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Chapter 13. Game Theory and Competitive Strategy. Topics to be Discussed. Gaming and Strategic Decisions Dominant Strategies The Nash Equilibrium Revisited Repeated Games. Topics to be Discussed. Sequential Games Threats, Commitments, and Credibility Entry Deterrence Bargaining Strategy

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Chapter 13

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Chapter 13 l.jpg

Chapter 13

Game Theory and Competitive Strategy


Topics to be discussed l.jpg

Topics to be Discussed

  • Gaming and Strategic Decisions

  • Dominant Strategies

  • The Nash Equilibrium Revisited

  • Repeated Games

Chapter 13


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Topics to be Discussed

  • Sequential Games

  • Threats, Commitments, and Credibility

  • Entry Deterrence

  • Bargaining Strategy

  • Auctions

Chapter 13


Gaming and strategic decisions l.jpg

Gaming and Strategic Decisions

  • Game is any situation in which players (the participants) make strategic decisions.

    • Ex: firms competing with each other by setting prices, group of consumers bidding against each other in an auction

  • Strategic decisions result in payoffs to the players: outcomes that generate rewards or benefits

Chapter 13


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Gaming and Strategic Decisions

  • Game theory tries to determine optimal strategy for each player

  • Strategy is a rule or plan of action for playing the game

  • Optimal strategy for a player is one that maximizes the expected payoff

  • We consider players who are rational – they think through their actions

Chapter 13


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Gaming and Strategic Decisions

  • “If I believe that my competitors are rational and act to maximize their own profits, how should I take their behavior into account when making my own profit-maximizing decisions?”

Chapter 13


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Noncooperative v. Cooperative Games

  • Cooperative Game

    • Players negotiate binding contracts that allow them to plan joint strategies

      • Example: Buyer and seller negotiating the price of a good or service or a joint venture by two firms (i.e. Microsoft and Apple)

      • Binding contracts are possible

Chapter 13


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Noncooperative v. Cooperative Games

  • Noncooperative Game

    • Negotiation and enforcement of binding contracts between players is not possible

      • Example: Two competing firms assuming the others behavior determine, independently, pricing and advertising strategy to gain market share

      • Binding contracts are not possible

Chapter 13


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Noncooperative v. Cooperative Games

  • “The strategy design is based on understanding your opponent’s point of view, and (assuming you opponent is rational) deducing how he or she is likely to respond to your actions”

Chapter 13


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Gaming and Strategic Decisions

  • An Example: How to buy a dollar bill

    • Auction a dollar bill

    • Highest bidder receives the dollar in return for the amount bid

    • Second highest bidder must pay the amount he or she bid but gets nothing in return

    • How much would you bid for a dollar?

  • Typically bid more for the dollar when faced with loss as second highest bidder

Chapter 13


Acquiring a company l.jpg

Acquiring a Company

  • Scenario

    • Company A: The Acquirer

    • Company T: The Target

    • A will offer cash for all of T’s shares

  • The value and viability of T depends on the outcome of a current oil exploration project

Chapter 13


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Acquiring a Company

  • Project failure: T’s value = $0

  • Project success: T’s value = $100/share

  • All outcomes in between equally likely

  • T’s value will be 50% greater with A’s management

Chapter 13


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Acquiring a Company

  • Scenario

    • A, must submit the proposal before the exploration outcome is known.

    • T will not choose to accept or reject until after the outcome is known only to T.

    • Company T will accept any offer that is greater than the per share value of the company under current management?

  • How much should A offer?

Chapter 13


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Dominant Strategies

  • Dominant Strategy is one that is optimal no matter what an opponent does.

