Suppose two outdoor apparel firms, L.L. Bean and Eddie Bauer, are contemplating introducing the same new product to their existing product lines. For this problem, assume that Eddie Bauer "moves" (makes this decision) first, and then L.L. Bean makes its decision. Each firm can choose to either introduce the new product or continue with the existing product. Eddie Bauer moves first, and there is "full information," meaning that each firm knows the potential payoffs (profits associated with each action). In the extensive form of this sequential game, shown in the figure below, profits (shown in parentheses in the art) are annual profits in thousands of dollars.
Given the information above, which of the following statements is true? Explain how you arrived at your answer.

Question

Suppose two outdoor apparel firms, L.L. Bean and Eddie Bauer, are contemplating introducing the same new product to their existing product lines. For this problem, assume that Eddie Bauer "moves" (makes this decision) first, and then L.L. Bean makes its decision. Each firm can choose to either introduce the new product or continue with the existing product. Eddie Bauer moves first, and there is "full information," meaning that each firm knows the potential payoffs (profits associated with each action). In the extensive form of this sequential game, shown in the figure below, profits (shown in parentheses in the art) are annual profits in thousands of dollars.
 Given the information above, which of the following statements is true? Explain how you arrived at your answer.

Quizplus · Accepted Answer

We solve these types of problems by working backward, a technique called backward induction. Essentially, Eddie Bauer can figure out what L.L. Bean will do in period 2 based on its own (Eddie Bauer?s) strategy in period 2, because each firm has complete information (e.g., Eddie Bauer knows the payoffs L.L. Bean will receive by following each strategy). So, Eddie Bauer asks itself, if we maintain the existing product, what will L.L. Bean's best response be' L.L. Bean earns profits of 200 if it chooses to introduce a new product, but only 50 if it maintains the existing product only. So L.L. Bean's best response to Eddie Bauer?s decision to maintain the existing product only is to introduce a new product. Knowing L.L. Bean's best response, Eddie Bauer can see that its profits in Period 2 will be -40 if it chooses to maintain the existing product only.
If Eddie Bauer chooses to introduce a new product, L.L. Bean will incur a loss of 40 if it also maintains the existing product only, or a profit of 20 if it also introduces a new product. So, L.L. Bean's best response to Eddie Bauer's introduction of a new product is to also introduce a new product. If L.L. Bean pursues a strategy of introducing a new product in period 2 in response to Eddie Bauer's introduction of a new product in period 1, Eddie Bauer will earn profits of 20 in period 2.
So by solving this game backward, Eddie Bauer realizes it will incur a loss of 40 by choosing to maintain the existing product only, or a profit of 20 if it chooses to introduce a new product. Since we assume firms are profit maximizers, Eddie Bauer's optimal period 1 strategy is to introduce a new product, because this strategy maximizes period 2 profits, given L.L. Bean's best response in period 2.

Suppose Two Outdoor Apparel Firms, L