Question

Scenario 17-4.

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Consider two cigarette companies, PM Inc. and Brown Inc. If neither company advertises, the two companies split the market and earn $50 million each. If they both advertise, they again split the market, but profits are lower by $10 million since each company must bear the cost of advertising. Yet if one company advertises while the other does not, the one that advertises attracts customers from the other. In this case, the company that advertises earns $60 million while the company that does not advertise earns only $30 million.

Refer to Scenario 17-4. What will these two companies do if they behave as individual profit maximizers?

	a.	Neither company will advertise.
	b.	Both companies will advertise.
	c.	One company will advertise, the other will not.
	d.	There is no way of knowing without knowing how many customers are stolen through advertising.

Answer 1

Correct option is b. Both companies will advertise.

Both the companies will advertise when they behave as individual profit maximizers. Since the companies are not following the collusion strategy & are behaving as individual profit maximizers, so both of them will advertise as a result of which the revenue of each company will decline by $10 million as they have to bear the cost of advertising. So, the total payoff in this case will be $80 million (2X$40). If they would have followed the collusion strategy then the total payoff would be $100 million (2X$50). So, by following the joint strategy both of the would have been able to maximize their profits. But since both of them are behaving as individual profit maximizers, therefore, both of them have to bear a $10 million decline in their revenue.