Académique Documents
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Topics to be Discussed
Gaming and Strategic Decisions
Dominant Strategies
The Nash Equilibrium Revisited
Repeated Games
Chapter 13
Topics to be Discussed
Sequential Games
Bargaining Strategy
Auctions
Chapter 13
Strategic decisions result in payoffs to the players: outcomes that generate rewards or benefits
2005 Pearson Education, Inc. Chapter 13 4
Chapter 13
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
Two competing firms, assuming the others behavior, independently determine pricing and advertising strategy to gain market share Binding contracts are not possible
Chapter 13
Chapter 13
Typically bid more for the dollar when faced with loss as second highest bidder
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Acquiring a Company
Scenario
Company A: The Acquirer Company T: The Target A will offer cash for all of Ts shares
The value and viability of T depends on the outcome of a current oil exploration project
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Acquiring a Company
Project failure: Ts value = $0 Project success: Ts value = $100/share All outcomes in between equally likely Ts value will be 50% greater with As management
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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
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
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14
Dont Advertise
Advertise
10, 5
15, 0
Dont Advertise
6, 8
10, 2
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15
10, 5
15, 0
Dont Advertise
6, 8
10, 2
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10, 5
15, 0
6, 8
10, 2
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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
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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
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Advertise
10, 5
15, 0
Dont Advertise
6, 8
20, 2
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10, 5
15, 0
6, 8
20, 2
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Nash Equilibrium
Im doing the best I can given what you are doing. Youre doing the best you can given what I am doing.
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Crispy
-5, -5
10, 10
Sweet
10, 10
-5, -5
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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?
Crispy
Sweet
-5, -5
10, 10
10, 10
-5, -5
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Beach
200 yards
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.
2005 Pearson Education, Inc. Chapter 13 29
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Maximin Strategy
Firm 2
Dont invest Invest
Dont invest
0, 0
-10, 10
Firm 1
Invest
-100, 0
20, 10
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Maximin Strategy
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
2005 Pearson Education, Inc.
Invest
0, 0
-10, 10
Invest
-100, 0
20, 10
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Maximin Strategy
Observations
If Firm 2 does not invest, Firm 1 incurs significant losses Firm 1 might play dont invest Minimize losses to 10 maximin strategy
Firm 2 Dont invest
Invest
0, 0
-10, 10
Invest
-100, 0
20, 10
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Maximin Strategy
If both are rational and informed
Both firms invest Nash equilibrium
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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 1s strategy depends critically on its assessment of probabilities for Firm 2
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Prisoners Dilemma
Prisoner B
Confess Dont Confess
Confess
-5, -5
-1, -10
Dont Confess
-10, -1
-2, -2
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Prisoners Dilemma
What is the:
Dominant strategy Nash equilibrium Maximin solution
Prisoner B
Confess Dont Confess
Dominant strategies Confess are also maximin strategies Both confess is both Prisoner A Dont Nash equilibrium and Confess maximin solution
-5, -5
-1, -10
-10, -1
-2, -2
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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
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Matching Pennies
Player B Heads Tails
Heads
1, -1
-1, 1
Tails
-1, 1
1, -1
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Matching Pennies
Pure strategy: No Nash equilibrium
No combination of head and tails leaves both players better off
Heads Player A Tails Player B Heads Tails
1, -1
-1, 1
-1, 1
1, -1
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Matching Pennies
Player A might flip coin playing heads with probability and tails with 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
2005 Pearson Education, Inc. Chapter 13 41
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
2005 Pearson Education, Inc. Chapter 13 42
Wrestling
2,1
0,0
Jim
Opera
0,0
1,2
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Mixed Strategy
Jim chooses wrestling Joan chooses wrestling
Wrestling
2,1
0,0
Jim
Opera
0,0
1,2
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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
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Pricing Problem
Firm 2
Low Price High Price
Low Price
10, 10
100, -50
Firm 1
High Price
-50, 100
50, 50
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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 opponents previous play, cooperating with cooperative opponents and retaliating against uncooperative ones
