Bill is the only booth selling used record at Coachella. As the monopoly seller of used records, Bill earns $700 in profit. This year, Ted is considering setting up a competing booth. It would cost him $150 to do so. However, Bill tells Ted that if he sets up a booth, he would face a record price war. After some research, Ted learns that if Bill follows through on his threat Bill would earn $100 in profit while he himself would earn $25 (before accounting for the $150 set up cost). Nevertheless, if Bill does not start a record price war, he would earn $300 while Ted would earn $120.
1. Draw this game in extensive form. Fully label the game tree
2. What is the subgame perfect equilibrium outcome?
3. Would you advise Ted to set up the booth?
4. Doing more research, Ted learns his set up costs will actually be $75, not $150. How would your advise to Ted change?