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Free response question

Microeconomics · Hard · 30 marks

IEO past paper: 2025 International Economics Olympiad, open questions

Open Question 1. Buying Cars Two neighbouring families, Lee and Xi, are thinking about buying new cars. Each family can choose to buy a modest or a luxury car; these decisions are made simultaneously and independently. The matrix below shows the payoffs from each possible outcome of this social interaction (Lee's payoff first, Xi's second). $\begin{array}{l|cc} & \text{Xi: Modest} & \text{Xi: Luxury} \\ \hline \text{Lee: Modest} & 2,\ 2 & 0.5,\ 2.5 \\ \text{Lee: Luxury} & 2.5,\ 0.5 & 1,\ 1 \end{array}$

(a)Provide a narrative that is consistent with all four pairs of payoffs.[6](b)Find the Nash equilibrium or equilibria for this social interaction (explain your reasoning) and discuss its social desirability.[6](c)Describe a reasonable policy that yields a socially preferable outcome and its corresponding payoff matrix.[8](d)In a nearby suburb, families replace their cars every few years and keep a close eye on one another's choices. A market-research firm surveyed the households and found out that their individual preferences are consistent with the story you came up with in (a); however, the observed choices are at odds with the prediction you derived in (b). Using game-theoretic reasoning, discuss why this can be the case.[10]

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