IQ Inc. currently monopolizes the market for a certain type of microprocessor, the 666. The present value of the stream of monopoly profits from this design is thought to be $500 million. Enginola (which is currently in a completely different segment of the micro-processor market from this one) and IQ are contemplating spending money to develop a superior design that will make the 666 completely obsolete. Whoever develops the design first gets the entire market. The present value of the stream of monopoly profit from the superior design is expected to be $150 million greater than the present value of the profit from the 666.

Success in developing the design is not certain, but the probability of a firm's success is directly linked to the amount of money it spends on the project (more spending on this project, greater probability of success). Moreover, the productivity of Enginola's spending on this project and IQ's spending is exactly the same: Starting from any given level of spending, an additional $1 spent by Enginola has exactly the same impact on its probability of winning. The table below illustrates this. It shows the probability of winning the race if each firm's spending equals 0, $100 million, and $200 million. The first number represents Enginola's probability of winning the race, the second is IQ's probability of winning, and the third is the probability that neither succeeds.

Assuming that:

(i) Each firm makes its spending decision simultaneously and non-cooperatively.

(ii) Each seeks to maximize its expected profit.

(iii) Neither firm faces any financial constraints, which company, if any, has the greater incentive to spend money to win this "R&D race"? Of the effects discussed in the chapter (sunk cost effect, replacement effect, efficiency effect), which are shaping the incentives to innovate in this example?

IQ's spending Engineless Spending $100 million $200 million so (0,0,1) (0,.6,.4) (0,.8,.2) so s100 million (.3,.6,.1) (.4,.4,.2) (.6,0,.4) $200 million (.8,0,.2) (.5,.5.0) (.6,.3,.1)