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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**Game Theory and Competitive Strategy**Topics to be Discussed**• Gaming and Strategic Decisions • Dominant Strategies • The Nash Equilibrium Revisited • Repeated Games Chapter 13**Topics to be Discussed**• Sequential Games • Threats, Commitments, and Credibility • Entry Deterrence • Bargaining Strategy • Auctions Chapter 13**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**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**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?”(Text, p. 474) Chapter 13**Noncooperative vs. 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**Noncooperative vs. Cooperative Games**• Noncooperative Game • Negotiation and enforcement of binding contracts between players is not possible • Example: Two competing firms, assuming the other’s behavior, independently determine pricing and advertising strategy to gain market share • Binding contracts are not possible Chapter 13**Noncooperative vs. Cooperative Games**• “The strategy design is based on understanding your opponent’s point of view, and (assuming your opponent is rational) deducing how he or she is likely to respond to your actions.” (Text, p. 475) Chapter 13**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**• 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**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**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**Dominant Strategies**• Dominant Strategy is one that is optimal no matter what an opponent does • An Example • A and B sell competing products • They are deciding whether to undertake advertising campaigns Chapter 13**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**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**Observations**Dominant strategy for A and 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**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 the actions of other players • However, not every game has a dominant strategy for each player Chapter 13**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**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**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**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**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 firm’s outputs are fixed. Cournot equilibrium is a Nash Equilibrium. Chapter 13**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 a special case of Nash equilibrium Chapter 13**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**-5, -5**10, 10 10, 10 -5, -5 Product Choice Problem Firm 2 Crispy Sweet Crispy Firm 1 Sweet Chapter 13**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**Beach Location Game**• Scenario • Two competitors, Y and C, selling soft drinks • Beach is 200 yards long • Sunbathers are spread evenly along the beach • Price Y = Price C • Customer will buy from the closest vendor Chapter 13**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**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**0, 0**-10, 10 -100, 0 20, 10 Maximin Strategy Firm 2 Don’t invest Invest Don’t invest Firm 1 Invest Chapter 13**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**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 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 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**-5, -5**-1, -10 -10, -1 -2, -2 Prisoners’ Dilemma Prisoner B Confess Don’t Confess Confess Prisoner A Don’t Confess Chapter 13**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**• 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**1, -1**-1, 1 -1, 1 1, -1 Matching Pennies Player B Heads Tails Heads Player A Tails Chapter 13**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**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 players will be doing the best they can given what their opponent is doing • Although the outcome is random, the expected payoff is 0 for each player Chapter 13**Mixed Strategy**• One reason to consider mixed strategies is when there is a game that does not have any Nash equilibriums in pure strategy • When allowing for mixed strategies, every game has a Nash equilibrium • Mixed strategies are popular for games like poker • A firm might not find it reasonable Chapter 13**2,1**0,0 0,0 1,2 The Battle of the Sexes Joan Wrestling Opera Wrestling Jim Opera Chapter 13**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**• Game in which actions are taken and payoffs are 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**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 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 kind to an opponent’s previous play, cooperating with cooperative opponents and retaliating against uncooperative ones Chapter 13**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 Strategy**• What if repeated 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 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, prisoner’s dilemma can have cooperative outcome Chapter 13

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