Question

Two firms dominate the market for ski equipment and compete aggressively with respect to R&D. The following payoff table depicts the profit implications of their different R&D strategies.

		Firm’s B R&D spending
		Small	Medium	Large
	Small	8, 11	6, 12	5, 14
Firm’s A R&D	Medium	12, 9	8, 10	6, 8
spending	Large	11, 6	10, 8	4, 6

a/ Suppose that no communication is possible between the firms; each must choose its R&D strategy independently of the other. What actions will the firms take, and what is the outcome?

b/ If the firms can communicate before setting their R&D strategies, what outcome will occur? Explain.

Answer 1

Answer:

a/ If communication is not possible, then the outcome will be (Large , Medium) with payoff (10, 8).
reason: When B opts for Small spending, A has 3 options: Small (payoff 8), Medium (payoff 12), and Large ( with payoff 11). A will opt for Medium because it gives him better payoff than the other two moves. (12>11>8). If B moves Medium, A will move Large (10>8>6). If B moves Large, A moves Medium (6>5>4).

Similarly, if A moves Large, B will move Large (14>12>11). For A's Medium, B will move Medium (10>9>8). If A moves Large, B will move Medium (8>6=6). Thus we see that (Large, Medium) is the only outcome where their actions coincide. (Nash equilibrium). Hence that will be the outcome.
b/ If they communicate and decide on a strategy, then (Medium, Small) will be the outcome with payoff (12, 9). Because that's the only Pareto optimal equilibrium, where both the players can be made better off without making any one   of them worse off.