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Game Theory and Backward Induction
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In a competitive market, two companies, A and B, are deciding whether to launch a new product. Company A moves first and chooses between a high investment or a low investment. Company B observes A's choice and then decides on its own investment level. If A chooses high investment, B can either choose high or low investment. If A chooses low investment, B similarly has the option to choose high or low. How should Company A decide on its investment using backward induction to maximize its payoff?

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Learning Path

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Choose AnswerChoose the Best Answer

A

Company A should always choose low investment regardless of Company B's choice.

B

Company A should choose high investment, anticipating that Company B will choose low investment to maximize its own payoff.

C

Company A should choose high investment, expecting Company B to also choose high investment, thus ensuring a competitive edge.

D

Company A should randomly choose between high and low investment to keep Company B uncertain.

Understanding the Answer

Let's break down why this is correct

Company A looks at what B will do after seeing A's choice. Other options are incorrect because Choosing low no matter what ignores B's best reply; Assuming both will invest high ignores that B wants the best payoff.

Key Concepts

Backward Induction
Game Theory
Strategic Decision Making
Topic

Game Theory and Backward Induction

Difficulty

hard level question

Cognitive Level

understand

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Definition
Definition

Game theory is a mathematical framework used to analyze strategic interactions among rational decision-makers. Backward induction is a method used to solve sequential move games, where players make decisions based on the observed actions of others, as illustrated by the game tree format. This concept is significant in business as it helps understand competitive behavior and decision-making processes in various strategic situations.

Topic Definition

Game theory is a mathematical framework used to analyze strategic interactions among rational decision-makers. Backward induction is a method used to solve sequential move games, where players make decisions based on the observed actions of others, as illustrated by the game tree format. This concept is significant in business as it helps understand competitive behavior and decision-making processes in various strategic situations.

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