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IMBA Managerial Economics Jack Wu

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1 IMBA Managerial Economics Jack Wu
Strategic Thinking IMBA Managerial Economics Jack Wu

2 Nov. 16: Coca-Cola raised price 7% Nov. 22: Pepsi raised price 6.9%
Coke vs. Pepsi, 1999 Nov. 16: Coca-Cola raised price 7% Nov. 22: Pepsi raised price 6.9% “Coke and Pepsi will move now from price-based competition to marketing-based competition”, Andrew Conway, Morgan Stanley 2

3 What should Coke do? Competitive Dilemma 5
Nash equilibrium: for both parties, “raise price” is dominated by “discount”. but discounting is bad for both -- if only they could agree somehow to raise price. Coke and Pepsi stuck in this situation for four years until November 1999. What should Coke do? 5

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

5 Dominated Strategy generates worse consequences than another strategy, regardless of the choices of the other parties never use dominated strategy

6 Nash Equilibrium Given that the other players choose their Nash equilibrium strategies, each party prefers its own Nash equilibrium strategy No one is willing to deviate unilaterally from a Nash equilibrium

7 Solving for Nash Equilibrium
eliminate dominated strategies, then check remaining cells “arrow” technique

8 Nash equilibrium: Competitive dilemma
Pepsi Raise price Discount Coke C: 3, P: 3 C: 0, P: 5 C: 5, P: 0 C: 1, P: 1 From [IP] 10strt-ap-wo What should Coke do?

9 Coke and Pepsi Game Nash equilibrium: for both parties, “raise price” is dominated by “discount”. but discounting is bad for both -- if only they could agree somehow to raise price. Coke and Pepsi stuck in this situation for four years until November 1999.

10 Radio Formats Merkur Lite AC no change Jupiter Hot AC J: 60, M: 40

11 Radio Formats For Merkur, “Lite AC” is dominated by “no change”; so consider only “no change”, assuming Merkur chooses “no change”, Jupiter should choose “Hot AC”. Repeat using “arrow technique”.

12 Nash equilibrium: Radio formats
Merkur Lite AC no change Jupiter Hot AC J: 60, M: 40 J: 70, M: 30 J: 50, M: 50 From [IP] 10strt-ap-wo

13 Nash equilibrium: Prisoners’ dilemma
Sam Do not confess Confess Ian Do not confess I: 0, S: 0 I: -10, S: -10 I: -5, S: -5 From [IP] 10strt-ap-wo What should Sam do?

14 OPEC: Oil Cartel June 1998: Saudi Oil Minister Naimi, “I don’t think anybody expects 100% compliance… Once the price goes up, there will be cheating” March 1999: Algerian Oil Minister Youcef Yousfi, “OPEC is still able to act collectively and restore market stability” Suppose that each OPEC member must choose between “follow quota” and “produce more” -- “follow quota” is dominated by “produce more”. Cartel is naturally unstable -- each member will produce more and excess production drives down market price. 1998 production cuts not effective: Asian economic crisis -- falling demand for oil buyers had large inventories Price of oil fell to record lows. 6

15 Out of Nash Equilibrium
What if another player doesn’t play Nash equilibrium strategy? Nash equilibrium strategy may not be best still don’t use dominated strategy

16 No Nash equilibrium in pure strategies
WHERE TO ADVERTISE? No Nash equilibrium in pure strategies 8

17 Randomized Strategies
choose among pure strategies according to probabilities must be unpredictable Example: where to advertise _ We.com: ½ NBA and ½ NHL _ Competitor.com: ½ NBA and ½ NHL

18 Randomized strategies: Retail price competition
Two competing retailers – Jaya and Ming Three segments captive (loyal) to Ming captive (loyal) to Jaya switchers From [IP] 10strt-ap-wo

19 Randomized strategies: Retail price competition
Ming High price Low price Jaya J: 60, M: 40 J: 40, M: 50 J: 50, M: 30 From [IP] 10strt-ap-wo

20 Randomized strategies: Retail price competition
Pricing trade-off: high price to extract buyer surplus of loyal customers low price to get store switchers Solution: randomized discounts From [IP] 10strt-ap-wo

21 Coordination/competition: Evening news
Delta 7.30pm 8.00pm Zeta A: 1, B: 1 A: 3, B: 4 A: 4, B: 3 A: 2.5, B: 2.5 From [IP] 10strt-ap-wo

22 Coordination and Competition
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 slot

23 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: competition and coordination

