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Thinking Strategically

Thinking Strategically

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Thinking Strategically

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  1. Thinking Strategically

  2. Analyze This Warner Brothers Production Budget: $30,000,000 Both major characters in the movie are big funs of Tony Bennett WB’s initial offer to Tony Bennett for a performance is only $15,000, but they ended up paying $200,000. Problem: WB determined to buy the performance and had bought it (sunk cost), but forgot to ask the price first! Chapter 11: Thinking Strategically

  3. Thinking Strategically • The payoff to many actions will depend on • The actions themselves. • When the actions are taken. • How the actions relate to those taken by others. • Example: firms in imperfect competitions have to consider the responses of their rivals when they set their own prices or advertisement budget. Chapter 11: Thinking Strategically

  4. The Theory of Games • Three Basic Elements of a Game • The Players • Their Strategies • The Payoffs • Payoffs are different for different combination of strategies of all the players • Game Theory: Mathematical Theory! Chapter 11: Thinking Strategically

  5. The Theory of Games • Example • Should United Airlines spend more on advertising? • Players: United Airlines and American Airlines • Strategies: increase or stand pat • Same choices for both players • They choose the move at the same time • Payoff: listed in the Payoff Matrix Chapter 11: Thinking Strategically

  6. American gets $5,500 American gets $2,000 United gets $5,500 United gets $8,000 American gets $8,000 American gets $6,000 United gets $2,000 United gets $6,000 The Payoff Matrix for an Advertising Game American’s Choice Leave ad spending the same Raise ad spending Raise ad spending United’s Choice Leave ad spending the same Chapter 11: Thinking Strategically

  7. The Theory of Games • Best Response – (conditional) • one that yields the best payoff for a given strategy by the other player(s). • Dominant Strategy – (unconditional) • One that yields a higher payoff no matter what the other players in a game choose • Dominated Strategy • Any other strategy available to a player who has a dominant strategy Chapter 11: Thinking Strategically

  8. American gets $5,500 American gets $2,000 United gets $5,500 United gets $8,000 American gets $8,000 American gets $6,000 United gets $2,000 United gets $6,000 The Payoff Matrix for an Advertising Game American’s Choice American’s dominant strategy Best Response to United’s “raise ad spending” Leave ad spending the same Raise ad spending United’s dominant strategy Raise ad spending United’s Choice Leave ad spending the same Chapter 11: Thinking Strategically

  9. The Theory of Games • Nash Equilibrium • Any combination of strategies in which each player’s strategy is her or his best choice, given the other player’s strategies • When each player has a dominant strategy, equilibrium occurs when each player follows that strategy • When a game is in equilibrium, no player has any incentive to deviate from his current strategy Chapter 11: Thinking Strategically

  10. American gets $5,500 American gets $2,000 United gets $5,500 United gets $8,000 American gets $8,000 American gets $6,000 United gets $2,000 United gets $6,000 The Payoff Matrix for an Advertising Game American’s Choice Leave ad spending the same Raise ad spending Raise ad spending Nash Equilibrium United’s Choice Leave ad spending the same Chapter 11: Thinking Strategically

  11. The Theory of Games • Nash Equilibrium • There can be an equilibrium when players do not have a dominant strategy • Example • Should United Airlines spend more on advertising? Chapter 11: Thinking Strategically

  12. American gets $4,000 American gets $3,000 United gets $3,000 United gets $8,000 American gets $5,000 American gets $2,000 United gets $4,000 United gets $5,000 Equilibrium When One Player Lacks a Dominant Strategy American’s Choice What is the dominant strategy for United Airlines?__________ Leave ad spending the same Raise ad spending Which cell is the Nash Equilibrium for the game?__________ Raise ad spending United’s Choice Leave ad spending the same Chapter 11: Thinking Strategically

  13. American gets $2,000 American gets $3,000 United gets $3,000 United gets $4,000 American gets $3,000 American gets $4,000 United gets $2,000 United gets $3,000 What Should United and American Do If Their Payoff Matrix is Modified? American’s Choice Leave ad spending the same Raise ad spending Raise ad spending United’s Choice Leave ad spending the same Chapter 11: Thinking Strategically

