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Thinking Strategically

Thinking Strategically. 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. The Theory of Games. Basic Elements of a Game The players Their strategies The payoffs.

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Thinking Strategically

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  1. Thinking Strategically

  2. 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. Chapter 10: Thinking Strategically

  3. The Theory of Games • Basic Elements of a Game • The players • Their strategies • The payoffs Chapter 10: Thinking Strategically

  4. The Theory of Games • Example • Should United Airlines spend more on advertising? Chapter 10: Thinking Strategically

  5. 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 10: Thinking Strategically

  6. The Theory of Games • Dominant Strategy • One that yields a higher payoff no matter what the other players in a game choose Chapter 10: Thinking Strategically

  7. The Theory of Games • Dominated Strategy • Any other strategy available to a player who has a dominant strategy Chapter 10: Thinking Strategically

  8. 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 Chapter 10: Thinking Strategically

  9. The Theory of Games • Nash Equilibrium • When each player has a dominant strategy, equilibrium occurs when each player follows that strategy Chapter 10: Thinking Strategically

  10. The Theory of Games • Nash Equilibrium • There can be an equilibrium when players do not have a dominant strategy Chapter 10: Thinking Strategically

  11. The Theory of Games • Example • Should United Airlines spend more on advertising? Chapter 10: 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 Leave ad spending the same Raise ad spending Raise ad spending United’s Choice Leave ad spending the same Chapter 10: 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 10: Thinking Strategically

  14. 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 Chapter 10: Thinking Strategically

  15. The Prisoner’s Dilemma • Example • Should the prisoners confess? Chapter 10: Thinking Strategically

  16. Jasper gets 5 years Jasper gets 20 years Horace gets 5 years Horace gets 0 years Jasper gets 0 years Jasper gets 1 years Horace gets 20 years Horace gets 1 years The Payoff Matrix for a Prisoner’s Dilemma Jasper’s Choice Remain silent Confess Confess Horace’s Choice Remain silent Chapter 10: Thinking Strategically

  17. The Prisoner’s Dilemma • Exercise • Which of these games is a prisoner’s dilemma? Chapter 10: Thinking Strategically

  18. 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 10: Thinking Strategically

  19. 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 10: Thinking Strategically

  20. 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 Chapter 10: Thinking Strategically

  21. The Prisoner’s Dilemma • Economic Naturalist • Why are cartel agreements notoriously unstable? Chapter 10: Thinking Strategically

  22. 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 output and profits Price $/bottle) Bottles/day Chapter 10: Thinking Strategically

  23. Aquapure lowers P • P = $.90/bottle • Q = 1,100 bottles/day 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 10: Thinking Strategically

  24. $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 Mountain Spring’s Choice Charge $1 Charge $0.90 Charge $1 Aquapure’s Choice Charge $0.90 Chapter 10: Thinking Strategically

  25. The Prisoner’s Dilemma • Economic Naturalist • When will the rival firms stop cutting prices? Chapter 10: Thinking Strategically

  26. The Prisoner’s Dilemma • Economic Naturalist • How did Congress unwittingly solve the television advertising dilemma confronting cigarette producers? Chapter 10: Thinking Strategically

  27. $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 10: Thinking Strategically

  28. The Prisoner’s Dilemma • Economic Naturalist • Why do people stand at concerts, even though they can see just as well when everyone sits? Chapter 10: Thinking Strategically

  29. -$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 10: Thinking Strategically

  30. The Prisoner’s Dilemma • Economic Naturalist • Why do people shout at parties? Chapter 10: Thinking Strategically

  31. 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. Chapter 10: Thinking Strategically

  32. 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 Chapter 10: Thinking Strategically

  33. The Prisoner’s Dilemma • Tit-for-tat strategy for repeated games • Tit-for-tat strategy requirements • Two players • A stable set of players • Players recall other player’s moves • Players have a stake in future outcomes Chapter 10: Thinking Strategically

  34. The Prisoner’s Dilemma • Question • Why is the tit-for-tat strategy unsuccessful in competitive, monopolistically competitive, and oligopolistic markets? Chapter 10: Thinking Strategically

  35. 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 at least $1 (X = Tom and $100 - X = Michael) • Michael must accept the proposal • If he does, Tom and Michael get the money • If he does not, the money goes to the experimenter Chapter 10: Thinking Strategically

  36. 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 10: Thinking Strategically

  37. $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 10: Thinking Strategically

  38. $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 he will accept Chapter 10: Thinking Strategically

  39. 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 Chapter 10: Thinking Strategically

  40. Games in Which Timing Matters • Example • Is it safe to steal Veronica’s briefcase? • Hint.... • What are the costs and benefits of filing charges in the theft of a briefcase? Chapter 10: Thinking Strategically

  41. Games in Which Timing Matters • Credible Promise • A promise to take action that is in the promiser’s interest to keep Chapter 10: Thinking Strategically

  42. 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 10: Thinking Strategically

  43. 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? Is the outcome an equilibrium? Decision Tree for the Remote Office Game Chapter 10: Thinking Strategically

  44. 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 10: Thinking Strategically

  45. Games in Which Timing Matters • Commitment Device • A way of changing incentives so as to make otherwise empty threats or promises credible Chapter 10: Thinking Strategically

  46. Games in Which Timing Matters • Commitment Problems • Prisoner’s dilemma • Cartels • Kidnapper • Remote office Chapter 10: Thinking Strategically

  47. Games in Which Timing Matters • Commitment Devices • Underworld code, omerta • Military arms control agreements • Tips for waiters Chapter 10: Thinking Strategically

  48. Games in Which Timing Matters • What do you think? • How could the kidnap victim create a commitment device to remain silent? Chapter 10: Thinking Strategically

  49. Games in Which Timing Matters • What do you think? • Will Sylvester leave a tip when dining on the road? Chapter 10: Thinking Strategically

  50. 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 10: Thinking Strategically

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