There are two existing firms in the market for computer chips. Firm A knows how to reduce the production costs for the chip and is considering whether to adopt the innovation or not. Innovation incurs a fixed setup cost of C, while increasing the revenue. However, once the new technology is adopted, another firm, B, can adopt it with a smaller setup cost of C/3. If A innovates and B does not, A earns $30 in revenue while B earns $10. If A innovates and B does likewise, both firms earn $20 in revenue. If neither firm innovates, both earn $10. If C = 12, which is the perfect equilibrium of the game?
A) A innovates, B does not.
B) A innovates, B innovates.
C) Neither firm innovates.
D) None of the answers is correct.

Question

Quizplus · Accepted Answer

If neither firm innovates, both earn $10, which is higher than the payoff for A if it innovates and B also innovates (since A would earn $20 - $12 = $8). Therefore, neither firm innovating is the equilibrium.

There Are Two Existing Firms in the Market for Computer