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Module 5 - Game Theory and Pricing Strategy

Game theory is the process of modeling the strategic interaction between two or more players in a situation containing set rules and outcomes. While used in a number of disciplines, game theory is most notably used as a tool within the study of economics.

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Charlotte Fayne Natulla
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600 views44 pages

Module 5 - Game Theory and Pricing Strategy

Game theory is the process of modeling the strategic interaction between two or more players in a situation containing set rules and outcomes. While used in a number of disciplines, game theory is most notably used as a tool within the study of economics.

Uploaded by

Charlotte Fayne Natulla
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPT, PDF, TXT or read online on Scribd
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Game Theory and

Pricing Strategy
INTRODUCTION

• As industry grows, the number of


firms operating within it also
reduces
• Structure of the market transitions
from competitive to oligopolistic
• The conduct of the market also
becomes more interdependent.
INTRO…

• this section provides insights in


making decisions under this type
of market [oligopolistic].
• These decisions are; pricing
strategy, entering/developing
markets, advertising strategy etc.
the basic tool to use for this;
• Game theory is the basic tool
Overview of the Games
and Strategic Thinking

Sample of Games

-Tic-Tac-To
- Poker
-checkers/dama
-Hawk-Dove (chicken)game
-Prisoners’ dilemma, etc.
Overview…

Game theory is actually a much


more general framework to aid in
decision making when your pay-
off depends on the actions taken
by the other player.
Terminologies…

Players- are participants or


individuals in a game which
make decisions
Strategies- these are the planned
decisions of the players
Payoff- the resulting benefit/revenue
given the actions or decisions
Terminologies…

The pay-off table or matrix

Strategy Left Right

Up 10,20 15,8

Down -10,7 10,10


Two General Types of Games

Simultaneous-Move, One-Shot Games

•Players must move/ make a decision at the


same time.
• Players must decide without the
knowledge of the decision made by the
other players
•One-shot means (the game is played
once)
Types of Games…

Sequential-Move,Games

•Players must move/ make a decision after


the opponent has made a move.
• Players must observe what the opponent
is doing and determine his course of action
given the move of the other
•E.g. Chess, checker, etc.
Types of Games…

Sequential-Move,Games

•Players must move/ make a decision after


the opponent has made a move.
• Players must observe what the opponent
is doing and determine his course of action
given the move of the other
•E.g. Chess, checker, etc.
Simultaneous-Move,
One-Shot Games

•The most relevant to mgr’l decision,


•Deciding without the knowledge of
other player is the essence of this
game.
• This is important to managers making
decisions in an environment of
interdependence
Simultaneous-Move…

Theoretical Scaffolds

We define the following;

• Strategy- a decision rule that describes the


actions of a player will take at each decision
point
• Normal-form game - a representation of
game indicating the players, their possible
strategies, and the payoff resulting from
alternative strategies.
Simultaneous-Move…

Given (Figure 2);

Player B
Strategy Left Right

Up 10,20 15,8
Player A
Down -10,7 10,10
Simultaneous-Move…

Questions??

• What are the strategies of each


player?
• What are the P/O for each player?
• What is the optimal/dominant
strategy of A or B?
Simultaneous-Move…

Given (Figure 2);

Player B
Strategy Left Right

Up 10,20 15,8
Player A
Down -10,7 10,10
Simultaneous-Move…

In a game-theoretic situation, it is
essential to know the Optimal
strategy.
Depending on the nature of the game,
we can characterize the optimum by
a situation involving a Dominant
strategy.
Simultaneous-Move…

What is a dominant strategy??

Dominant strategy - a strategy that


results in the highest pay-off to a
player regardless of the opponents’
action
Simultaneous-Move…

Given (Figure 2);

Player B
Strategy Left Right

Up 10,20 15,8
Player A
Down -10,7 10,10
Simultaneous-Move…

In the game illustrated in Fig 2, the


dominant strategy for player A is UP!!
(pls. verify! Does B has a dominant
strategy?)

