ loss \ from \ price \ cuts \ ) \ + \ ( \ probability \ o f \ rivals\ not \ matching \ * \ gain \ from \ price \ cuts )]$

where;

P(rival not matching ) = (100 - 98)% = 2%

P(rival not matching ) = 0.02

The expected payoff = [(0.98 * -800) + (0.02*50000)]

The expected payoff = [( -784+ 1000)]

The expected payoff = 216

(b) Probability of rivals reducing price = 5%

= 5/100

= 0.05

∴

Probability of rivals reducing price = 1 - 0.05 = 0.95

The expected payoff = (0.05 * -6000) + (0.95 *0)

The expected payoff = -300 + 0

The expected payoff = -300

(c) Yes.

Based on answers (a) and (b), the firm should cut the price.