Consider the following sequential-move game: (i) firm 1 first decides whether to adopt an aggressive low-price policy or an accommodating high-price policy; (ii) after seeing firm 1’s choice, firm 2 then decides whether or not to invest in a new technology that reduces its production cost. The investment cost is k. If firm 1 sets a low price and firm 2 doesn’t invest, then firm 1 will earn 5, and firm 2 will have no business and earn 0 (because its production cost is too high). If firm 1 sets a low price and firm 2 invests to reduce its production cost, then firm 1 earns 1 and firm 2 earns 4 (before taking into account its investment cost). If firm 1 sets a high price and firm 2 doesn’t invest, firm 1 will earn 4 and firm 2 will earn 2. If firm 1 sets a high price and firm 2 invests, then firm 1 will have no business and earn 0, and firm 2 will now earn 5.

1) For what values of k, will firm 1 choose to set a high price

2) Suppose firm 2’s investment cost increases from k=2.5 to k=3.5. Will firm 2 suffer or benefit from that cost increase?

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Firm I A For what values set high price Low Price High Price K will firm I choose to Payo... View the full answer