1. Game Theory and Competitive Strategy
Chapter 13
Game Theory and Competitive Strategy 1

2. Topics to be Discussed Gaming and Strategic Decisions
Dominant Strategies
The Nash Equilibrium Revisited
Repeated Games
Chapter 13 2

3. Topics to be Discussed Sequential Games
Threats, Commitments, and Credibility
Entry Deterrence
Bargaining Strategy
Chapter 13 3

4. Gaming and Strategic Decisions
“If I believe that my competitors are rational and act to maximize their own profits, how should I take their behavior into account when making my own profit-maximizing decisions?”
Definition of a game
Chapter 13 4

5. Gaming and Strategic Decisions
Noncooperative versus Cooperative Games
Cooperative Game
Players negotiate binding contracts that allow them to plan joint strategies
Example: 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 6

6. Gaming and Strategic Decisions
Noncooperative versus Cooperative Games
Noncooperative Game
Negotiation and enforcement of a binding contract are not possible
Example: Two competing firms assuming the others behavior determine, independently, pricing and advertising strategy to gain market share
Binding contracts are not possible
Chapter 13 5

7. Gaming and Strategic Decisions
Noncooperative versus Cooperative Games
“The strategy design is based on understanding your opponent’s point of view, and (assuming you opponent is rational) deducing how he or she is likely to respond to your actions”
Chapter 13 7

8. Dominant Strategies Dominant Strategy
One that is optimal no matter what an opponent does.
An Example
A & B sell competing products
They are deciding whether to undertake advertising campaigns
Chapter 13 9

9. Payoff Matrix for Advertising Game
Firm B
Don’t
Advertise
Advertise
Advertise
10, 5
15, 0
10, 2
6, 8
Firm A
Don’t
Advertise
Chapter 13 14

10. Payoff Matrix for Advertising Game
Observations
A: regardless of B, advertising is the best
B: regardless of A, advertising is best
Firm A
Advertise
Don’t
Firm B
10, 5
15, 0
10, 2
6, 8
Chapter 13 14

11. Payoff Matrix for Advertising Game
Observations
Dominant strategy for A & B is to advertise
Do not worry about the other player
Equilibrium in dominant strategy
Firm A
Advertise
Don’t
Firm B
10, 5
15, 0
10, 2
6, 8
Chapter 13 14

12. Dominant Strategies Game Without Dominant Strategy
The optimal decision of a player without a dominant strategy will depend on what the other player does.
Chapter 13 16

13. Modified Advertising Game
Firm B
Don’t
Advertise
Advertise
Advertise
10, 5
15, 0
20, 2
6, 8
Firm A
Don’t
Advertise
Chapter 13 18

14. Modified Advertising Game
Observations
A: No dominant strategy; depends on B’s actions
B: Advertise
Question
What should A do? (Hint: consider B’s decision
10, 5
15, 0
20, 2
6, 8
Firm A
Advertise
Don’t
Firm B
Chapter 13 18

15. The Nash Equilibrium Revisited
Dominant Strategies
“I’m doing the best I can no matter what you do.”
“You’re doing the best you can no matter what I do.”
Chapter 13 20

16. The Nash Equilibrium Revisited
“I’m doing the best I can given what you are doing”
“You’re doing the best you can given what I am doing.”
Chapter 13 21

17. The Nash Equilibrium Revisited
Product Choice Problem
Examples With A Nash Equilibrium
Two cereal companies
Market for one producer of crispy cereal
Market for one producer of sweet cereal
Each firm only has the resources to introduce one cereal
Noncooperative
Chapter 13 22

18. Product Choice Problem
Firm 2
Crispy
Sweet
Crispy
-5, -5
10, 10
Firm 1
Sweet
Chapter 13 24

19. Product Choice Problem
Question
Is there a Nash equilibrium?
If not, why?
If so, how can it be reached
Firm 1
Crispy
Sweet
Firm 2
-5, -5
10, 10
Chapter 13 24

20. The Nash Equilibrium Revisited
Maximin Strategies
Scenario
Two firms compete selling file-encryption software
They both use the same encryption standard (files encrypted by one software can be read by the other - advantage to consumers)
Chapter 13 21

