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1 Strategic Thinking
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2 Medium-sized commercial jets Why do manufacturers intensively publicize order book (especially for models under development)? Should Embraer enter?
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Businesses with market power can influence buying/selling conditions; need to consider interactions with suppliers/buyers/competitors/cooperators use the framework for strategic thinking Business applications competitive business strategy Pricing corporate finance – takeover bidding and defense industrial relations -- strike 3
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4 Strategic situations Parties actively consider the interactions with one another in making decisions. Game theory – set of ideas and principles to guide strategic thinking simultaneous actions – strategic form sequential actions – extensive form
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5 Learning objectives Appreciate strategic situations. Apply game in strategic form to situations with simultaneous moves. Appreciate the use of randomization in competitive situations. Distinguish zero-sum and non-zero sum games. Apply game in extensive form to situations with sequential moves. Plan strategic moves and conditional strategic moves, both threats and promises. Appreciate strategy in repeated situations.
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6 Outline Nash equilibrium Randomized strategies Coordination / competition Sequencing Strategic move Conditional strategic move Repetition
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Gasoline stations Saturn Maintain priceCut price Jupiter Maintain price J: 1000, S: 1000 J: 700, S: 1300 Cut price J: 1300, S: 700 J: 800, S: 800 What should Saturn do? 7
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8 Nash equilibrium: Dominated strategy Dominated strategy: Generates worse consequences than another strategy, regardless of the choices of the other parties Should never use dominated strategy
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9 Nash equilibrium Given that the other players choose their Nash equilibrium strategies, each party prefers its own Nash equilibrium strategy No one should deviate unilaterally from a Nash equilibrium
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10 Nash equilibrium: Solution Conventional method: eliminate dominated strategies, then check remaining cells “arrow” method
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11 Nash equilibrium: Competitive dilemma Saturn Maintain priceCut price Jupiter Maintain price J: 1000, S: 1000 J: 700, S: 1300 Cut price J: 1300, S: 700 J: 800, S: 800 What should Saturn do?
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Nash equilibrium: for both parties, “maintain price” is dominated by “cut price”. but cutting price is bad for both -- if only they could agree somehow to maintain price. Similar situation – supermarkets competing by cutting prices 12 Nash equilibrium: Competitive dilemma
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13 Embraer EnterDo not enter COMAC Enter C: ‒ 1, E: ‒ 2 C: 2, E: 0 Do not enter C: 0, E: 1 C: 0, E: 0
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Two Nash equilibria: COMAC “enter” and Embraer “do not enter” COMAC “do not enter” and Embraer “enter” 14
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15 Out of Nash Equilibrium Nash equilibrium is just one way to play in a strategic situation What if another player doesn’t play Nash equilibrium strategy? Still don’t use dominated strategy Nash equilibrium strategy may not be best
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16 Outline Nash equilibrium Randomized strategies Coordination / competition Sequencing Strategic move Conditional strategic move Repetition
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17 Randomized strategies: Supermarket competition Two competing retailers – Jaya and Ming Three segments captive (loyal) to Ming captive (loyal) to Jaya switchers
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Randomized strategies: Retail price competition Ming High priceLow price Jaya High priceJ: 60, M: 40 J: 40, M: 50 Low priceJ: 50, M: 40 J: 50, M: 30 18
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If competitor sets high price, then I can set lower price and grab business from competitor Pricing trade-off: high price to extract buyer surplus of loyal customers low price to get store switchers Note: situation is asymmetric – Jaya has larger loyal customer base 19 Randomized strategies: Supermarket competition
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20 Randomized strategies: Supermarket competition No Nash equilibrium in pure strategies problem of infinite regress -- my best strategy depends on competitors, her best depends on mine, etc. Solution: randomized discounts Randomized strategies only work if they are random -- must be unpredictable
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21 Outline Nash equilibrium Randomized strategies Coordination / competition Sequencing Strategic move Conditional strategic move Repetition
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Prime time for news is 8:0pm; second best is 7:30pm; since audience is limited, get maximum viewership if two channels schedule at different times. Question: which station gets 8:0pm? Situation has elements of coordination -- avoiding same time slot competition -- getting the 8:0pm 22 Coordination/competition: Evening news
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Channel Z 7.30pm8.00pm TV Delta 7.30pm D: 1, Z: 1 D: 3, Z: 4 8.00pm D: 4, Z: 3 D: 2.5, Z: 2.5 23
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24 Coordination/competition: Zero/positive sum Zero-sum games (pure competition): one party better off only if other is worse off Positive-sum games (coordination): both can be better off or both worse off Co-opetition: strategic situation that involves elements of both competition and coordination Both stations will be better off if they schedule at different times But one station will benefit relatively more
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25 Outline Nash equilibrium Randomized strategies Coordination / competition Sequencing Strategic move Conditional strategic move Repetition
