Philip Morris and R.J. Reynolds spend huge sums of money each year to advertise their tobacco products in an attempt to steal customers from each other. Suppose each year Philip Morris and R.J. Reynolds have to decide whether or not they want to spend money on advertising. If neither firm advertises, each will earn a profit of $2 million. If they both advertise,each will earn a profit of $1.5 million. If one firm advertises and the other does not, the firm that advertises will earn a profit of $2.8 million and the other firm will earn $1 million.
a. Use a payoff matrix to depict this problem.
b. Suppose Philip Morris and R.J. Reynolds can write an enforceable contract about what they will do. What is the cooperative solution to this game?
c. What is the Nash equilibrium without an enforceable contract? Explain why this is the likely outcome.