21. The Nash Equilibrium Revisited
Maximin Strategies
Scenario
Firm 1 has a much larger market share than Firm 2
Both are considering investing in a new encryption standard
Chapter 13 21

22. Maximin Strategy 0, 0 -10, 10 20, 10 -100, 0 Firm 2 Firm 1
Don’t invest
Invest
Don’t invest
0, 0
-10, 10
20, 10
-100, 0
Firm 1
Invest
Chapter 13 29

23. Maximin Strategy Observations Dominant strategy Firm 2: Invest
Nash equilibrium
Firm 1: invest
Firm 2: Invest
Firm 1
Don’t invest
Invest
Firm 2
0, 0
-10, 10
20, 10
-100, 0
Chapter 13 29

24. Maximin Strategy Observations
If Firm 2 does not invest, Firm 1 incurs significant losses
Firm 1 might play don’t invest
Minimize losses to maximin strategy
Firm 1
Don’t invest
Invest
Firm 2
0, 0
-10, 10
20, 10
-100, 0
Chapter 13 29

25. The Nash Equilibrium Revisited
Maximin Strategy
If both are rational and informed
Both firms invest
Nash equilibrium
Chapter 13 30

26. The Nash Equilibrium Revisited
Maximin Strategy
Consider
If Player 2 is not rational or completely informed
Firm 1’s maximin strategy is to not invest
Firm 2’s maximin strategy is to invest.
If 1 knows 2 is using a maximin strategy, 1 would invest
Chapter 13 31

27. Prisoners’ Dilemma -5, -5 -1, -10 -2, -2 -10, -1 Prisoner B Prisoner A
Confess
Don’t Confess
Confess
-5, -5
-1, -10
-2, -2
-10, -1
Prisoner A
Don’t
Confess
Chapter 13 33

28. Prisoners’ Dilemma What is the: Dominant strategy Nash equilibrium
Maximin solution
Prisoner A
Confess
Don’t Confess
Don’t
Prisoner B
-5, -5
-1, -10
-2, -2
-10, -1
Chapter 13 33

29. Repeated Games 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.
Chapter 13 39

30. Pricing Problem 10, 10 100, -50 50, 50 -50, 100 Firm 2 Firm 1
Low Price
High Price
Low Price
10, 10
100, -50
50, 50
-50, 100
Firm 1
High Price
Chapter 13 41

31. Pricing Problem Non-repeated game Repeated game Strategy is Low1, Low2
Tit-for-tat strategy is the most profitable
Firm 1
Low Price
High Price
Firm 2
10, 10
100, -50
50, 50
-50, 100
Chapter 13 41

32. Repeated Games Conclusion: With repeated game
The Prisoners’ Dilemma can have a cooperative outcome with tit-for-tat strategy
Chapter 13 44

33. Repeated Games Conclusion
Cooperation is difficult at best since these factors may change in the long-run.
Chapter 13 45

34. Sequential Games Players move in turn
Players must think through the possible actions and rational reactions of each player
Chapter 13 49

35. Sequential Games Examples Responding to a competitor’s ad campaign
Entry decisions
Responding to regulatory policy
Chapter 13 50

36. The Extensive Form of a Game
Sequential Games
The Extensive Form of a Game
Scenario
Two new (sweet, crispy) cereals
Successful only if each firm produces one cereal
Sweet will sell better
Both still profitable with only one producer
Chapter 13 51

37. Modified Product Choice Problem
Firm 2
Crispy
Sweet
Crispy
-5, -5
10, 20
20, 10
Firm 1
Sweet
Chapter 13 53

38. Modified Product Choice Problem
Question
What is the likely outcome if both make their decisions independently, simultaneously, and without knowledge of the other’s intentions?
Firm 1
Crispy
Sweet
Firm 2
-5, -5
10, 20
20, 10
Chapter 13 53

39. Modified Product Choice Problem
The Extensive Form of a Game
Assume that Firm 1 will introduce its new cereal first (a sequential game).
Question
What will be the outcome of this game?
Chapter 13 55

