5. To advertise or not to advertise Suppose that Expresso and Beantown are the o

Question

5. To advertise or not to advertise

Suppose that Expresso and Beantown are the only two firms that sell coffee. The following payoff matrix shows the profit (in millions of dollars) each company will earn depending on whether or not it advertises:

For example, the upper right cell shows that if Expresso advertises and Beantown doesn't advertise, Expresso will make a profit of $18 million, and Beantown will make a profit of $2 million. Assume this is a simultaneous game and that Expresso and Beantown are both profit-maximizing firms.

If Expresso decides to advertise, it will earn a profit ofmillion if Beantown advertises and a profit ofmillion if Beantown does not advertise.

If Expresso decides not to advertise, it will earn a profit ofmillion if Beantown advertises and a profit ofmillion if Beantown does not advertise.

If Beantown advertises, Expresso makes a higher profit if it chooses   .

If Beantown doesn't advertise, Expresso makes a higher profit if it chooses   .

Suppose that both firms start off not advertising. If the firms act independently, what strategies will they end up choosing?

Expresso will choose to advertise and Beantown will choose not to advertise.

Both firms will choose not to advertise.

Both firms will choose to advertise.

Expresso will choose not to advertise and Beantown will choose to advertise.

Again, suppose that both firms start off not advertising. If the firms decide to collude, what strategies will they end up choosing?

Expresso will choose not to advertise and Beantown will choose to advertise.

Both firms will choose to advertise.

Both firms will choose not to advertise.

Expresso will choose to advertise and Beantown will choose not to advertise.

Beantown Advertise Doesn’t Advertise Expresso Advertise 10, 10 18, 2 Doesn’t Advertise 2, 18 11, 11

Explanation / Answer

a. If Expresso decides to advertise, then the following two situations will arise:

b. If Expresso decides not to advertise, then the following cases would arise:

c. If Beantown advertises: then in case of Expresso decides to advertise, Expresso will earn $10 million of profit and if Expresso decide not to advertise, then will earn $2 million. So, Expresso will make higher profit by choosing to advertise in case Beantown advertises.

d. Now, if Beantown doesn’t advertise: then in case of Expresso decides to advertise, will earn $18 million of profit and if Expresso decides not to advertise, then will earn $11 million of profit. So, Expresso will make higher profit by deciding to advertise, in case Beantown advertises.

e. If both the firms start off by deciding not to advertise and both decide these strategies independently (i.e, they don’t know each –others decision before make their own decision), then we will get the following scenario, starting the analysis with Expresso:

Expresso will think that Beantown will continue to choose the strategy of not advertising, and so to reap the benefit, will go for advertising as in that case Expresso will gain higher profit ($18 million in case advertising > $11 million in case of not advertising). And so will end up choosing the strategy of advertising, thinking all the while that Beantown will not deviate from its strategy of not advertising.

Now, if we start the analysis with Beantown, then they will think that Expresso will not deviate from its strategy of not advertising and so to gain higher profit will deviate from its own strategy of not advertising to advertising (Since, Beantown will earn $18 million of profit by advertising compared to $11 million in case of sticking to not advertising strategy). So, Beantown will end up choosing the strategy of advertising thinking that Expresso will stick to their strategy of not advertising.

Thus, we could see that, if both the firms choose their strategy independently, then both will end up choosing the strategy of advertising and so this game will reach a non-cooperative Nash-Equilibrium (Advertise, Advertise).

So, both the firms here will decide to Advertise.

f. Now, if the firms after staring from the strategy of not advertising, decides later to collude, will choose that strategy mix that maximizes the total profit and then will divide the profit among themselves equally.

From the payoff matrix, we could see that they both will earn maximum profit of $11 million each in case they decide to stick to their strategy of not advertising. That is, if they collude and trust each-other, then they will end up with the Pareto-Optimal equilibrium (Doesn’t Advertise, Doesn’t Advertise).

So, in this case, both the firms will decide not to advertise.

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