    • An Example

      • A & B sell competing products

      • They are deciding whether to undertake advertising campaigns

Chapter 13


Payoff matrix for advertising game l.jpg

10, 5

15, 0

6, 8

10, 2

Payoff Matrix for Advertising Game

Firm B

Don’t

Advertise

Advertise

Advertise

Firm A

Don’t

Advertise

Chapter 13


Payoff matrix for advertising game16 l.jpg

Observations

A: regardless of B, advertising is the best

B: regardless of A, advertising is best

Firm B

Don’t

Advertise

10, 5

15, 0

Advertise

Advertise

Firm A

6, 8

10, 2

Don’t

Advertise

Payoff Matrix for Advertising Game

Chapter 13


Payoff matrix for advertising game17 l.jpg

Observations

Dominant strategy for A & B is to advertise

Do not worry about the other player

Equilibrium in dominant strategy

Firm B

10, 5

15, 0

Don’t

Advertise

Advertise

Advertise

6, 8

10, 2

Firm A

Don’t

Advertise

Payoff Matrix for Advertising Game

Chapter 13


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Dominant Strategies

  • Equilibrium in dominant strategies

    • Outcome of a game in which each firm is doing the best it can regardless of what its competitors are doing

    • Optimal strategy is determined without worrying about actions of other players

  • However, not every game has a dominant strategy for each player

Chapter 13


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Dominant Strategies

  • Game Without Dominant Strategy

    • The optimal decision of a player without a dominant strategy will depend on what the other player does.

    • Revising the payoff matrix we can see a situation where no dominant strategy exists

Chapter 13


Modified advertising game l.jpg

10, 5

15, 0

6, 8

20, 2

Modified Advertising Game

Firm B

Don’t

Advertise

Advertise

Advertise

Firm A

Don’t

Advertise

Chapter 13


Modified advertising game21 l.jpg

Observations

A: No dominant strategy; depends on B’s actions

B: Dominant strategy is to Advertise

Firm A determines B’s dominant strategy and makes its decision accordingly

Firm B

Don’t

Advertise

Advertise

Advertise

10, 5

15, 0

Firm A

Don’t

Advertise

6, 8

20, 2

Modified Advertising Game

Chapter 13


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The Nash Equilibrium Revisited

  • A dominant strategy is stable, but in many games one or more party does not have a dominant strategy.

  • A more general equilibrium concept is the Nash Equilibrium introduced in chapter 12

    • A set of strategies (or actions) such that each player is doing the best it can given the actions of its opponents

Chapter 13


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The Nash Equilibrium Revisited

  • None of the players have incentive to deviate from its Nash strategy, therefore it is stable

    • In the Cournot model, each firm sets its own price assuming the other firms outputs are fixed. Cournot equilibrium is a Nash Equilibrium

Chapter 13


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The Nash Equilibrium Revisited

  • Dominant Strategy

    • “I’m doing the best I can no matter what you do. You’re doing the best you can no matter what I do.”

  • Nash Equilibrium

    • “I’m doing the best I can given what you are doing. You’re doing the best you can given what I am doing.”

  • Dominant strategy is special case of Nash equilibrium

Chapter 13


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The Nash Equilibrium Revisited

  • Two cereal companies face a market in which two new types of cereal can be successfully introduced provided each type is introduced by only one firm

  • Product Choice Problem

    • Market for one producer of crispy cereal

    • Market for one producer of sweet cereal

    • Each firm only has the resources to introduce one cereal

    • Noncooperative

Chapter 13


Product choice problem l.jpg

-5, -5

10, 10

10, 10

-5, -5

Product Choice Problem

Firm 2

Crispy

Sweet

Crispy

Firm 1

Sweet

Chapter 13


Product choice problem27 l.jpg

If firm 1 hears firm 2 is introducing a new sweet cereal, its best action is to make crispy

Bottom left corner is Nash equilibrium

What is other Nash Equilibrium?

Firm 2

Crispy

Sweet

-5, -5

10, 10

Crispy

Firm 1

Sweet

10, 10

-5, -5

Product Choice Problem

Chapter 13


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Beach Location Game

  • Scenario

    • Two competitors, Y and C, selling soft drinks

    • Beach 200 yards long

    • Sunbathers are spread evenly along the beach

    • Price Y = Price C

    • Customer will buy from the closest vendor

Chapter 13


Beach location game29 l.jpg

Ocean

C

0

B

Beach

A

200 yards

Beach Location Game

  • Where will the competitors locate (i.e. where is the Nash equilibrium)?

  • Will want to all locate in center of beach.

    • Similar to groups of gas stations, car dealerships, etc.

