Two firms are engaged in a potential joint venture. Firm 1 first chooses whether to make a

sunk, costly investment that increases the potential profitability of the venture. If it does

not make the investment (K = 0), the overall potential profitability will be small ( = 5).

If Firm 1 does make an investment (K = 5), the overall potential profitability will be large

( = 20). After Firm 1 chooses whether to invest or not, Firm 2 observes this choice. Then,

the two firms bargain over how to split the profit. Consider two bargaining protocols.

Under protocol A, Firm 2 proposes a share of profits s [0.20, 0.80] it gets to keep. If

Firm 1 accepts, the project is implemented, and the payoffs are u1 = (1 s) K and

u2 = s . If Firm 1 rejects, the project is not implemented and the payoffs are u1 = K

and u2 = 0.

Under protocol B, Firm 2 proposes a share of profits s [0.40, 0.60] it gets to keep.

Everything else is the same. If Firm 1 accepts, the project is implemented, and the payoffs

are u1 = (1 s) K and u2 = s . If Firm 1 rejects, the project is not implemented

and the payoffs are u1 = K and u2 = 0.

Which protocol does Firm 1 prefer? Which protocol does Firm 2 prefer? Discuss.