Strategic Corporate Management 45-870

1. Strategic Corporate Management45-870 Professor Robert A. Miller Fourth Mini 2014 Teaching assistant: John Gardner: jrgardne@andrew.cmu.edu

2. 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.

3. 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.

4. 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

5. Lecture 1Introduction to Strategy:Best Responses We begin this course by laying out the four basic questions of every strategic situation. Then we define the extensive form, and explain: what we mean by the empirical distribution of moves, what is a best response (to that distribution for example), and the concept of dominance.

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. The Ware case 10 years ago Ware received a patent for Dentosite that has since captured 60 percent share in the market. National had been the largest supplier of material for dental prosthetics before Dentosite was introduced. A new material FR 8420 was recently developed by NASA. If Ware develops a new composite with FR 8420 it will be a perfect substitute for Dentosite. If the technique is feasible then Ware would have just as good a chance as National of proving it first. If Ware develops it first they could extend the patent protection to this technique and prevent any competitors.

21. Strategic considerations Ware’s problem is bound to National’s. Ware does not want to develop a technology that would not be used if the competitor does not develop it. If National develops the technology Ware cannot afford to drop out of the race. It all depends how people at National see this situation. Are Ware and National equally as well informed?

22. Some facts

23. Ware case in the extensive form Using the facts we can present the case in the following diagram:

24. Simplifying the extensive form Folding back the moves of chance that are related to developing a new technology we obtain the following simplification.

25. What should National do? • National is indifferent between the two choices if the expected profits are equal. • If Ware chooses “in” with probability p, the value to National from choosing “out” is 0, and the expected profits to National from choosing “in” are: -0.401*p + 1.106*(1 – p) • Solving for p we obtain: -0.401*p + 1.106*(1 – p) = 0 => p = 0.734 • Thus if Ware enters with a higher probability than 0.734, then National should stay out, but if Ware enters with a lower probability than 0.734, National should enter itself.

26. What should Ware do? • If National chooses “in” with probability q, then the expected value to Ware from choosing “in” is: -2.462*q - 0.955*(1 – q) • Also the expected value to Ware from choosing “out” is: -3.015*q • Solving for q we obtain: 2.462*q + 0.955*(1 – q) = 3.015*q => q = .633 • Thus if National enters with probability higher than 0.633, then Ware should enter too, but if National enters with probability lower than 0.633, then Ware should stay out.

27. Rule 1 Play a best response to the empirical distribution as best you understand it.

28. How much do you need to know about the other players? • In the cola war, if Coke never acquiesces to Pepsi, then the best response of Pepsi is to enter Canada, but if Coke only responds in kind in Canada, then Pepsi should enter the African American market. • Similarly in the Ware case, the best response of each firm depended upon the probability that the other firm would seek to develop the patent. • Under what conditions does your best response depend on the choices of the other players?

29. Simultaneous move games In many situations, you must decide all your moves without knowing what your rivals are doing, and their situations are similar to yours. Even if the moves are not literally taking place at the same moment, but all the moves must be made before anybody can react, the moves are effectively simultaneous. A game where no player can make a choice that depends on the moves of the other players is called a simultaneous move game. The Ware case is an example of a simultaneous move game.

30. Acquiring Federated Department Stores • Robert Campeau and Macy's are competing for control of Federated Department Stores in 1988. • If both offers fail, then the market price will be benchmarked at 100. If one succeeds, then any shares not tendered to the winner will be bought from the current owner for 90. • The argument here is that losing minority shareholders will get burned by the new majority shareholders.

31. Campeau’s offer . . . Campeau made an unconditional two tier offer. The price paid per share would depend on what fraction of the company Campeau was offered. If Campeau got less than half, it would pay 105 per share. If it got more than half, it would pay 105 on the first half of the company, and 90 on any remaining shares. Each share tendered would receive a blend of these two prices so that every share received the average price paid. If a percentage x > 50 of the company is tendered, then 50/x of them get 105, and (1 - 50/x) of them get 90 for a blended price of: 105* 50/x + 90(1 - 50/x) = 90 + 15(50/x).

32. Macy’s offer . . . Macy's offer was conditional at a price of 102 per share: it offered to pay 102 for each share tendered, but only if at least 50% of the shares were tendered to it. Note that if everyone tenders to Macy's, they receive 102 per share, while if everyone tenders to Campeau, they receive 97.50. so, shareholders are collectively better off tendering to Macy's than to Campeau.

33. The game between shareholders After the offers are made, Federated shareholders play an acceptance/rejection game. Each shareholder asks what proportion of their shares should be: sold to Macy’s sold to Campeau’s retained. Note the payoffs received by each shareholder depend on what the other shareholders do.

34. The payoff matrix to a stockholder Shareholders are better off as a group tendering to Macy’s, but each individual shareholder is better off tendering to Campeau, regardless of what the other players do.

35. Dominant strategies Strategies that are optimal for a player regardless of whether the other players play rationally or not are called dominant. If a dominant strategy is unique, it is called strictly dominant. Although a player's payoff might depend on the choices of the other players, when a dominant strategy exists, the player has no reason to introspect about the objectives of the other players in order to make his own decision. He should simply play the dominant strategy.

36. Rule 2 A dominant response is always a best response to the empirical distribution. Therefore if you have a dominant response, you should play it.

37. Summary • The extensive form summarizes the four dimensions of every strategic situation (players, actions, information and consequences). • 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. • Also in some but not all games the best response is independent of the empirical distribution. • When this occurs a player has a dominant strategy.