Principle:
“Always check if you have a dominant
strategy, if you have then play it!”
Simultaneous-Move…

Given (Figure 2);

Player B
Strategy Left Right

Up 10,20 15,8
Player A
Down -10,7 10,10
Simultaneous-Move…

In case a dominant strategy is


absent, the player plays a Secure
strategy; a strategy that
guarantees highest pay-off given
the worst possible scenario.
Simultaneous-Move…

Principle:
“When playing; always put
yourself in your rivals shoes” If
you don’t have a dominant
strategy, see if your rival has,
then anticipate it!”
Given this situation, a very natural
way of formalizing the end result is
captured by Nash Equilibrium (Dr.
John Nash, 1994)
Nash Equilibrium- a condition describing
a set of strategies in which no player can
improve his/her payoff by unilaterally
changing his/her own strategy, given the
other player strategies.
Again we have the pay-off table;

(B)

Strategy Left Right

Up 10,20 15,8
(A)
Down -10,7 10,10
What are the NE strategies for
player A and B?

Answer: (UP/LEFT)…
Check using the P/O matrix above!!
Again we have the pay-off table;

(B)

Strategy Left Right

Up 10,20 15,8
(A)
Down -10,7 10,10
Application!!
1.Pricing decisions
2. Coordination decisions
3. Monitoring of employees
4. Advertising decision
Example:
(B)

Strategy Low Price High Price


Low Price 0,0 50-10
(A)
High Price -10,50 10,10

Required:
-Dom Strat
-N.E
Example:
(B)

Strategy Low Price High Price


Low Price 0,0 50-10
(A)
High Price -10,50 10,10

Answer:
- Both the Dominant and the
N.E. strategies are the
same.
Pricing Strategies for
Managerial Decisions

1. Pricing strategies for firms with


relative market power

a. Block pricing- is a pricing strategy in which


identical products are package together in
order to enhance profits by forcing
customers to make an all-or-none decision
to buy. This is designed to maximize the
consumers surplus to the customers.
Principle!!

-forces customers to make an all-or-none purchase


none decision.
b. Commodity bundling- The
practical way of bundling
several different products
together and selling them at a
single “bundled price”

e.g. -telephone and DSL internet


-airfare and hotel accommodation
-etc.
2. Pricing strategies for special cost
and demand structures.

a. Peak-load pricing - pricing strategy


which a higher prices are charged
during peak hours and /exam
during off-peak hours

Purpose:
To maximize profit
To allocate them and
Discriminate customers
a. Peak-load pricing
b. Cross-Subsidies- a pricing strategy in
which profit gained from the sale of
one product are used to subsidize
sales of a related product.

Example:
Adobe suite developer (PDF)
Acrobat reader- free
Adobe Acrobat-pay/for sale

To enjoy economies of scope


3. Price strategies in markets with
intense price competition

a.Price Matching - a strategy in which a


firm advertises a price and a promise to
match any lower price offered by
competitor.

This will tend to create a monopolistic


pricing service if all firm are offer same
price. Then it will just end up sharing the
market.
There are two cautions if we use this
strategy;

• Devise a truth revealing mechanism for


customer not to shirk.

• Cumbersome if competitors have lower


cost than your firm.
b. Inducing Brand Loyalty-stimulate
the customer to think that your
product is different than the other.

Example:

Frequent- flyer-buyer promo.


Comparative advertising
c.Randomized pricing- Pricing strategy
in which the firm intentionally varies its
price in an attempt to hide price info
from consumers and rivals.

Advantage:

• Reduces customer switching to other


products
• Reduces price cutting/ price wars
Disadvantage

•Costly
•Can work only if done on-line
through computer simulation
What do all these pricing
strategies say about the
traditional cost plus mark up
pricing approach??
Mechanics…

1. Determine the cost


AC=AVC+AFC
2. Determine the mark up over cost
Let X= Target profit in peso
Q= Number of units to be
produce
X/Q= Mark up

Therefore: P/unit=AVC + AFC + X/Q


Mechanics…

Then, if; P/unit=AVC + AFC + X/Q;

….and knowing that Q is uncertain,


then there goes the problem of
“Cost + Mark Up” pricing
strategy!!!
Thank You..

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