MBA201a: Strategic Thinking

Overview –Context: You’re in an industry with a small number of competitors. You’re concerned that if you cut your price, your competitors will, too. How do you act? –The same reasoning applies for pretty much any strategic decision: Capacity expansion, Entry and exit, Product positioning, Advertising expenditures, etc. Professor Wolfram Page 1MBA201a - Fall 2009

Short digression on the term “strategy” Strategy includes: –Organizational structure and processes needed to implement the firm’s plan. –Boundaries of the firm: scale, scope, extent of outsourcing. –Formal analysis of interactions between competitors: game theory. Professor WolframMBA201a - Fall 2009 Page 2

We will apply the tools of game theory Informally, game theory reminds us to: –Understand our competitors. Our results depend not only on our own decisions but on our competitors’ decisions as well. –Look into the future. Decisions taken today may have an impact in future decisions, both by ourselves and by our competitors. –Pay attention to information. Who knows what can make a difference. –Look for win-win opportunities. Some situations are competitive, but others offer benefits to all. Professor Wolfram Page 3MBA201a - Fall 2009

The E.T. “chocolate wars” In the movie E.T. a trail of Reese's Pieces, one of Hershey's chocolate brands, is used to lure the little alien into the house. As a result of the publicity created by this scene, sales of Reese's Pieces tripled, allowing Hershey to catch up with rival Mars. Professor Wolfram Page 4MBA201a - Fall 2009

Chocolate wars…the details –Universal Studio's original plan was to use a trail of Mars’ M&Ms and charge Mars $1mm for the product placement. –However, Mars turned down the offer, presumably because it thought $1mm was high. –The producers of E.T. then turned to Hershey, who accepted the deal, which turned out to be very favorable to them (and unfavorable to Mars). Professor Wolfram Page 5MBA201a - Fall 2009

Formal analysis of the chocolate wars Suppose: –Publicity from the product placement would have increased Mars’ profits by $800,000. –Hershey's increase in market share cost Mars $500,000. –Benefit to Hershey from having its brand featured is given by b. –Hershey knows the value of b. Mars knows only that b=$1,200,000 or b=$700,000 with equal probability. Professor Wolfram Page 6MBA201a - Fall 2009

Mars 1: decision approach [-200] buy not buy M [0] Professor Wolfram Page 7MBA201a - Fall 2009

Mars 2: naïve game theory [-200, 0] buy not buy M [-500, -50] [0, 0] not buy buy H 0 Professor Wolfram Page 8MBA201a - Fall 2009 Payoff to Mars Payoff to Hershey Payoff to Hershey =.5x(1.2M-1M) +.5(.7M-1M)

Mars 3: real game theory [-500, 200] [0, 0] [-500, -300] [0, 0] [-200, 0] buy not buy b = 1200 (50%) not buy buy not buy buy M N H H b = 700 (50%) Professor Wolfram Page 9MBA201a - Fall 2009

Mars: summary –Think about your competitor: Mars should think about Hershey, and vice versa. –Timing matters: Hershey had the last move. –Information matters: Hershey has more information than Mars, and in this example it made a difference. –Key business insight: part of the benefit to Mars was to keep the opportunity from Hershey. Professor Wolfram Page 10MBA201a - Fall 2009

Game theory: concepts –What are the elements of a game? Players (in previous example: Mars and Hershey) Rules (sequentially respond to Universal’s offer) Strategies (Yes or No) Payoffs (sales minus payment to Universal) –What can I do with it? Determine how good each of my strategies is Figure out what my rival is probably going to do Professor Wolfram Page 11MBA201a - Fall 2009

Normal-form games –A convenient way to represent games with two players who make simultaneous choices. –Imagine the Beauty Contest game with two players, and assume players can only choose 0 or 1. Player P/2P 0 0 P Player 1 Professor Wolfram Page 12MBA201a - Fall 2009 Player 2’s payoff if player 1 chooses 0. Player 1’s payoff if player 2 chooses 1.