  14. RECAP • The three elements of a game • Players, strategies and payoffs • Strategies: best response, dominant and dominated • Equilibrium: each player chooses the best response respectively – this combination of strategies is called Nash Equilibrium Chapter 11: Thinking Strategically

  15. The Prisoner’s Dilemma • Prisoners Dilemma • A game in which each player has a dominant strategy, and when each plays it, the resulting payoffs are smaller than if each had played a dominated strategy • If every player is smart on self-interest, all together, the players will achieve a worse outcome than everyone was naïve in playing games. Chapter 11: Thinking Strategically

  16. The Prisoner’s Dilemma • Example • Should the prisoners confess? • Two prisoners: held in separate cells • caught with minor crime: 1 year • They did commit a serious crime, but the prosecutor doesn’t have enough hard evidence to convict them. • If one confesses and the other remains silent • Confessor: 0 year; the other: 20 years • If both of them confess, 5 years for both. Chapter 11: Thinking Strategically

  17. Prisoner 2 gets 5 years Prisoner 2 gets 20 years Prisoner 1 gets 5 years Prisoner 1 gets 0 year Prisoner 2 gets 0 year Prisoner 2 gets 1 year Prisoner 1 gets 20 years Prisoner 1 gets 1 year The Payoff Matrix for a Prisoner’s Dilemma Prisoner 2’s Choice Remain silent Confess Confess Prisoner 1’s Choice Remain silent Chapter 11: Thinking Strategically

  18. The Prisoner’s Dilemma • Exercise • Which of these games is a prisoner’s dilemma? Chapter 11: Thinking Strategically

  19. 10 for Chrysler 12 for Chrysler 10 for GM 4 for GM 4 for Chrysler 5 for Chrysler 12 for GM 5 for GM Which of These GamesIs a Prisoner’s Dilemma? Chrysler’s Choice GAME 1 Don’t Invest Invest Don’t Invest GM’s Choice Invest Chapter 11: Thinking Strategically

  20. 12 for Chrysler 5 for Chrysler 4 for GM 5 for GM 10 for Chrysler 4 for Chrysler 10 for GM 12for GM Which of These GamesIs a Prisoner’s Dilemma? Chrysler’s Choice GAME 2 Don’t Invest Invest Don’t Invest GM’s Choice Invest Chapter 11: Thinking Strategically

  21. The Prisoner’s Dilemma • Common thread • Conflict between the narrow self-interest of individuals and the broader interests of larger communities • Countless social/economic interactions with similar payoff structures • Some may involve more than 2 players. Chapter 11: Thinking Strategically

  22. The Prisoner’s Dilemma • Prisoner’s Dilemmas Confronting Imperfectly Competitive Firms • Cartel • A coalition of firms that agrees to restrict output for the purpose of earning an economic profit • Economic Naturalist • Why are cartel agreements notoriously unstable? Chapter 11: Thinking Strategically

  23. 2.00 • Impact of Cartel • Q = 1,000 bottles/day • P = $1/bottle • Each firm makes $500/day 1.00 MR D 1,000 2,000 The Market Demandfor Mineral Water • Assume • 2 firms (Aquapure & Mountain Spring) • MC = 0 • Cartel is formed & agree to split monopolistic output and profits Price $/bottle) Bottles/day Chapter 11: Thinking Strategically

  24. Aquapure lowers P • P = $0.90/bottle • Q = 1,100 bottles/day • Mountain Spring: Q = 0! 0.90 1,100 The Temptation to Violate a Cartel Agreement 2.00 • Mountains Spring retaliates • P = $.90/bottle • Both firms split 1,100 bottles/day @ $.90 • Profit = $495/day Price $/bottle) 1.00 MR D 1,000 2,000 Bottles/day Chapter 11: Thinking Strategically

