1. Managerial Economics and Organizational Architecture, 5e Chapter 9: Economics of Strategy: Game Theory
McGraw-Hill/Irwin
Copyright © 2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.

2. Game Theory Managers must put themselves in their rival’s shoes
Determine how they will respond to your actions
Assume
all decision agents are rational
each attempts to anticipate actions of rivals
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3. Simultaneous-Move, Non-Repeated Interaction
Rivals must make decisions without knowledge of each other’s decisions
Nonrepeated
The interaction occurs only once
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4. Example
Boeing and Airbus individually choose and simultaneously submit a bid price (high or low) for 10 planes
Each cell entry represents the payoffs
A dominant strategy is one the firm chooses no matter what its rival does
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5. Strategic Form Dominant Strategy
Airbus
Airbus Low Price
Airbus High Price
$500
$1000
Boeing Low Price
$500 $0
Boeing $0
$750
Boeing High Price
$1000
$750
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6. Nash Equilibrium revisited
In the absence of a dominant strategy, Nash equilibrium may predict outcome
Nash equilibrium is set of strategies where firm does its best given rival’s actions
Use circle technique to identify Nash equilibrium
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7. Nash Equilibrium Airbus Airbus Low Price Airbus High Price $500 $1000
Boeing Low Price
$500 $0
Boeing
$600
$750
Boeing High Price
$1000
$750
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8. Nash Equilibrium This is a stable outcome
No firm has an incentive to make another choice
When dominant strategies exist, firms have strong incentives to choose them
More likely to occur when rivals have good information about potential payoffs
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9. Competition Versus Cooperation
Boeing and Airbus make simultaneous choices of new communications systems
two technologies: Alpha & Beta
both benefit with same choice
Results in two Nash equilibria
benefits from pre-commitment communication
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10. Coordination Game: Two Nash Equilibria
Airbus
Airbus Alpha
Airbus Beta
$100
$50
Boeing Alpha
Boeing
Boeing Beta
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11. Coordination/Competition Game
Airbus
Airbus Alpha
Airbus Beta
$100
$40
Boeing Alpha
$50
$40
Boeing
$25
$50
Boeing Beta
$25
$100
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12. Coordination/Cooperation
In the previous example, Boeing prefers Alpha and Airbus prefers Beta
Credible statements about upcoming choices may help
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13. Mixed Strategies Mixed strategy offers an element of surprise
Boeing and Airbus must simultaneously commit to an advertising campaign
Boeing benefits most from same strategy
Airbus benefits most from differentiation
Randomization with p=.5 is Nash equilibrium for both
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14. Mixed Strategy Airbus Negative campaign Positive campaign $10 -$10
Boeing
-$10
$10
Positive campaign
$10
-$10
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15. Managerial Implications
Estimate payoffs given the potential actions of your firm and your competitors
If a firm has a dominant strategy, follow it
Make best estimate of what competitor will do and identify best action
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16. Sequential Interactions
Boeing & Airbus communications technology choice
Boeing chooses first
Analyze with backward induction
Boeing must take Airbus’s best response into account in making its choice
Boeing has first mover advantage
Credible commitment by second mover can alter first mover choice
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17. Extensive Form Sequential Game
If Boeing chooses Alpha,
Airbus chooses Alpha
Boeing 100
Equilibrium
Alpha
Airbus 50
Airbus
Beta
Alpha
Boeing 40
Airbus 40
Boeing
Boeing 25
Alpha
Airbus 25
Beta
Airbus
Beta
If Boeing chooses Beta,
Airbus chooses Beta
Boeing 50
Airbus 100
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18. Repeated Strategic Interaction
Strategic choices can come to incorporate more than short-term payoffs
The cooperative outcome is more likely if
long-run gains from cooperating are greater than short-run gains from not cooperating
It is easier to recognize whether cooperation has occurred
The expected length of the relationship is long
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19. Strategic Interaction and Organizational Architecture
Kiana manages Lenin
Len must choose between working and shirking
Kiana must choose whether to incur monitoring costs
No pure strategy equilibrium exists
A labor contract paying a share of output may solve this problem
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20. Mixed Strategy Lenin Shirk Don’t shirk -$5 $15 Don’t monitor $15 $10
Kiana $0
$10
Monitor
$10 $5
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