Chapter 13


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The Nash Equilibrium Revisited

  • Maximin Strategies - Scenario

    • Two firms compete selling file-encryption software

    • They both use the same encryption standard (files encrypted by one software can be read by the other - advantage to consumers)

    • Firm 1 has a much larger market share than Firm 2

    • Both are considering investing in a new encryption standard

Chapter 13


Maximin strategy l.jpg

0, 0

-10, 10

-100, 0

20, 10

Maximin Strategy

Firm 2

Don’t invest

Invest

Don’t invest

Firm 1

Invest

Chapter 13


Maximin strategy32 l.jpg

Observations

Dominant strategy Firm 2: Invest

Firm 1 should expect firm 2 to invest

Nash equilibrium

Firm 1: invest

Firm 2: Invest

This assumes firm 2 understands the game and is rational

Firm 2

Don’t invest

Invest

0, 0

-10, 10

Don’t invest

Firm 1

-100, 0

20, 10

Invest

Maximin Strategy

Chapter 13


Maximin strategy33 l.jpg

Observations

If Firm 2 does not invest, Firm 1 incurs significant losses

Firm 1 might play don’t invest

Minimize losses to 10 – maximin strategy

Firm 2

Don’t invest

Invest

0, 0

-10, 10

Don’t invest

Firm 1

-100, 0

20, 10

Invest

Maximin Strategy

Chapter 13


Maximin strategy34 l.jpg

Maximin Strategy

  • If both are rational and informed

    • Both firms invest

    • Nash equilibrium

  • If Player 2 is not rational or completely informed

    • Firm 1’s maximin strategy is to not invest

    • Firm 2’s maximin strategy is to invest.

    • If 1 knows 2 is using a maximin strategy, 1 would invest

Chapter 13


Maximin strategy35 l.jpg

Maximin Strategy

  • If firm 1 is unsure about what firm 2 will do, it can assign probabilities to each possible action

    • Could use a strategy that maximizes its expected payoff

    • Firm 1’s strategy depends critically on its assessment of probabilities for firm 2

Chapter 13


Prisoners dilemma l.jpg

-5, -5

-1, -10

-10, -1

-2, -2

Prisoners’ Dilemma

Prisoner B

Confess

Don’t Confess

Confess

Prisoner A

Don’t

Confess

Chapter 13


Prisoners dilemma37 l.jpg

What is the:

Dominant strategy

Nash equilibrium

Maximin solution

Dominant strategies are also maximin strategies

Both confess is both Nash equilibrium and maximin solution

Prisoner B

Confess

Don’t Confess

-5, -5

-1, -10

Confess

Prisoner A

Don’t

Confess

-10, -1

-2, -2

Prisoners’ Dilemma

Chapter 13


Mixed strategy l.jpg

Mixed Strategy

  • Pure Strategy

    • Player makes a specific choice or takes a specific action

  • Mixed Strategy

    • Player makes a random choice among two or more possible actions, based on a set of chosen probabilities

Chapter 13


Matching pennies l.jpg

1, -1

-1, 1

-1, 1

1, -1

Matching Pennies

Player B

Heads

Tails

Heads

Player A

Tails

Chapter 13


Matching pennies40 l.jpg

Pure strategy: No Nash equilibrium

No combination of head and tails leaves both players better off

Mixed strategy: Random choice is a Nash equilibrium

Player B

Heads

Tails

Heads

1, -1

-1, 1

Player A

Tails

-1, 1

1, -1

Matching Pennies

Chapter 13


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Matching Pennies

  • Player A might flip coin playing heads with ½ probability and tails with ½ probability.

  • If both players follow this strategy, there is a Nash equilibrium – both player will be doing the best they can given what they opponent is doing.

  • Although the outcome is random, the expected payoff is 0 for each player.

Chapter 13


Mixed strategy42 l.jpg

Mixed Strategy

  • One reason to consider mixed strategies is when there is a game that do not have any Nash equilibriums in pure strategy.