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26 Sequencing Game in extensive form – depicts the sequence of moves and corresponding outcomes: Nodes: a node represents a point at which a party must make a choice. Branches: the branches leading from a node represent the possible choices at the node. Outcomes
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Sequencing: TV news 27
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28 Sequencing: Extensive form – equilibrium Backward induction The procedure of looking forward to the final nodes and then reasoning backward toward the initial node Equilibrium strategy: consists of a sequence of best actions, with each action decided at the corresponding node
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COMAC vs Embraer 29
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30 Sequencing: First/second mover advantage Advantage doesn’t always go to first mover In war, better to see opponent’s move, and then take action, eg, is enemy moving south or north? New product category – let competitor test the market and educate the customers
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Uncertain consequences One party may be uncertain about the consequence of the actions of the other party. 31 Sequencing: Uncertainty
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32 Sequencing: Uncertainty
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TV Z can calculate expected profit from 7:30pm and 8:00pm if choose 7:30pm, expected profit = [1/3 x 1] + [2/3 x 3] = 2.33 if choose 8:00pm, expected profit = [1/2 x 4] + [1/2 x 2.5] = 3.25 33 Sequencing: Uncertainty
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34 Outline Nash equilibrium Randomized strategies Coordination / competition Sequencing Strategic move Conditional strategic move Repetition
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35 Strategic move Definition: Action to influence beliefs or actions of other parties in a favorable way Action must be credible Commitment Contractual Physical Reputation
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Serial number Destroy the plate Other solution? Strategic move: Lithographer 36
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Strategic move: Leveraged buyout 37
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Competing for market share: When does it make sense? Sunk costs become switching costs learning complementary investments Lock-in strategy initially, price low/free to lock in buyer exploit later 38
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39 Outline Nash equilibrium Randomized strategies Coordination / competition Sequencing Strategic move Conditional strategic move Repetition
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40 Sequencing: Conditional actions Expand strategies – condition actions on Actions of other parties Other markets Other times External events
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41 Conditional strategic move Ideal: strategic move that doesn’t impose costs Promise – if it succeeds, then needn’t be carried out Threat – if it succeeds, then needn’t be carried out
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Promise: Deposit insurance Should depositor maintain or withdraw deposit? 42
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Promise: Deposit insurance 43
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44 Promise: Controlling hyperinflation Central Bank prints money => hyperinflation How can government use promise to guard against hyperinflation?
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Threat: Strike American professional sports: Why are strikes less common in football than baseball? 45
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46 Threat: Shareholder rights plan (poison pill)
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47 Outline Nash equilibrium Randomized strategies Coordination / competition Sequencing Strategic move Conditional strategic move Repetition
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48 Repetition: Cooperation without explicit agreement Repeated situation: Tit-for-tat – punishment strategy I will follow quota, but if you cheat, then in next period, I will also cheat Can achieve cooperation (avoid price competition) depending on time horizon discounting of future profit relative to current profit
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49 Repetition: Cooperation without explicit agreement Tit-for-tat: Examples Gasoline stations competing for drivers Grocery stores competing for customers
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50 Repetition: Cooperation without explicit agreement Axelrod’s rules do not strike first reciprocate both good and bad act simply and clearly do not be envious (IPng: do not be greedy)
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51 Key takeaways A situation is strategic if the parties consider interactions with one another in making decisions. Never use a dominated strategy. In a situation of simultaneous moves, a Nash equilibrium strategy is stable in the sense that, if other parties choose their Nash equilibrium strategies, each party prefers its own Nash equilibrium strategy. In competitive situations, it may help to randomize. Zero-sum games characterize extreme competition: one party can be better off only if another is worse off.
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52 Key takeaways, cont’d In a situation of sequential moves, plan by looking forward to the final nodes and reasoning backward toward the initial node. Use strategic moves to influence beliefs or actions of other parties in favorable way. To be effective, they must be credible. If possible, use conditional strategic moves, both threats and promises, as they are more cost-effective than unconditional strategic moves. In repeated situations, get better outcomes through strategies that condition actions on the actions of others.
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53 Applicability Competitive strategy Pricing Corporate finance – takeover bidding and defense Industrial relations Public policy
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