When Other Firms React CHAPTER 8 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Strategy as Game Theory Defines strategic behavior as the interdependence of actions What one does affects and is affected by what others do Help managers to understand that The world of business is one of interdependence Strategic decisions cannot be made in isolation © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Strategy as Game Theory Interaction of the firms Players Decision-makers in the firms Strategies Planned decisions of the players © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Strategy as Game Theory Payoffs to the players Profits or losses that result from strategies Payoff to one player Depends on His strategy Strategies employed by other players Interdependence © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

One-Period Games Simultaneous-move game Sequential-move game Each player makes decisions without knowledge of the other players’ decisions Rock-paper-scissors Sequential-move game One player makes a move after observing the other player’s move Chess, checkers © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

One-Period Games One-period game Repeated game Interaction that occurs just once Repeated game Interactions that are repeated a number of times Normal form representation of a game Players in the game Possible strategies of the players Payoffs to the players © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Table 8.1 Magazine Cover Selections The payoffs for selecting one of two stories, S or GW, for each player are shown. Time’s payoffs are shown first and Newsweek’s second in each cell. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

One-Period Games Simultaneous-move, one-shot game Dominant strategy The players get to make one, and only one, decision Must make their decision at the same time Cannot make conditional decisions Dominant strategy Optimal decision It results in the highest payoff regardless of the action of the opponent © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Nash Equilibrium Nash equilibrium Set of strategies If, given the strategies of the other players, no player can improve his payoff by unilaterally changing his own strategy Every player is doing the best he or she can given what other players are doing © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The Prisoner’s Dilemma Situations in which interaction can cause the players to select an inferior strategy Cigarette advertising Dominant strategy: advertise Even if both firms have lower profits Price war Dominant strategy: low price Even if both firms earn zero profits © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Table 8.2 Prisoner’s Dilemma The options available to each firm are to advertise or not advertise. In this case, both firms advertise even though both would be better off not advertising. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Table 8.3 Pricing Strategies Each firm is better off charging a low price if the other chooses a high price. The dilemma is that they each select the low price which is the worst outcome. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Standards: Cooperation Game Two Nash equilibria The firms do the same thing Both use HD or both use Blue-Ray No collusion Lobby the government to create a standard © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Table 8.4 The Cooperation Game The two players are better off agreeing to a standard or a similar technology. Without that, the solution is the possibility of selecting a result that is not a Nash equilibrium. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Repeated Games Repeated games Players receive payoffs during each repetition of the game Firms may “collude” without fear of being cheated on Automatic penalties, trigger strategies Strategies that are contingent on the past plays of players in a game © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Repeated Games Trigger strategy Collusion A player continues to choose the same action Until some other player takes an action that “triggers” a different action by the first player Collusion Two or more firms agree to fix prices or otherwise reduce competition Punishment - used to support collusion and prevent cheating © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Repeated Games Tit-for-tat strategy Participants cooperate in the first period And from then on mimic the rival’s action from the previous period It never initiates cheating It never lets cheating go unpunished Problem: the slightest possibility of misperception can result in a complete breakdown © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Repeated Games Scorched-earth policy Commitment A strategic move is designed to alter the beliefs and actions of others In a direction favorable to yourself The move purposefully limits your freedom of action © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Credible Threats Collusion Easier when few firms are involved Many firms – many monitors May fail if the monitoring threat used is not credible Single enforcer - one player who is able to essentially monitor everyone Make the credible threat that if cheating occurs, penalties will be severe © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Business Insight Game Theory and Weight Loss Game that would effectively induce people to lose weight One team: positive reinforcement to lose weight The other team: they would have their plump forms broadcast on a Jumbotron at a major league baseball game if they didn’t lose 15 pounds in two months © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Business Insight Game Theory and Weight Loss Credible threat The risk of humiliation - more of an incentive to lose weight than long-term worries about health Results Threat – worked for all but two people Positive reinforcement - worked better than the credible threat All members met the target weight loss © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Brand Name & Other Sunk Cost Investments Firm – continued business It does not pay to cheat customers If the one-time gain is more than offset by lost future sales Satisfaction guaranteed Back up the quality promises Expenditures To back up quality promises - change the game from one of a one-period game to an infinitely repeated game © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Sequential Games Sequential Games Players make decisions in sequence Extensive form Circles - decision nodes At that stage of the game the particular player must choose a strategy Beginning of the game – single point Payoffs at the end of the game Each player’s payoff depends on Own action and actions of the other player © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Figure 8.1 Extensive Form When one player makes a decision before the other has to make a decision, the game is called a sequential game. The circles with letters are decision nodes, indicating who has to make a decision. The lines show the possible decisions. The payoffs are indicated at the end of the lines. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Converting Simultaneous to Sequential Simultaneous game Each firm – two strategies Four possible outcomes Equilibrium of the game Intel’ s dominant strategy: low effort AMD’s dominant strategy: high advertising © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Table 8.5 A Simultaneous Game The payoffs to the game when the players must move at the same time © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Converting Simultaneous to Sequential Sequential game Intel preempts – announces high advertising Equilibrium Intel – high advertising AMD – low © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Table 8.6 Sequential Game © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Converting Simultaneous to Sequential Transform a simultaneous game into a sequential one Commitment to an action or a response rule Payoffs – unchanged Dramatically different outcomes © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The Ultimatum Game Credible threat Ultimatum game Credible ultimatum In bargaining situations – people have in mind a division that is “fair” to them If the share they are offered is not fair - they reject the offer Even though they end up with zero © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Risk Decision in the face of uncertainty Knowledge of the relative likelihood of the alternative possible outcomes List all the possible outcomes that could follow a decision Assign probabilities to them Calculate the expected value of the outcome © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Figure 8.2 The Sequential Game with Certainty Go to the end and reason backward, outlining the branches that define the best path. These are known with certainty. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Risk Risk-adverse Risk premium People who prefer the sure thing over the bet when the expected return is the same Risk premium Measure of how cautious you are toward this particular gamble Difference between the expected return of the gamble And the amount of money that, if received for sure, the individual regards as equivalent to the gamble © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.