  • When allowing for mixed strategies, every game has a Nash equilibrium

  • Mixed strategies popular for games like poker

  • A firm might not find it reasonable

Chapter 13


The battle of the sexes l.jpg

2,1

0,0

0,0

1,2

The Battle of the Sexes

Joan

Wrestling

Opera

Wrestling

Jim

Opera

Chapter 13


The battle of the sexes44 l.jpg

Pure Strategy

Both watch wrestling

Both watch opera

Mixed Strategy

Jim chooses wrestling

Joan chooses wrestling

Joan

Wrestling

Opera

2,1

0,0

Wrestling

Jim

Opera

0,0

1,2

The Battle of the Sexes

Chapter 13


Repeated games l.jpg

Repeated Games

  • Game in which actions are taken and payoffs received over and over again

  • Oligopolistic firms play a repeated game.

  • With each repetition of the Prisoners’ Dilemma, firms can develop reputations about their behavior and study the behavior of their competitors.

Chapter 13


Pricing problem l.jpg

10, 10

100, -50

-50, 100

50, 50

Pricing Problem

Firm 2

Low Price

High Price

Low Price

Firm 1

High Price

Chapter 13


Pricing problem47 l.jpg

Pricing Problem

  • How does a firm find a strategy that would work best on average against all or almost all other strategies

  • Tit-for-tat strategy

    • Repeated game strategy in which a player responds in kink to an opponent’s previous play, cooperating with cooperative opponents and retaliating against uncooperative ones.

Chapter 13


Tit for tat strategy l.jpg

Tit-for-Tat Strategy

  • What if the game is infinitely repeated

    • Competitors repeatedly set price every month, forever

    • Tit-for-tat strategy is rational

      • If competitor charges low price and undercuts firm

      • Will get high profits that month but know I will lower price next month

      • Both of us will get lower profits if keep undercutting, so not rational to undercut.

Chapter 13


Tit for tat strategy49 l.jpg

Tit-for-Tat Strategy

  • What if repeat a finite number of times

    • If both firms are rational, they will charge high prices until the last month

    • After the last month, there is no retaliation possible

    • But in the month before last month, knowing that will charge low price in last month, will charge low price in month before

    • Keep going and see that only rational outcome is for both firms to charge low price every month

Chapter 13


Tit for tat strategy50 l.jpg

Tit-for-Tat Strategy

  • If firms don’t believe their competitors are rational or think perhaps they aren’t, cooperative behavior is a good strategy.

  • Most managers don’t know how long they will be competing with their rivals

  • In a repeated game, prisoners dilemma can have cooperative outcome

Chapter 13


Repeated games51 l.jpg

Repeated Games

  • Conclusion

    • Cooperation is difficult at best since these factors may change in the long-run.

    • Need a small number of firms

    • Need stable demand and cost conditions

      • This could lead to price wars if don’t have them

Chapter 13


Oligopolistic cooperation in the water meter industry l.jpg

Oligopolistic Cooperationin the Water Meter Industry

  • Characteristics of the Market

    • Four producers of water meters

      • Rockwell International (35%)

      • Badger Meter

      • Neptune Water Meter Company

      • Hersey Products

      • Rockwell has about 35 % of market share

      • Badger, Neptune, and Hersey combined have about a 50 to 55% share

Chapter 13


Oligopolistic cooperation in the water meter industry53 l.jpg

Oligopolistic Cooperationin the Water Meter Industry

  • Most buyers are municipal water utilities

  • Very inelastic demand

    • Not a significant part of the budget for providing water

  • Demand is stable

    • Demand grows steadily with population

  • Utilities have long-standing relationships with suppliers

    • Reluctant to switch

Chapter 13


Oligopolistic cooperation in the water meter industry54 l.jpg

Oligopolistic Cooperationin the Water Meter Industry

  • Significant economies of scale

  • Both long term relationship and economies of scale represent barriers to entry

    • Hard for new firms to enter market

  • If firms were to cooperate, could earn significant monopoly profits

  • If compete aggressively to gain market share, profits will fall to competitive levels

Chapter 13


Oligopolistic cooperation in the water meter industry55 l.jpg

Oligopolistic Cooperationin the Water Meter Industry

  • This is a Prisoners’ Dilemma – what should the firms do?