  25. $500/day for Mountain Spring $990/day for Mountain Spring $500/day for Aquapure $0/day for Aquapure $0/day for Mountain Spring $495/day for Mountain Spring $990/day for Aquapure $495/day for Aquapure The Payoff Matrix for a Cartel Agreement Both firms keep cutting price until the price = MC = 0. The Cartel breakdown! Mountain Spring’s Choice Charge $1 Charge $0.90 Charge $1 Aquapure’s Choice Charge $0.90 Chapter 11: Thinking Strategically

  26. Cartel and The Prisoner’s Dilemma • When will the rival firms stop cutting prices? – Never until P = MC • Cartel may have more than two members, retaliation can hurt all members, not only the price cutter. • Hard to discover the price cutter. Chapter 11: Thinking Strategically

  27. The Prisoner’s Dilemma • Economic Naturalist • How did Congress unwittingly solve the television advertising dilemma confronting cigarette producers? • When cigarette companies stopped advertising, their profits were higher. • Increase in demand from advertising • Bring in smokers • Entice smokers switch their brands. Chapter 11: Thinking Strategically

  28. $10 million/year for Philip Morris $5 million/year for Philip Morris $10 million/ year for RJR $35 million/ year for RJR $35 million/year for Philip Morris $20 million/year for Philip Morris $5 million/ year for RJR $20 million/ year for RJR Cigarette Advertising as a Prisoner’s Dilemma Philip Morris’s Choice Advertise on TV Don’t advertise on TV Advertise on TV RJR’s Choice Don’t Advertise on TV Chapter 11: Thinking Strategically

  29. The Prisoner’s Dilemma • Economic Naturalist • Why do people stand at concerts, even though they can see just as well when everyone sits? Chapter 11: Thinking Strategically

  30. -$2 for others -$3 for others -$2 for you $1 for you $1 for others $0 for others -$3 for you $0 for you Standing versus Sitting at a Concert as a Prisoner’s Dilemma Other People’s Choice Stand Sit Stand Your Choice Sit Chapter 11: Thinking Strategically

  31. The Prisoner’s Dilemma • Economic Naturalist • Why do people shout at parties? Chapter 11: Thinking Strategically

  32. The Prisoner’s Dilemma • Tit-for-Tat and the Repeated Prisoner’s Dilemma • Cooperation between players will increase the payoff in a prisoner’s dilemma. • There is a motive to enforce cooperation. • One shot game: hard to enforce cooperation, but possible for repeated encounters. Chapter 11: Thinking Strategically

  33. The Prisoner’s Dilemma • Tit-for-tat strategy for repeated games • Tit-for-tat strategy • Players cooperate on the first move, then mimic their partner’s last move on each successive move • Remarkably effective strategy to enforce cooperation in repeated prisoner’s dilemma. Chapter 11: Thinking Strategically

  34. The Prisoner’s Dilemma • Tit-for-tat strategy for repeated games • Tit-for-tat strategy requirements • Two same players – “a stable set” of players • Players recall other player’s moves • Memory is important. • Players have a stake in future outcomes Chapter 11: Thinking Strategically

  35. The Prisoner’s Dilemma • Why is the tit-for-tat strategy unsuccessful in competitive, monopolistically competitive, and oligopolistic markets? • Many firms: more than 2 players • Retaliation by cutting price may hurt cooperative firms • Entry threats for an industry with only 2 firms • Forming a coalition may induce entrance, then the firms would rather just start to cut price now. • It is hard to implement tit-for-tat strategy effectively in a cartel. Chapter 11: Thinking Strategically

  36. RECAP: The Prisoner’s Dilemma • Payoff to each player is smaller when all the players choose their dominant strategies than all choose their dominated strategies. • The prisoner’s dilemma can explain a lot of situations. • The tit-for-tat strategy may support cooperation in repeated prisoner’s dilemma under certain conditions. Chapter 11: Thinking Strategically

  37. Games in Which Timing Matters • The Ultimate Bargaining Game • Should Michael accept Tom’s offer? • Rules of the game • Experimenter gives $100 to Tom • Tom proposes how to divide $100 with Michael • Tom must give Michael X (X = Tom and $100 - X = Michael) • Michael must either accept the proposal or reject it • If he does, Tom and Michael get the money • If he does not, the money goes to the experimenter Chapter 11: Thinking Strategically

