Question

Firm 1 and Firm 2 are two major companies that compete in the aeronautics industry. Even though there are only two major firms in the industry, competitions is intense. The competition occurs mostly in the form of cost-reducing innovation. As the result, both firms are forced to spend heavily on research and development (R&D) in a race to reduce cost. Each company has the option to select a high R&D budget or a low R&D budget. The following payoff table facing the two firm shows the yearly profit outcomes attributable to the R&D budget allocated under each spending decisions.

		Firm 2
		High R&D budget	Low R&D budget
Firm 1	High R&D budget	$40         $200	$100       $60
	Low R&D budget	$30                $0	$80           $40

                                                                                    Payoffs in millions dollars

             

1. Assuming that the game described above is a one-shot simultaneous game, does Firm 2 has a dominant strategy? If yes, what is it? Why? If not, why not?

2. Describe the notion of Nash equilibrium. Determine the Nash equilibrium for this game. Explain how you arrived at your conclusion.               

Answer 1

1. Given that firm 1 choose high R&D budget, firm 2's best response is high R&D budget(200).
Given that firm 1 choose low R&D budget, firm 2's best response is low R&D budget(40).
So, Firm 2 does not have a dominant strategy because there is no single strategy which is the best response of firm 2 in all situations irrepective of firm 1's decision.

2. Nash equilibrium is the optimal outcome where best response of both players occur simultaneously so they have no incentive to deviate from it.

Given that firm 2 choose high R&D budget, firm 1's best response is high R&D budget(40).
Given that firm 2 choose low R&D budget, firm 1's best response is high R&D budget(100).
So, the NE is for both firms to choose high R&D budget as their best response occur simultaneously when they choose hugh R&D budget. The NE is (High R&D budget, High R&D budget) = ($40, $200)