Strategic Corporate Management 45-870

1. Strategic Corporate Management45-870 Professor Robert A. Miller Fourth Mini 2019 Teaching assistant: Chi (Faith) Feng: cfeng1@andrew.cmu.edu

2. Lecture 1Introduction to Strategy We begin this course by laying out an agenda for this course, and then using an example to illustrate how we shall proceed.

3. Preamble • Being “strategic” means intelligently seeking your own goals in situations that involve other parties who do not share your goals, a theme we emphasize in this course. • In business “corporate” typically refers to a publicly traded company with limited liability, a corporation owned by shareholders. We will focus more broadly on business entities, and management goals. • And “management” refers to organizing people, when you lack the absolute powers of a dictator, but can wield some incentives and help set the rules.

4. Course objectives • Recognize strategic situations and opportunities • Summarize the essential elements in order to undertake an analysis • Predict the outcomes from strategic play • Conduct experiments, that is “human simulations”, to verify and revise your predictions • Analyze the experimental data to increase your knowledge and familiarity using simple statistics . . . to help you make better strategic decisions.

5. Course materials • The course website is: http://www.comlabgames.com/45-870 • At the website you can find: • the course syllabus • power point lecture notes • experiments you can download • project assignments • the on line (draft) textbook • other reading material

6. A cola war After struggling through the Great Depression of the 1930s Pepsi finds its soft drink sales are stalled in the 1940s. Coke is the industry leader, and its products command a premium price over Pepsi’s. The country is at war, but remains segregated along racial lines, with blacks economically and socially disadvantaged.

7. Who are the main players in this episode? Pepsi shareholders Coke shareholders Management at Pepsi White cola demanders Black cola demanders

8. What options or choices face the main players? Pepsi could target its product line to African American consumers, Pepsi could target a new product line to African American consumers, or Pepsi could pursue another strategy, such as expanding its operations in Canada. Coke could respond aggressively or passively to any marketing initiative taken by Pepsi. White consumers might be alienated by a marketing campaign that targets African American consumers.

9. How do the players evaluate the consequences of their choices? If Coke responds to an advertising campaign both firms will sell more cola in return for lower profits. If Coke does not respond to Pepsi, how much value will be added or lost to each company? If the white community is alienated by both companies targeting the African American community, would Coke be hurt more than Pepsi?

10. Where are the sources of uncertainty in this unfolding drama? Will white cola drinkers be alienated by the introduction of a marketing campaign that targets the African American community? If both companies target blacks, the probability of alienating whites is higher than if only Pepsi does. Moreover as the company with the bigger white market share, Coke has more to lose in this case.

11. Illustrating the four critical questions in an extensive form game

12. The extensive form • The game we just played was represented by its extensive form. • The extensive form representation answers the four critical questions in strategy: Who are the players? What are their potential moves? What is their information? How do they value the outcomes? • These are the ingredients used to design all games in extensive form.

13. Who is involved? • How many major players are there, and whose decisions we should model explicitly? • Can we consolidate some of the players into a team because they pool their information and have common goals? • Should we model the behavior of the minor players should be modeled directly as nature, using probabilities to capture their effects on the game? • Does nature play any other role in resolving uncertainty, for example through a new technology that has chance of working?

14. What can they do? • Each node designates whose turn it is. It could be a player or nature. The initial node shows how the game starts, while terminal nodes end the game. • A branch join two nodes to each other. Branches display the possible choices for the player who should move, and also the possible random outcomes of nature’s moves. • Tracing a path from the initial node to a terminal node is called a history. A history is uniquely identified by its terminal node.

15. What are the payoffs? • Payoffs capture the consequences of playing a game. • They represent the utility or net benefit to each player from a game ending at any given terminal node. • Payoffs show how resources are allocated to all the players contingent on a terminal node being reached.

16. What do they know? • Each non-terminal decision node is associated with an information set. • If a decision node is not connected to a dotted line, the player assigned to the node knows the partial history. • If two nodes are joined by a dotted line, they belong to the same information set, and the two sets of branches emanating from them, which define the player’s choice set, must be identical. • A player cannot distinguish between partial histories leading to nodes that belong to the same information set.

17. Changing the informationavailable to Coke • Suppose we draw a dotted line connecting the two decision nodes for Coke. • Then we prevent Coke from seeing which market Pepsi enters, before it chooses whether to acquiesce or not.

18. The empirical distribution • The empirical distribution is the probability distribution of choices made by all the players in the game. • It is formed from the relative frequencies of choices made at each information set observed in the experiment. • For example, the empirical distribution characterizing Coke comprise two relative frequencies, showing how likely Coke is to cut price if Pepsi advertises in the: • Quebec market • African American market

19. Best response to empirical distribution • For any given player (Pepsi), treat the moves by all other players (Coke) as nature. • Form the choice probabilities for the other players from the relative frequencies of the choices observed in the experiment (by experimental subjects playing Coke). • This transforms the game into a dynamic programming problem for the given player (Pepsi). Use dynamic programming methods, such as backwards induction, to find the (Pepsi’s )best response to the empirical distribution. • To compute the best response for Pepsi you need to know Pepsi’s payoffs but not Coke’s.

20. Summary • The extensive form summarizes the four dimensions of every strategic situation: • Players • Actions • Information • Consequences • The empirical distribution describes how all the players choose their moves. • If you know the probabilities of the moves for everyone else, you can calculate your own expected value from making the different choices that you have. • Playing the best response to the empirical distribution mimics optimal decision making. • It only requires you to know the other players, and their choice probabilities.