  38. Possible Moves and Payoffs $X for Tom $(100 – X) for Michael Michael accepts A B Michael refuses Tom proposes $X for himself, $(100 – X) for Michael $0 for Tom $0 for Michael Decision Tree for Tom Chapter 11: Thinking Strategically

  39. $99 for Tom $1 for Michael Michael accepts A B Michael refuses Tom proposes $99 for himself, $1 for Michael $0 for Tom $0 for Michael Tom’s Best Strategy in an Ultimatum Bargaining Game • Tom can give Michael a take-it-or-leave-it offer • Tom will propose $1 • Michael will accept • The outcome is a Nash Equilibrium Chapter 11: Thinking Strategically

  40. $X for Tom $(100 – X) for Michael Tom proposes $X < $(100 - Y) for himself $(100 - X) > Y for Michael A B Michael announces that he will reject any offer less than $Y Tom proposes $X > $(100 - Y) for himself $(100 - X) < Y for Michael $0 for Tom $0 for Michael The Ultimatum Bargaining Gamewith an Acceptance Threshold New Rule: Michael can specify in advance the minimum offer (Y) he will accept Michael’s best bet Y = 99! Chapter 11: Thinking Strategically

  41. Games in Which Timing Matters • Credible Threats and Promises • Credible Threat • A threat to take an action that is in the threatener’s interest to carry out • Will Michael credibly threaten to refuse the $1 offer from Tom? • Could Warner Brothers credibly threaten to change the singer in the movie? • Could Chevy credibly threaten to offer a hybrid no matter what Dodge did? Chapter 11: Thinking Strategically

  42. Games in Which Timing Matters • Credible threat may be impossible to make so as … • Credible Promise • A promise to take action that is in the promiser’s interest to keep Chapter 11: Thinking Strategically

  43. Decision Tree for the Kidnapper Game Victim is safe, kidnapper executed Victim goes to police C Kidnapper sets victim free Victim remains silent Victim remains in danger, kidnapper survives A B Kidnapper kills victim Victim promises to remain silent Victim dies, kidnapper survives Will the kidnapper release his victim? Chapter 11: Thinking Strategically

  44. Manager manages honestly; owner gets $1,000, manager gets $1,000 C Owner opens remote office Manager manages dishonestly; owner gets -$500, manager gets $1,500 A B Managerial candidate promises to manage honestly Owner does not open remote office Owner gets $0, manager gets $500 by working elsewhere Should a business owner open a remote office? Decision Tree for the Remote Office Game Chapter 11: Thinking Strategically

  45. Games in Which Timing Matters • Commitment Problem • A situation in which people cannot achieve their goals because of an inability to make credible threats or promises Chapter 11: Thinking Strategically

  46. Games in Which Timing Matters • Commitment Device • A way of changing incentives so as to make otherwise empty threats or promises credible • Prisoner’s dilemma – Underworld code of omerta • kidnapping – blackmailable acts by the victim • Remote office • Tips from customers for the waiters • Share of profit in the remote business Chapter 11: Thinking Strategically

  47. Games in Which Timing Matters • RECAP • Decision tree is used for dynamic games • Impossibility of credible threat: undesirable outcomes in games – commitment problem • Commitment devices may help Chapter 11: Thinking Strategically

  48. The Strategic Roleof Preferences • Game theory assumes that the goal of the players is to maximize their outcome. • In most games, players do not attain the best outcomes. • Altering psychological incentives may also improve the outcome of a game. Chapter 11: Thinking Strategically

  49. The Strategic Roleof Preferences • Question • In a moral society, will the business owner open a remote office? Chapter 11: Thinking Strategically

  50. Manager manages honestly; owner gets $1,000, manager gets $1,000 C Owner opens remote office Manager manages dishonestly; owner gets -$500, manager gets -$8,500 A B Managerial candidate promises to manage honestly Owner does not open remote office Owner gets $0, manager gets $500 by working elsewhere The Remote Office Game with an Honest Manager The value of dishonesty to the manager is $10,000 Chapter 11: Thinking Strategically