Dominant/dominated strategies –Dominant strategy: payoff is greater than any other strategy regardless of rival’s choice. Rule 1: if there is one, choose it. –Dominated strategy: payoff is lower than some other strategy regardless of rival’s choice. Rule 2: do not choose dominated strategies. Professor Wolfram Page 13MBA201a - Fall 2009

Outcomes of games –Sometimes a game can be “solved” just by looking at dominant and dominated strategies (e.g., example above). –However, there are many games for which this isn’t enough to produce an outcome. –Nash equilibrium: Combination of moves in which no player would want to change her strategy unilaterally. Each chooses its best strategy given what the others are doing. Professor Wolfram Page 14MBA201a - Fall 2009

Prisoner’s dilemma Iraq’s Output Iran’s Output Example: output setting (million barrels a day) by OPEC members Professor Wolfram Page 15MBA201a - Fall 2009

Prisoner’s dilemma… –Dominant strategies: high output. –Equilibrium payoffs are (32,24), much worse than would be attained by low output, (46,42). –Conflict between individual incentives and joint incentives. –Typical of many business situations. –Are cartels inherently unstable? Professor Wolfram Page 16MBA201a - Fall 2009

Auctions –Remember we said that games involved players, rules and payoffs? –In auctions, the rules of the game, and how players’ choices affect their payoffs, are very well-defined. –Auctions have become relevant in a number of business contexts. Professor Wolfram Page 17MBA201a - Fall 2009

Common auction mechanisms –English auction (a.k.a. oral ascending auction). Price is successively raised until only one bidder remains. Antiques, Artwork, Wine Used cars –Sealed-bid first-price auction (or simply first-price auction). Highest/lowest bid is selected and pays/receives that value. Mineral rights Building contracts Professor Wolfram Page 18MBA201a - Fall 2009

More auction mechanisms –Dutch auction (a.k.a. oral descending auction). Price is successively decreased until one bidder calls. Flowers, tobacco, fish Privatizations –Second price auction (a.k.a. Vickrey auction). Just like first price auction, but: winner pays price equal to second highest bid. eBay Stamps and other collectibles Radio spectrum rights in New Zealand Professor WolframMBA201a - Fall 2009 Page 19

Bidding strategies vary by auction type –Optimal bidding strategy in second-price auction is to bid own value. –Optimal bidding strategy in English auction is to continue bidding up to own valuation. –What about in a Dutch or sealed-bid auction? –… beware the Winner’s Curse. Professor WolframMBA201a - Fall 2009 Page 20

Winner’s Curse example –Example: bids for oil-track auction –True, common, value of object is X. –Each bidder i estimates that value is X + e i. –Average e i is zero: bidders’ estimates are unbiased. –Suppose each bidder bids his or her valuation minus some margin m i. –Winning bid will correspond to highest e i, i.e., winner will be the most “optimistic” bidder. –If m i is not sufficiently large, i.e., if m i < e i, then winner will lose money (bids more than true value). Professor Wolfram Page 21MBA201a - Fall 2009

The Winner’s Curse graphically Xs 1 = X + e 1 s 2 = X + e 2 b1b1 b2b2 value X = true value s i = signal received by bidder i b i = bidder i’s bid Winner’s Curse: Bidder 1 (winner), while bidding less than his/her value assessment ends up losing money. Should take this effect into account and bid even lower relative to signal. Professor Wolfram Page 22MBA201a - Fall 2009

Comparing auction mechanisms –If valuations are independent and bidders are similar and risk neutral, then all of the above auction mechanisms induce the same average seller revenue. –If valuations are correlated (extreme: common value), then the English auction implies higher average revenue than the sealed-bid auction. –Collusion among bidders easier with English auction. –Transactions costs vary across auctions. Professor Wolfram Page 23MBA201a - Fall 2009

Takeaways –Game theory is a formal approach to strategy. –Highlights impact of strategic interactions among firms or other “players.” –Forces you to consider your competitors’ choices. –Auctions lend themselves well to game-theoretic analysis. –Concepts: players, strategies, dominant and dominated strategies, best responses, Nash equilibrium. –Stay tuned for another example on Thursday… Professor Wolfram Page 24MBA201a - Fall 2009