During graduate school, you patented a specialized instrument called the hyrdowidget that helped to dramatically reduce the cost of hydraulic fracturing

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During graduate school, you patented a specialized instrument called the hyrdowidget that helped to dramatically reduce the cost of hydraulic fracturing. You are now the CEO of a successful firm called Hydrowidgets R Us that manufactures hydrowidgets. Your profits continue to grow, but your patent will soon run out. You are considering the possibility of investing in a major expansion of capacity that would reduce your marginal cost below that of any potential rival who might choose to enter the industry. Specifically:

 

• If you don't make the investment, you expect to earn $2M if a competitor enters and $5M if it does not. In that case, your competitor would earn $1M if she enters and nothing if she does not.
• If you do make the investment, you expect to earn $1M (net of the investment) if a competitor enters and $4M if it does not. In that case, your competitor would lose $2M if she enters and noting if she does not.

 

All payoffs are total discounted values and it is common knowledge that the competitor is unable to enter until you make your investment decision and begin expanding your operations.

 

a. Model your strategic decision using game theory and show the resulting game

b. Solve the game. Should you invest or not 

 

During a Board Meeting, one of your Board Members, Mr. Isaacson, says, "You clearly should not invest in this case. You are losing $1M regardless of whether a potential competitor enters the market or not!"

c. How do you respond to Mr. Isaacson