Two firms compete against each other. Currently Firm 1 earns $10 million per yea

Question

Two firms compete against each other. Currently Firm 1 earns $10 million per year and Firm 2 earns $13 million. Both expect to earn the same amount in the future if no changes are made. Firm 1, however, is considering whether to introduce an improved version of its product. If it does, and if Firm 2 does nothing in response, Firm 1's profit will increase to $13 million and Firm 2's profit will drop to $12 million.

Instead of doing nothing in response to Firm 1's improved product, Firm 2 could respond by increasing its advertising budget. If it does so, and if Firm 1 does not retaliate, Firm 1's profit will be $10 million and Firm 2's profit will be $12 million.

Finally, if Firm 2 increases its advertising budget and Firm 1 retaliates by raising its advertising budget, Firm 1 will earn $12 million and Firm 2 will make $11 million.

To solve this sequential game, work backward from the end to determine each firm's optimal action at each stage of the game. Both firms are rational, fully informed, and want to maximize their profits. You may find it useful to write out the game in extensive form.

The solution to the game is a sequence of moves by the two firms. For example, Firm 1 could do nothing and that would be the end of the game. Or Firm 1 could introduce the new product version, Firm 2 could increase its advertising budget, and Firm 1 could then increase its advertising budget in retaliation. There are also two other possible sequences.

The solution to this game is the following sequence of actions by the two firms:

A. Firm 1 does not introduce the new product version.

B. Firm 1 introduces the new product version and Firm 2 does not increase its advertising budget.

C. Firm 1 introduces the new product version, Firm 2 increases its advertising budget, and Firm 1 does not retaliate.

D. Firm 1 introduces the new product version, Firm 2 increases its advertising budget, and Firm 1 retaliates by raising its advertising budget.

Explanation / Answer

Sequence of actions -

1) Profits of the firms : Firm 1 - $10 million, Firm 2 - $13 million untill there are no chnages made

2) Firm 1 introduces new version of the product, then their profits become $13 million and if there are no changes to firm 2 then their profits reduce to $12 million

3) Firm 2 increases its marketing budget and if firm 1 does not retaliate, firm 1's profits are $10 million and firm 2's profits are $12 million

4) Firm 1 retaliates to the firm 2's step then the profits for firm 1 and 2 are - $12 million and $11 million respectively.

The best option to this is option d. Firm 1 introduces the new product version, Firm 2 increases its advertising budget, and firm 1 retaliates by raising its advertising budget.

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