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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
2005 Pearson Education, Inc. Chapter 13 48
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
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Tit-for-Tat Strategy
If firms dont believe their competitors are rational or think perhaps they arent, cooperative behavior is a good strategy Most managers dont know how long they will be competing with their rivals In a repeated game, prisoners dilemma can have cooperative outcome
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Repeated Games
Conclusion
Cooperation is difficult at best since these factors may change in the long run Need a small number of firms Need stable demand and cost conditions
This
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International Badger Meter Neptune Water Meter Company Hersey Products Rockwell has about 35% of market share Badger, Neptune, and Hersey combined have about a 50 to 55% share
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Demand is stable
Demand grows steadily with population
If firms were to cooperate, could earn significant monopoly profits If compete aggressively to gain market share, profits will fall to competitive levels
2005 Pearson Education, Inc. Chapter 13 54
Companies have been playing repeated game for decades Cooperation has prevailed given market characteristics
2005 Pearson Education, Inc. Chapter 13 55
Sequential Games
Players move in turn, responding to each others actions and reactions
Ex: Stackelberg model (ch. 12) Responding to a competitors ad campaign Entry decisions Responding to regulatory policy
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Sequential Games
Going back to the product choice problem
Two new (sweet, crispy) cereals Successful only if each firm produces one cereal Sweet will sell better Both still profitable with only one producer
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Crispy
-5, -5
10, 20
Sweet
20, 10
-5, -5
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Allows one to work backward from the best outcome for Firm 1
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Sweet
Crispy
10, 20
20, 10
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Sequential Games
The Advantage of Moving First
In this product-choice game, there is a clear advantage to moving first The first firm can choose a large level of output, thereby forcing second firm to choose a small level Can show the firms mover advantage by revising the Stackelberg model and comparing to Cournot
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1 112.50
2 56.25
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Choosing Output
Firm 2 7.5 10
93.75, 125
15
56.25, 112.50
100, 100
50, 75
15 112.50, 56.25
75, 50
0, 0
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Choosing Output
This payoff matrix illustrates various outcomes
Firm 2 7.5 10 15
Move together, both produce 10 If Firm 1 moves first (Q=15), best Firm 2 can do is 7.5
93.75, 125
56.25, 112.50
Firm 1
10
125, 93.75
100, 100
50, 75
15 112.50, 56.25
75, 50
0, 0
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entry Induce competitors to reduce output, leave, raise price Implicit agreements that benefit one firm
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in expensive advertising campaign Buy large order of sugar and send invoice to Firm 2
Commitment must be enough to induce Firm 2 to make the decision Firm 1 wants it to make
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High Price
100, 80
80, 100
Firm 1
Low Price
20, 0
10, 20
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Small engines
3, 6
3, 0
1, 1
8, 3
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Small engines
0, 6
0, 0
1, 1
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8, 3
76
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Role of Reputation
If Far Out gets the reputation of being irrational
They threaten to produce large engines no matter what Race Car does
Threat might be credible because irrational people dont always make profit maximizing decisions A party thought to be crazy can lead to a significant advantage
2005 Pearson Education, Inc. Chapter 13 78
Bargaining Strategy
Bargaining situation can depend on ability to affect relative bargaining position Consider two firms introducing one of two complementary goods:
Firm 1 has cost advantage in Good A Firm 2 has cost advantage in Good B
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Bargaining Strategy
Firm 2
Produce A Produce B
Produce A
40, 5
50, 50
Firm 1
Produce B
60, 40
Chapter 13
5, 45
80
Bargaining Strategy
With collusion:
Firm 1 Produces A and Firm 2 produces B (50,50)
Firm 2
Produce A Produce B
Without collusion:
Produce A
Firm 1 produces A and Firm 2 produces Firm 1 B (50,50) Produce B Nash equilibrium
40, 5
50, 50
60, 40
5, 45
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Bargaining Strategy
Suppose each firm is also bargaining on the decision to join in a research consortium with a third firm Dominant strategy is for both firms to enter consortium
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Bargaining Strategy
Firm 2
Work alone Enter consortium
Work alone
10, 10
10, 20
Firm 1
Enter consortium
20, 10
Chapter 13
40, 40
83
Bargaining Strategy
Linking the Bargaining Problem