24 Coordination/Competition: Instant Messaging Technologies
Venus Inc. Orange Green Sol Corp. S: 1.5 V: 1.5 S: 1 V: 1 *

25 Coordination/competition: Future DVD standard
Consumers Blu-ray HD-DVD DVD player manuf- acturers M: 1, C: 1 M: -1, C: -1 Similar problem in mid-1990s: adoption of new 56kbps modem for data communications. New technology assumed that ISP connected to exchange by digital circuit; economized on conversion, so offers higher speed; Market was frozen: for technology to work, both IAP (Internet access provider) and end-user must acquire matching modems; IAP and end-users daren’t buy modems for fear of buying the wrong technology – needed to coordinate Eventually settled: 3Com (belonging to Rockwell alliance) bought US Robotics; Two standards harmonized as ITU standard

26 Coordination/Competition: Focal Point
Single Nash equilibrium - clear focal point Multiple Nash equilibria - look for focal point to see which one to play *

27 nodes branches outcomes Sequencing
Game in extensive form – sequence of moves: nodes branches outcomes In some strategic situations, players act in sequence; examples: takeover bidding; tennis; Sotheby’s bidding; tic-tac-toe; use different model to analyze sequential moves -- game in extensive form: explicitly shows timing of moves node -- where party must choose an action branches leading from a node represent the possible choices outcome after each move

28 Extensive Form: Equilibrium
backward induction final nodes  intermediate nodes  initial node

29 Sequencing: Extensive Form - TV News
Fig.2 17

30 Strategic Move credibility first mover advantage
Action to influence beliefs or actions of other parties in a favorable way credibility first mover advantage second mover advantage

31 Examples Examples: Evening TV news -- both stations want to move first: which one can? Use strategic move, eg, contracts with advertisers to deliver news at 8pm. Famous Chinese general: after crossing a river, burnt his ships -- strategic move to force soldiers to fight harder. Issue: Is the move credible? Will it convince the other players? 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

32 (2) destroying the plate (3) other solution?
Lithographer Make more prints Buy Litho Make prints consumer Do not Do not Litho (1) serial number (2) destroying the plate (3) other solution? Do not 20

33 Conditional Strategic Moves
Threats – if it succeeds, then it needn’t be carried out Promises – if it succeeds, then it needn’t be carried out Ideal strategic move doesn’t impose costs Strategic move may be very costly, eg, upon arriving in Mexico, Cortes dismantled his ships; similar example in Chinese history lithographer destroys plates Ideal -- strategic move that doesn’t impose costs: threat: if it succeeds, then needn’t be carried out promise: if it succeeds, then needn’t be carried out Examples of promises: Lithographer: put money in escrow, and offer to buy back prints from dissatisfied customers. If successful, then no buybacks. United States Federal Deposit Insurance Corporation (FDIC) guarantees deposits of up to $100,000 at participating banks. FDIC’s promise aims to forestall bank runs. If successful, then FDIC doesn’t spend anything. 22

34 MORGAN STANLEY: “SHAREHOLDER RIGHTS PLAN”
If any party acquires 10% or more of company’s shares, other shareholders get right to buy additional shares at 50% discount. Impact on hostile bidder? 23

35 Shareholder Rights Plan
This shareholder rights plan is a threat to potential bidders: most hostile bidders begin with small stake; with shareholder rights plan, if bidder acquires more than 15%, then rights triggered, and bidder will be diluted. Nickname: poison pill. Actually works against shareholder rights -- by entrenching existing management.

36 Poison Pill Hilda loses on initial stake + cost of takeover rises
activates rights acquires 100,000 shares Sharon Hilda does not doesn’t bid 25

37 American professional football?
Strike Lose current wage and possibly gain in future wage strike reject union demand Union do not Maintain current wage Employer accept Why are strikes rare in American professional football? 27

38 Conditional strategic move: Without deposit insurance
bank insolvent bank remains solvent principal + interest zero depositor depositor maintains deposit withdraws deposit principal bank remains solvent bank insolvent For depositor, no dominant strategy: maintain deposit benefit -- small amount of interest risk – lose entire principal withdraw deposit – no interest, but safety of principal critical factor– perceived probability that bank will become insolvent if probability sufficiently high, depositor would withdraw immediately on hearing rumors Next transparency: deposit insurance if there is a bank run, depositor will only suffer inconvenience working back to initial node, depositor would not withdraw immediately on hearing rumors

39 Conditional strategic move: With deposit insurance
bank insolvent bank remains solvent principal + interest principal depositor depositor maintains deposit withdraws deposit principal bank remains solvent bank insolvent With deposit insurance if there is a bank run, depositor will only suffer inconvenience working back to initial node, maintaining deposit is dominant strategy depositor would not withdraw immediately on hearing rumors Good example of promise U.S. Federal Deposit Insurance Corporation (FDIC) guarantees deposits of up to $100,000 at participating banks. FDIC’s promise aims to forestall bank runs. If successful, then FDIC doesn’t spend anything.


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