40. The Extensive Form of a Game
Sequential Games
The Extensive Form of a Game
The Extensive Form of a Game
Using a decision tree
Work backward from the best outcome for Firm 1
Chapter 13 56

41. Product Choice Game in Extensive Form
Crispy
Sweet
-5, -5
10, 20
20, 10
Firm 1
Crispy
Sweet
Firm 2
Chapter 13 61

42. Sequential Games The Advantage of Moving First
In this product-choice game, there is a clear advantage to moving first.
Chapter 13 62

43. Threats, Commitments, and Credibility
Strategic Moves
What actions can a firm take to gain advantage in the marketplace?
Deter entry
Induce competitors to reduce output, leave, raise price
Implicit agreements that benefit one firm
Chapter 13 68

44. Threats, Commitments, and Credibility
How To Make the First Move
Demonstrate Commitment
Firm 1 must constrain his behavior to the extent Firm 2 is convinced that he is committed
Chapter 13 69

45. Threats, Commitments, and Credibility
Empty Threats
If a firm will be worse off if it charges a low price, the threat of a low price is not credible in the eyes of the competitors.
Chapter 13 70

46. Pricing of Computers and Word Processors
Firm 2
High Price
Low Price
High Price
100, 80
80, 100
10, 20
20, 0
Firm 1
Low Price
Chapter 13 72

47. Pricing of Computers and Word Processors
Question
Can Firm 1 force Firm 2 to charge a high price by threatening to lower its price?
Firm 2
High Price
Low Price
High Price
100, 80
80, 100
10, 20
20, 0
Firm 1
Low Price
Chapter 13 72

48. Threats, Commitments, and Credibility
Scenario
Race Car Motors, Inc. (RCM) produces cars
Far Out Engines (FOE) produces specialty car engines and sells most of them to RCM
Sequential game with RCM as the leader
FOE has no power to threaten to build big since RCM controls output.
Chapter 13 76

49. Production Choice Problem
Race Car Motors
Small cars
Big cars
3, 6
3, 0
8, 3
1, 1
Small engines
Far Out Engines
Big engines
Chapter 13 75

50. Threats, Commitments, and Credibility
Question
How could FOE force RCM to shift to big cars?
Chapter 13 77

51. Modified Production Choice Problem
Race Car Motors
Small cars
Big cars
0, 6
0, 0
8, 3
1, 1
Small engines
Far Out Engines
Big engines
Chapter 13 79

52. Modified Production Choice Problem
Questions
1) What is the risk of this strategy?
2) How could irrational behavior give FOE some power to control output?
Chapter 13 80

53. Wal-Mart Stores’ Preemptive Investment Strategy
Question
How did Wal-Mart become the largest retailer in the U.S. when many established retail chains were closing their doors?
Hint
How did Wal-Mart gain monopoly power?
Preemptive game with Nash equilibrium
Chapter 13 81

54. The Discount Store Preemption Game
Company X
Enter
Don’t enter
Enter
-10, -10
20, 0
0, 0
0, 20
Wal-Mart
Don’t enter
Chapter 13 83

55. The Discount Store Preemption Game
Two Nash equilibrium
Low left
Upper right
Must be preemptive to win
Wal-Mart
Enter
Don’t enter
Company X
-10, -10
20, 0
0, 0
0, 20
Chapter 13 83

56. Entry Deterrence
To deter entry, the incumbent firm must convince any potential competitor that entry will be unprofitable.
Chapter 13 84

57. Entry Possibilities 100, 20 200, 0 130, 0 70, -10 Potential Entrant
Enter
Stay out
High price
(accommodation)
100, 20
200, 0
130, 0
70, -10
Incumbent
Low Price
(warfare)
Chapter 13 86

58. Entry Deterrence Question How could I keep X out?
Is the threat credible?
Chapter 13 89

59. Entry Deterrence How could I keep X out?
1) Make an investment before entry (irrevocable commitment)
2) Irrational behavior
Chapter 13 92