    • Lower price to a competitive level

    • Cooperate

  • Companies have been playing repeated game for decades

  • Cooperation has prevailed given market characteristics

Chapter 13


Sequential games l.jpg

Sequential Games

  • Players move in turn, responding to each other’s actions and reactions

    • Ex: Stackelberg model (ch. 12)

    • Responding to a competitor’s ad campaign

    • Entry decisions

    • Responding to regulatory policy

Chapter 13


Sequential games57 l.jpg

Sequential Games

  • Going back to the product choice problem

    • Two new (sweet, crispy) cereals

    • Successful only if each firm produces one cereal

    • Sweet will sell better

    • Both still profitable with only one producer

Chapter 13


Modified product choice problem l.jpg

Modified Product Choice Problem

  • If firms both announce their decision independently and simultaneously, they will both pick sweet cereal and both will lose money

  • What if firm 1 sped up production and introduced new cereal first

    • Now there is a sequential game

    • Firm 1 think about what firm 2 will do

Chapter 13


Modified product choice problem59 l.jpg

-5, -5

10, 20

20, 10

-5, -5

Modified Product Choice Problem

Firm 2

Crispy

Sweet

Crispy

Firm 1

Sweet

Chapter 13


Extensive form of a game l.jpg

Extensive Form of a Game

  • Extensive Form of a Game

    • Representation of possible moves in a game in the form of a decision tree

      • Allows one to work backward from the best outcome for Firm 1

Chapter 13


Product choice game in extensive form l.jpg

-5, -5

Crispy

Crispy

Firm 2

Sweet

10, 20

Firm 1

Crispy

20, 10

Sweet

Firm 2

Sweet

-5, -5

Product Choice Game in Extensive Form

Chapter 13


Sequential games62 l.jpg

Sequential Games

  • The Advantage of Moving First

    • In this product-choice game, there is a clear advantage to moving first.

    • The first firm can choose a large level of output thereby forcing second firm to choose a small level.

    • Can show the firms mover advantage by revising the Stackelberg model and comparing to Cournot

Chapter 13


First mover advantage l.jpg

First Mover Advantage

  • Assume: Duopoly

Chapter 13


First mover advantage64 l.jpg

First Mover Advantage

  • Duopoly

Chapter 13


Choosing output l.jpg

112.50, 112.50

93.75, 125

56.25, 112.50

125, 93.75

100, 100

50, 75

112.50, 56.25

75, 50

0, 0

Choosing Output

Firm 2

7.5

10

15

7.5

10

Firm 1

15

Chapter 13


Choosing output66 l.jpg

This payoff matrix illustrates various outcomes

Move together, both produce 10

If firm 1 moves first (Q=15), best firm 2 can do is 7.5

Firm 2

7.5

10

15

112.50, 112.50

93.75, 125

56.25, 112.50

7.5

125, 93.75

100, 100

50, 75

10

Firm 1

15

112.50, 56.25

75, 50

0, 0

Choosing Output

Chapter 13


Threats commitments and credibility l.jpg

Threats, Commitments, and Credibility

  • Strategic Moves

    • What actions can a firm take to gain advantage in the marketplace?

      • Deter entry

      • Induce competitors to reduce output, leave, raise price

      • Implicit agreements that benefit one firm

Chapter 13


Threats commitments and credibility68 l.jpg

Threats, Commitments, and Credibility

  • Strategic Move

    • Action that gives a player an advantage by constraining his behavior

    • Firm 1 must constrain his behavior to the extent Firm 2 is convinced that he is committed

Chapter 13


Threats commitments and credibility69 l.jpg

Threats, Commitments, and Credibility

  • How To Make the First Move

    • Demonstrate Commitment

    • Firm 1 must do more than announce they will produce sweet cereal

      • Invest in expensive advertising campaign

      • Buy large order of sugar and send invoice to firm 2

    • Commitment must be enough to induce firm 2 to make the decision firm 1 wants it to make

Chapter 13


Threats commitments and credibility70 l.jpg

Threats, Commitments, and Credibility

  • Empty Threats

    • If a firm will be worse off if it charges a low price, the threat of a low price is not credible in the eyes of the competitors.

    • When firms know the payoffs of each others actions, firms cannot make threats the other firm knows they will not follow.

