Question

Q6. [25 marks] Two firms are interested in undertaking Research and Development (R&D) to create a new drug. If one firm undertakes R&D and the other doesn't, the firm undertaking the R&D is likely successful and gets a net return of $40m in the following year; but corporate espionage means the other firm gains some information and is able to make some improvements which lead to a $10m increase in the following year. If both firms undertake R&D then rivalry and the inability to gain a patent means that both will benefit by $8m in the following year. However, if neither undertake the R&D then it's likely that profits will increase by only $5m in the following year. a. [5 marks] Draw up the payoff matrix for this situation. b. [10 marks] In a one-shot simultaneous game - what is the expected outcome? Explain. c. [10 marks] Are there any first-mover advantages if this 'game' was not played simultaneously? Explain.

Answer 1

Answer:

a. The payoff matrix:

  

Firm 1 Firm 2 R&D R&D 8,8 No R&D 10,40 No R&D 40, 10 5,5

b. In a one-shot simultaneous game, the outcome would be (No R&D, R&D) with payoffs (10, 40) respectively.
reason: When Firm 1 decides to invest in R&D, Firm 2 will not because of higher payoff. (10>8). If Firm 1 decides not to invest in R&D, Firm 2 will invest in R&D (40 > 5). On the other hand, if Firm 2 decides to invest in R&D, Firm 1 will not (10>8), and if Firm 2 decides not to invest in R&D, Firm 1 will invest (40 > 5). Thus the strategies that will coincide are: Firm 1 will not invest, and Firm 2 will invest. The equilibrium outcome is highlighted in yellow in the payoff matrix above.

c. Yes, there are first mover advantages as whoever moves first can manipulate the second mover's response and get the highest payoff (40) in the matrix.

reason: When Firm 1 moves first, it will check Firm 2's response it its moves. If Firm 1 decides to invest, Firm 2 will not (10 > 8). If Firm 1 decides not to invest in R&D, Firm 2 will (40 > 5). Between these two responses of Firm 2, Firm 1 will get a higher payoff in the first case (40 > 10). So, Firm 1 will invest, and Firm 2 will follow and not invest. The equilibrium outcome will be (R&D, No R&D), and the payoffs will be (40, 10).

On the other hand, if Firm 2 moves first, it will check Firm 1's response to its moves. If Firm 2 decides to invest in R&D, Firm 1 will not (10 > 8). If Firm 2 decides not to invest in R&D, Firm 1 will (40 >5). between these two responses of Firm 1, Firm 2 will benefit better with the first option. So, Firm 2 will invest in R&D and Firm 1 will follow with not investing in R&D. The equilibrium outcome will be (No R&D, R&D) with payoff (10, 40).  

Thus we see that whoever moves first will choose to invest in R&D and earn much higher payoff than the second mover, who will not invest in R&D.