60. After $50 million Early Investment
Entry Deterrence
After $50 million Early Investment
Potential Entrant
Enter
Stay out
High price
(accommodation)
50, 20
150, 0
130, 0
70, -10
Incumbent
Low Price
(warfare)
Chapter 13 91

61. After $50 million Early Investment
Entry Deterrence
After $50 million Early Investment
Warfare likely
X will stay out
Incumbent
Enter
Stay out
High price
(accommodation)
Low Price
(warfare)
Potential Entrant
50, 20
150, 0
130, 0
70, -10
Chapter 13 91

62. Entry Deterrence Airbus vs. Boeing
Without Airbus being subsidized, the payoff matrix for the two firms would differ significantly from one showing subsidization.
Chapter 13 93

63. Development of a New Aircraft
Airbus
Produce
Don’t produce
-10, -10
100, 0
0, 0
0, 100
Produce
Boeing
Don’t produce
Chapter 13 95

64. Development of a New Aircraft
Boeing will produce
Airbus will not produce
Boeing
Produce
Don’t produce
Airbus
-10, -10
100, 0
0, 0
0, 100
Chapter 13 95

65. Development of a Aircraft After European Subsidy
Airbus
Produce
Don’t produce
-10, 10
100, 0
0, 0
0, 120
Produce
Boeing
Don’t produce
Chapter 13 97

66. Development of a Aircraft After European Subsidy
Airbus will produce
Boeing will not produce
Boeing
Produce
Don’t produce
Airbus
-10, 10
100, 0
0, 0
0, 120
Chapter 13 95

67. Bargaining Strategy
Alternative outcomes are possible if firms or individuals can make promises that can be enforced.
Chapter 13
103

68. Bargaining Strategy Consider:
Two firms introducing one of two complementary goods.
Chapter 13
104

69. Bargaining Strategy 40, 5 50, 50 5, 45 60, 40 Firm 2 Firm 1 Produce A
Produce B
Produce A
40, 5
50, 50
5, 45
60, 40
Firm 1
Produce B
Chapter 13
106

70. Bargaining Strategy With collusion: Without collusion: Produce A1B2
Nash equilibrium
Firm 1
Produce A
Produce B
Firm 2
40, 5
50, 50
5, 45
60, 40
Chapter 13
106

71. Bargaining Strategy Suppose
Each firm is also bargaining on the decision to join in a research consortium with a third firm.
Chapter 13
108

72. Bargaining Strategy 10, 10 10, 20 40, 40 20, 10 Firm 2 Firm 1
Work alone
Enter consortium
10, 10
10, 20
40, 40
20, 10
Work alone
Firm 1
Enter
consortium
Chapter 13
110

73. Bargaining Strategy Dominant strategy Both enter 10, 10 10, 20 40, 40
Firm 1
Work alone
Enter consortium
Enter
consortium
Firm 2
10, 10
10, 20
40, 40
20, 10
Chapter 13
110

74. Bargaining Strategy Linking the Bargain Problem
Firm 1 announces it will join the consortium only if Firm 2 agrees to produce A and Firm 1 will produce B.
Firm 1’s profit increases from 50 to 60
Chapter 13
108

75. Bargaining Strategy Strengthening Bargaining Power Credibility
Reducing flexibility
Chapter 13
112

76. Summary
A game is cooperative if the players can communicate and arrange binding contracts; otherwise it is noncooperative.
A Nash equilibrium is a set of strategies such that all players are doing their best, given the strategies of the other players.
Chapter 13
113

77. Summary
Some games have no Nash equilibrium in pure strategies, but have one or more equilibria in mixed strategies.
Strategies that are not optimal for a one-shot game may be optimal for a repeated game.
In a sequential game, the players move in turn.
Chapter 13
114

78. Summary
An empty threat is a threat that one would have no incentive to carry out.
To deter entry, an incumbent firm must convince any potential competitor that entry will be unprofitable.
Bargaining situations are examples of cooperative games.
Chapter 13
115

79. Game Theory and Competitive Strategy
End of Chapter 13
Game Theory and Competitive Strategy 1