    • In our example, firm 1 will always charge high price and firm 2 knows it

Chapter 13


Pricing of computers and word processors l.jpg

100, 80

80, 100

20, 0

10, 20

Pricing of Computers and Word Processors

Firm 2

High Price

Low Price

High Price

Firm 1

Low Price

Chapter 13


Threats commitments and credibility72 l.jpg

Threats, Commitments, and Credibility

  • Sometimes firms can make credible threats

  • Scenario

    • Race Car Motors, Inc. (RCM) produces cars

    • Far Out Engines (FOE) produces specialty car engines and sells most of them to RCM

    • Sequential game with RCM as the leader

    • FOE has no power to threaten to build big since RCM controls output.

Chapter 13


Production choice problem l.jpg

3, 6

3, 0

1, 1

8, 3

Production Choice Problem

Race Car Motors

Small cars

Big cars

Small engines

Far Out Engines

Big engines

Chapter 13


Threats commitments and credibility74 l.jpg

Threats, Commitments, and Credibility

  • RCM does best by producing small cars

  • Knows that Far Out will then produce small engines

  • Far Out prefers to make big engines

  • Can Far Out induce Race Car to produce big cars instead?

Chapter 13


Threats commitments and credibility75 l.jpg

Threats, Commitments, and Credibility

  • Suppose Far Out threatens to produce big engines no matter what RCM does

    • Not credible since once RCM announces they are producing small cars, FO will not have incentive to carry out threat.

    • Can make threat credible by altering pay off matrix by constraining its own choices

      • Shutting down or destroying some small engine production capacity

Chapter 13


Modified production choice problem l.jpg

0, 6

0, 0

1, 1

8, 3

Modified Production Choice Problem

Race Car Motors

Small cars

Big cars

Small engines

Far Out Engines

Big engines

Chapter 13


Modified production choice problem77 l.jpg

Modified Production Choice Problem

  • Strategic commitments can be effect but not without risk

    • Rely heavily on accurate knowledge of payoff matrix and industry

    • May have competitors out there that they don’t know about and lose sale

Chapter 13


Role of reputation l.jpg

Role of Reputation

  • If Far Out gets the reputation of being irrational

    • They threaten to produce large engines not matter what Race Car does

  • Threat might be credible because irrational people don’t always make profit maximizing decisions

  • A party thought to be crazy can lead to a significant advantage

Chapter 13


Bargaining strategy l.jpg

Bargaining Strategy

  • Bargaining situation can depend on ability to affect relative bargaining position

  • Consider two firms introducing one of two complementary goods.

    • Firm 1 has cost advantage in Good A

    • Firm 2 has cost advantage in Good B

Chapter 13


Bargaining strategy80 l.jpg

40, 5

50, 50

60, 40

5, 45

Bargaining Strategy

Firm 2

Produce A

Produce B

Produce A

Firm 1

Produce B

Chapter 13


Bargaining strategy81 l.jpg

With collusion:

Produce A1B2

Without collusion:

Produce A1B2

Nash equilibrium

Firm 2

Produce A

Produce B

40, 5

50, 50

Produce A

Firm 1

60, 40

5, 45

Produce B

Bargaining Strategy

Chapter 13


Bargaining strategy82 l.jpg

Bargaining Strategy

  • Suppose each firm is also bargaining on the decision to join in a research consortium with a third firm.

  • Dominant strategy is for both firms to enter consortium

Chapter 13


Bargaining strategy83 l.jpg

10, 10

10, 20

20, 10

40, 40

Bargaining Strategy

Firm 2

Work alone

Enter consortium

Work alone

Firm 1

Enter

consortium

Chapter 13


Bargaining strategy84 l.jpg

Bargaining Strategy

  • Linking the Bargain Problem

    • Firm 1 announces it will join the consortium only if Firm 2 agrees to produce A and Firm 1 will produce B.

    • Firm 2’s best interest to produce A with firm 1 producing B

      • Firm 1’s profit increases from 50 to 60

Chapter 13


Bargaining strategy85 l.jpg

Bargaining Strategy

  • Strategic moves can be used in bargaining

  • Combining issues in bargaining can benefit one side at other’s expense

Chapter 13


Wal mart stores preemptive investment strategy l.jpg

Wal-Mart Stores’ Preemptive Investment Strategy

  • How did Wal-Mart become the largest retailer in the U.S. when many established retail chains were closing their doors?

