The diagram below shows the payoff matrix for the pollution abatement game. Two
ID: 1190255 • Letter: T
Question
The diagram below shows the payoff matrix for the pollution abatement game. Two countries, the U.S. and European Union (EU) have a policy choice of whether to abate pollution (Abate) or continue to pollute (Pollute). Pollution abatement benefits either country. Abatement cost a country $7MM but provides benefits amounting to $5MM. If both countries follow an abatement policy, then both experience benefits of S10MM. Show in the diagram above each country's best response given the other country's actions and the Nash equilibrium. Is the Nash equilibrium efficient? Briefly explain. Is the game an example of a prisoner's dilemma? Briefly explain. Are there tools used by the WTO that could improve the outcome of the game? If so, what are they?Explanation / Answer
(a)
When EU chooses to Pollute, US best strategy is to Pollute since this has highest payoff (0 > -2).
When EU chooses to Abate, US best strategy is to Pollute since this has highest payoff (5 > 3).
When US chooses to Pollute, EU's best strategy is to Pollute since this has highest payoff (0 > -2).
When US chooses to Abate, EU's best strategy is to Pollute since this has highest payoff (5 > 3).
So a Nash equilibrium exists when both US & EU chooses to Pollute.
(b)
This Nash equilibrium is inefficient because for both countries this is a suboptimal choice. Both US & EU could achieve higher payoff if they reacted independently.
(c)
Yes, this is example of a Prisoners Dilemma. If US & EU decided in collusion, the strategy (Abate, Abate) could give both of them higher payoff (3 > 0, 3 > 0) But in this case, since no country knows the strategy to be chosen by the other, they choose to minimize the risks & jointly select strategy that gives lower payoff.
(d)
WTO could provide pollution-reduction credits to both EU & US which they could use to deviate from the (Pollute, Pollute) strategy & choose the Abatement strategy.