Firm 1 announces it will join the consortium only if Firm 2 agrees to produce A and Firm 1 will produce B Firm 2s best interest is to produce A with Firm 1 producing B
Firm
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Bargaining Strategy
Strategic moves can be used in bargaining Combining issues in bargaining can benefit one side at others expense
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Enter
-10, -10
20, 0
Wal-Mart
Dont enter
0, 20
0, 0
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-10, -10 0, 20
20, 0 0, 0
Wal-Mart
Dont enter
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Entry Deterrence
Barriers to entry important for monopoly power
Economies of scale, patents and licenses, access to critical inputs Firms can also deter entry
To deter entry, the incumbent firm must convince any potential competitor that entry will be unprofitable
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Entry Possibilities
Potential Entrant (X) ($80 fixed costs)
Enter Stay out
High price
(accommodation)
100, 20
200, 0
Incumbent (I)
Low Price
(warfare)
70, -10
Chapter 13
130, 0
90
Entry Deterrence
Scenario
If X does not enter, I makes a profit of $200 million If X enters and charges a high price, I earns a profit of $100 million and X earns $20 million If X enters and charges a low price, I earns a profit of $70 million and X earns $-10 million
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Entry Deterrence
Could threaten X with warfare if enters market
Not credible because once X has entered, it is in your best interest to accommodate and maintain high price
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Entry Deterrence
What if firm I makes an investment before entry to increase capacity?
Irrevocable commitment
Gives new payoff matrix since profits will be reduced by investment Threat is completely credible Rational for Firm X to stay out of market
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Entry Deterrence
Potential Entrant (X)
Enter Stay out
High price
(accommodation)
50, 20
150, 0
Incumbent (I)
Low price
(warfare)
70, -10
130, 0
Chapter 13
94
Entry Deterrence
If incumbent has reputation of price cutting competitors even at loss, then threat will be credible Short run losses may be offset by long run gains as monopolist
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Entry Deterrence
Production of commercial airlines exhibit significant economies of scale Airbus and Boeing considering new aircraft Suppose it is not economical for both firms to produce the new aircraft
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Produce
-10, -10
100, 0
Boeing
Dont produce
0, 120
0, 0
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Airbus
Produce Dont produce
-10, -10
100, 0
0, 120
0, 0
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Produce
-10, 10
100, 0
Boeing
Dont produce
0, 120
0, 0
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100
Airbus
Produce Dont produce
-10, 10
100, 0
Boeing
Dont produce
0, 120
0, 0
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Diaper Wars
Even though there are only two major firms, competition is intense The competition occurs mostly in the form of cost-reducing innovation Small cost savings can lead to capturing of market share Both firms spend significantly on R&D
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R&D
40, 20
80, -20
P&G
No R&D
-20, 60
Chapter 13
60, 40
103
Kimberly-Clark
R&D No R&D
R&D
40, 20
80, -20
P&G
No R&D
-20, 60
60, 40
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Auctions
Markets in which products are bought and sold through formal bidding processes
Encourages competition that increases sellers revenue Low cost of transactions Useful for unique items or those with fluctuating value
Tokyo
fish market
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Auction Formats
1. Traditional English (oral)
Seller actively solicits progressively higher bids from a group of potential buyers Buyers are always aware of highest bid Stops when no one passes highest bid
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Auction Formats
2. Dutch auction
Seller begins by offering item at relatively high price, then reduces it by fixed amounts until item is sold First buyer accepting offered price can buy item at that price
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Auction Formats
3. Sealed-bid
All bids are made simultaneously in sealed envelopes, where winning bid is the one who submitted highest bid A. First price
Sales price equals highest bid Sales price equals second highest bid
B. Second price
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Signed baseball
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Price-Value Auctions
Each bidder must choose bidding strategy Payoff for winning is reservation price minus price paid Payoff for losing is zero
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Sealed-bid auction
Winning bid approximately equal to the second highest bidders reservation price
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Internet Auctions
Popularity of auctions has skyrocketed with growth of internet Most popular site is eBay
Dominates online person-person auction industry
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Internet Auctions
eBay auctions are somewhat different from types discussed A few caveats:
No quality control function Poor seller feedback Bid manipulation may occur
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