    • Gained monopoly power by opening in small town with no threat of other discount competition

    • Preemptive game with Nash equilibrium

Chapter 13


The discount store preemption game l.jpg

-10, -10

20, 0

0, 20

0, 0

The Discount Store Preemption Game

Company X

Enter

Don’t enter

Enter

Wal-Mart

Don’t enter

Chapter 13


The discount store preemption game88 l.jpg

Two Nash equilibrium

Low left

Upper right

Must be preemptive to win

Company X

Enter

Don’t enter

-10, -10

20, 0

Enter

Wal-Mart

Don’t enter

0, 20

0, 0

The Discount Store Preemption Game

Chapter 13


Entry deterrence l.jpg

Entry Deterrence

  • Barriers to entry important for monopoly power

    • Economies of scale, patents and licenses, access to critical inputs

    • Firms can also deter entry

  • To deter entry, the incumbent firm must convince any potential competitor that entry will be unprofitable.

Chapter 13


Entry possibilities l.jpg

100, 20

200, 0

70, -10

130, 0

Entry Possibilities

Potential Entrant ($80 fixed costs)

Enter

Stay out

High price

(accommodation)

Incumbent

Low Price

(warfare)

Chapter 13


Entry deterrence91 l.jpg

Entry Deterrence

  • Scenario

    • If X does not enter I makes a profit of $200 million.

    • If X enters and charges a high price I earns a profit of $100 million and X earns $20 million.

    • If X enters and charges a low price I earns a profit of $70 million and X earns $-10 million.

Chapter 13


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Entry Deterrence

  • Could threaten X with warfare if enter market

    • Not credible because once X has entered, it is in your best interest to accommodate and maintain high price.

Chapter 13


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Entry Deterrence

  • What if make an investment before entry to increase my capacity

    • Irrevocable commitment

  • Gives new payoff matrix since profits will be reduced by investment

  • Threat is completely credible

  • Rational for firm X to stay out of market

Chapter 13


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50, 20

150, 0

70, -10

130, 0

Entry Deterrence

Potential Entrant

Enter

Stay out

High price

(accommodation)

Incumbent

Low Price

(warfare)

Chapter 13


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Entry Deterrence

  • If incumbent has reputation of price cutting competitors even at loss, then threat will be credible.

  • Short run losses may be offset by long run gains as monopolist

Chapter 13


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Entry Deterrence

  • Production of commercial airlines exhibit significant economies of scale

  • Airbus and Boeing considering new aircraft

  • Suppose not economical for both firms to produce the new aircraft

Chapter 13


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-10, -10

100, 0

0, 120

0, 0

Development of a New Aircraft

Airbus

Produce

Don’t produce

Produce

Boeing

Don’t produce

Chapter 13


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Boeing has head start

Boeing will produce

Airbus will not produce

Airbus

Produce

Don’t produce

-10, -10

100, 0

Produce

Boeing

Don’t produce

0, 120

0, 0

Development of a New Aircraft

Chapter 13


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Development of a New Aircraft

  • Governments can change outcome of game

  • European government agrees to subsidize Airbus before Boeing decides to produce

  • With Airbus being subsidized, the payoff matrix for the two firms would differ significantly.

Chapter 13


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-10, 10

100, 0

0, 120

0, 0

Development of a AircraftAfter European Subsidy

Airbus

Produce

Don’t produce

Produce

Boeing

Don’t produce

Chapter 13


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Airbus will produce

Boeing will not produce

-10, 10

100, 0

0, 120

0, 0

Development of a AircraftAfter European Subsidy

Airbus

Produce

Don’t produce

Produce

Boeing

Don’t produce

Chapter 13


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Diaper Wars

  • Even though there are only two major firms, competition is intense.

  • The competition occurs mostly in the form of cost-reducing innovation.

