Company A and Company B have spent a lot of money on research to develop a cure for the common cold. Winter is approaching and there is certainly going to be a lot of demand for their product. However they both know that they are competitors and that both of them have very similar products. As a result, they have to decide whether to conduct an expensive advertising campaign or not.
If Company A and Company B both do not advertise, they do not have any additional costs and end up splitting the revenues from their market, so as to earn $ 500,000 each. This is shown in the top left box. If, however any one of them decides to advertise while the other company does not advertise, customers are only made aware of the product that the advertising company produces. As a result they will only buy the advertised product. If this is the case, the company which advertised will get $750,000, while the company which did not advertise loses $250,000 because of its costs in developing the drug. These situations are shown in the top right and bottom left boxes. Finally, if both companies decide to advertise, they become locked in an advertising war and spend a lot of money shooting down the competitor's product. If this happens, both companies will earn profits, but a significantly lower amount, $100,000 each. This is the bottom right box.
(A) If both companies pursued only their self-interest then which outcome would occur? Explain carefully.
(B) Can both companies do better if they have an agreement? What should this agreement force them to do? What will be the profit of each company in this case?