Assignment - Analyzing Productivity, Sunk Cost

Assignment

Analyzing Productivity, Sunk Cost, Replacement and Efficiency Effects

Consider Question 14, pp. 380 - 381 in the text:

Which company, if any, has the greater incentive to spend money to win the ‘R&D Race?'

Of the effects discussed in the chapter, (productivity effect, sunk cost effect, replacement effect, efficiency effect), which are shaping the company's incentives to innovate and in what fashion?

Submit your responses in a Word document. Answers should be clear, concise and compelling. Support your answers (external to text) in APA format.

In addition, you will be assessed on how compelling or persuasive you write. If your essay is fewer than 500 words, you are probably not compelling enough, if it is greater than 750 words, you are not concise enough. Specific reference to fact, terms used in the course, and logic will all help you to be compelling. Finally, a graduate level essay shall have no mechanical errors.

Question #14

IQ, Inc., currently monopolizes the market for a certain type of microprocessor: the 666. The present value of the stream of monopoly profits from this design is thought to be $500 million. Enginola (which is currently in a completely different segment of the microprocessor market from this one) and IQ are contemplating spending money to develop a superior design that will make the 666 completely obsolete. Whoever develops the design first gets the entire market. The present value of the stream of monopoly profit from the superior design is expected to be $150 million greater than the present value of the profit from the 666.

Success in developing the design is not certain, but the probability of a firm’s success is directly linked to the amount of money it spends on the project (more spending on this project, greater probability of success). Moreover, the productivity of Enginola’s spending on this project and IQ’s spending are exactly the same: Starting from any given level of spending, an additional $1 spent by Enginola has exactly the same impact on its probability of winning. The following table illustrates this. It shows the probability of winning the race if each firm’s spending equals 0, $100 million, and $200 million. The first number represents Enginola’s probability of winning the race, the second is IQ’s probability of winning, and the third is the probability that neither succeeds. Note: This is not a payoff table.

Assuming that

(i) each firm makes its spending decision simultaneously and noncooperatively;

(ii) each seeks to maximize its expected profit; and

(iii) neither firm faces any financial constraints,

which company, if any, has the greater incentive to spend money to win this “R&D race”? Of the effects discussed in the chapter (productivity effect, sunk cost effect, replacement effect, efficiency effect), which are shaping the incentives to innovate in this example?

Book: 'Economics of Strategy' (7th ed.), by Besanko et al. (2016).