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Profit Maximization

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Suppose your firm competes against another firm for customers. You and your rival know your products will be obsolete at the end of the year and must simultaneously determine whether or not to advertise. In your industry, advertising does not increase total industry demand but instead induces customers to switch among the products of different firms. Thus, if both you and your rival advertise, the two advertising campaigns will simply offset each other, and you will each earn $4 million in profits. If neither of you advertises, you will each earn $10 million in profits. However, if one of you advertises and the other one does not, the firm that advertises will earn $20 million and the firm that does not will earn $1 million in profits.

a. Is your profit maximizing choice to advertise or not to advertise? Explain.

b. How much money do you expect to earn? Explain.

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a.
This is a classic prisoner's dilemma. Both companies stand to gain if they do not advertise and hence make $10M each. However, it is the dominant strategy of both firms to advertise as they can either gain $20M (if the other firm does not advertise) or $4M (if ...

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