  • Small cost savings can lead to capturing of market share

  • Both firms spend significantly on R&D

Chapter 13


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40, 20

80, -20

-20, 60

60, 40

Competing Through R & D

Kimberly-Clark

R&D

No R&D

R&D

P&G

No R&D

Chapter 13


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Both spend on R&D

Dominant strategy

Why not cooperate

Strengthening Bargaining Power

Credibility

Reducing flexibility

Kimberly-Clark

R&D

No R&D

40, 20

80, -20

R&D

P&G

-20, 60

60, 40

No R&D

Competing Through R & D

Chapter 13


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Auctions

  • Markets in which products are bought and sold through formal biding processes

    • Encourages competition that increases seller’s revenue

    • Low cost of transactions

    • Useful for unique items or though with fluctuating value

      • Tokyo fish market

Chapter 13


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Auction Formats

  • Traditional English (oral)

    • Seller actively solicits progressively higher bids from a group of potential buyers

    • Buyers always aware of highest bid

    • Stops when no one passes highest bid

Chapter 13


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Auction Formats

  • Dutch auction

    • Seller begins by offering item at relatively high price, then reduces it by fixed amounts until item is sold

    • First buyer accepting offered price can buy item at that price

Chapter 13


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Auction Formats

  • Sealed-bid

    • All bids are make simultaneously in sealed envelopes, where winning bid is one who submitted highest bid.

    • First price

      • Sales price equals highest bid

    • Second price

      • Sales price equals second highest bid

Chapter 13


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Valuation and Information

  • How to choose an auction format

    • Private-value auction – bidder knows individual valuations of object, but valuations differ from bidder to bidder

      • Signed baseball

    • Common-value auction: bidders uncertain what the value is

      • Offshore oil reserve

Chapter 13


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Price-Value Auctions

  • Each bidder must choose bidding strategy

  • Payoff for winning is reservation price minus price paid

  • Payoff for losing is zero

Chapter 13


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Private Value Auction

  • English oral auction and second – price sealed bid auctions

    • Bidding truthfully is dominant strategy

    • Pay based on value of second highest bidder so no incentive not to bid reservation price

    • Risk to bidding higher than reservation price

Chapter 13


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Private Value Auctions

  • English auction

    • Continue bidding until second person is unwilling to make bid

  • Sealed-bid auction

    • Winning bid approximately equal to the second highest bidder’s reservation price

  • Both yield the same revenue

Chapter 13


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Common Value Auctions

  • Winner’s Curse

    • The winner is worse off because they over estimated the value of the item and thereby overbid

    • Must reduce bid by amount equal to the expected error of the winning bidder

    • If lot of variation in other bidders than estimates are fairly imprecise

Chapter 13


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Maximizing Auction Revenue

  • Private Value auction

    • Encourage many bidders to increase expected bid of winner

  • Common Value Auction

    • Use open rather than sealed bid

      • Generate greater revenue

    • Reveal information about true value reducing concern of winner’s curse

Chapter 13


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Maximizing Auction Revenue

  • Private value auction

    • Set min bid equal to or higher than value to you of keeping good for future sale

    • Protect against loss if bidders unaware of value

    • Increase size of bids by letting bidders think item is valuable

    • No sale could make bidders think item is low quality

Chapter 13


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Bidding and Collusion

  • Buyers can allow benefit from collusion

    • Can be done legally through buying groups

    • Can be done illegally through collusive agreements that violate antitrust laws

    • Collusion not easy because large incentive to cheat

    • Repeated auctions allow for penalizing participants that break agreement

Chapter 13


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Bidding and Collusion

  • Examples

  • Collusion among baseball owners to limit their bidding for free-agent players in 1980’s

  • Two of world’s most successful auction houses were found guilty of agreeing to fix prices of commissions

    • Sotheby’s and Christie’s

Chapter 13


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Internet Auctions

  • Popularity of auctions has skyrocketed with growth of internet

  • Most popular site is ebay

    • Dominates online person-person auction industry

  • Subject to large network externalities

    • Choose auction site with largest number of potential bidders

Chapter 13


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Internet Auctions

  • Ebay auctions somewhat different from types discussed

  • A Few Caveats

    • No quality control function

    • Poor seller feedback

    • Bid manipulation may occur

Chapter 13


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