Game Theory and Competitive Strategy

strategy, Ch 13)
Microeconomics (Game theory and competitive strategy,
Ch 13)

”A beautiful mind” clip: Nash Equlilibrium

https://www.youtube.com/watch?v=2d_dtTZQyUM
 4.1 GAMING AND STRATEGIC DECISIONS

Game: Situation in which players

(participants) make strategic decisions
that take into account each other’s
actions and responses.
Payoff: Value associated with a possible
outcome.
Strategy: Rule or plan of action for
playing a game.
Optimal strategy: Strategy that
maximizes a player’s expected payoff.
If I believe that my competitors are rational and act to maximize their
own payoffs, how should I take their behavior into account when
making my decisions?
 4.1 GAMING AND STRATEGIC DECISIONS

Noncooperative versus Cooperative Games

Cooperative game: Game in which participants can

negotiate binding contracts that allow them to plan joint
strategies.

Noncooperative game Game in which negotiation and

enforcement of binding contracts are not possible.
It is essential to understand your opponent’s point of view and to
deduce his or her likely responses to your actions.
4.2 DOMINANT STRATEGIES
Dominant strategy: Strategy that is optimal no
matter what an opponent does.

Suppose Firms A and B sell competing products and are

deciding
whether to undertake advertising campaigns. Each firm
will be
affected by its competitor’s decision.
Microeconomics (Game theory and competitive strategy,
Ch 13)

4.2 DOMINANT STRATEGIES

● equilibrium in dominant strategies

Outcome of a game in which each
firm is doing the best it can
regardless of what its competitors
are doing.

Unfortunately, not every game has a dominant

strategy for each
player. To see this, let’s change our advertising
example slightly.
Microeconomics (Game theory and competitive strategy,
Ch 13)

4.3 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.
Nash Equilibrium: I’m doing the best I can given
what
you are doing. You’re doing the best
you can given what I am doing.

The Product Choice Problem

Two breakfast cereal
companies face a
market in which two
new variations of
cereal can be
successfully
introduced.
Microeconomics (Game theory and competitive strategy,
Ch 13)

Original article (”Stability in Competition” - by Harold

Hotelling)
htt p://www.jstor.org /stable/2224214?origin=crossref&
seq=1#page_scan_tab_contents
4.3 THE NASH EQUILIBRIUM
REVISITED

The Beach Location Game

Figure 13.1

Beach Location Game

You (Y) and a competitor (C) plan to sell soft drinks on a beach.
If sunbathers are spread evenly across the beach and will walk to the closest vendor, the
two of you will locate next to each other at the center of the beach. This is the only
Nash equilibrium.
If your competitor located at point A, you would want to move until you were just to the
left, where you could capture three-fourths of all sales.
But your competitor would then want to move back to the center, and you would do the s
Microeconomics (Game theory and competitive strategy,
Ch 13)

13.3 THE NASH EQUILIBRIUM REVISITED

Mixed Strategies
● pure strategy Strategy in which a player makes a
specific choice or takes a specific action.
Matching Pennies
In this game, each player chooses heads or tails and the
two players reveal their coins at the same time. If the
coins match, Player A wins and receives a dollar from
Player B. If the coins do not match, Player B wins and
receives a dollar from Player A.
Microeconomics (Game theory and competitive strategy,
Ch 13)
Microeconomics (Game theory and competitive strategy,
Ch 13)

The derivatives with respect to the player’s respective probability

choices are
Microeconomics (Game theory and competitive strategy,
Ch 13)

4.3 Maximin Strategies

Maximin Strategies Strategy that maximizes the minimum gain that
can be earned.
Note that investing is a dominant strategy for Firm 2 because by
doing so it will do better regardless of what Firm 1 does. Thus
Firm 1 should expect Firm 2 to invest. In this case, Firm 1 would
also do better by investing (and earning
Microeconomics (Game theory and competitive strategy,
Ch 13)

4.3 Maximin Strategies

Clearly the outcome (invest, invest) is a Nash equilibrium for this game,
and you can verify that it is the only Nash equilibrium. But note that
Firm 1’s managers had better be sure that Firm 2’s managers
understand the game and are rational.
If Firm 2 should happen to make a mistake and fail to invest, it would be
extremely costly to Firm 1. (Consumer confusion over incompatible
standards would arise, and Firm 1, with its dominant market share,
would lose $100 million.)
If you were Firm 1, what would you do? If you tend to be cautious—and if you are
concerned that the managers of Firm 2 might not be fully informed or rational—you
might choose to play “don’t invest. In that case, the worst that can happen is that
you will lose $10 million; you no longer have a chance of losing $100 million. This
strategy is called a maximin strategy because it maximizes the minimum gain that
can be earned.

If both firms used maximin strategies, the outcome would be that Firm 1 does not
invest and Firm 2 does. A maximin strategy is conservative, but it is not profit-
maximizing.
Microeconomics (Game theory and competitive strategy,
Ch 13)

4.3 THE NASH EQUILIBRIUM REVISITED

Mixed Strategies
● mixed strategy Strategy in which a player makes a
random choice among two or more possible actions,
based on a set of chosen probabilities.
The Battle of the Sexes
Jim and Joan would like to spend Saturday night together
but have different tastes in entertainment. Jim would like
to go to the opera, but Joan prefers mud wrestling.
Microeconomics (Game theory and competitive strategy,
Ch 13)

13.4 REPEATED GAMES

Tit-for-Tat Strategy

● tit-for-tat strategy Repeated-game strategy in

which a player responds in kind to an
opponent’s previous play, cooperating
with cooperative opponents and
retaliating against uncooperative ones.

Infinitely Repeated Game

Suppose the game is infinitely repeated. In other words, my

competitor and I repeatedly set prices month after
month, forever.
With infinite repetition of the game, the expected gains
from
cooperation will outweigh those from undercutting.
Microeconomics (Game theory and competitive strategy,
Ch 13)

13.4 REPEATED GAMES

Finite Number of Repetitions

Now suppose the game is repeated a finite number of times
—say, N months. If my competitor (Firm 2) is rational and
believes that I am rational, he will reason as follows:
―Because Firm 1 is playing tit-for-tat, I (Firm 2) cannot
undercut—that is, until the last month. I should undercut the last
month because then I can make a large profit that month,
and afterward the game is over, so Firm 1 cannot retaliate.
Therefore, I will charge a high price until
the last month, and then I will charge a low price.‖
However, since I (Firm 1) have also figured this out, I also
plan to charge a low price in the last month. Firm 2
figures that it should undercut and charge a low price in
the next-to-last month.
And because the same reasoning applies to each preceding
month, the game unravels: The only rational outcome is for
both of us to charge a low price every month.
Microeconomics (Game theory and competitive strategy,
Ch 13)

13.4 REPEATED GAMES

Tit-for-Tat in Practice
Since most of us do not expect to live forever, the unraveling
argument would seem to make the tit-for-tat strategy of little
value, leaving us stuck in the prisoners’ dilemma. In practice,
however, tit-for- tat can sometimes work and cooperation can
prevail.
There are two primary reasons.
Most managers don’t know how long they will be
competing with their rivals, and this also serves to
make cooperative behavior a good strategy.
My competitor might have some doubt about the
extent of my rationality.
In a repeated game, the prisoners’ dilemma can have a
cooperative
outcome.
Microeconomics (Game theory and competitive strategy,
Ch 13)

13.5 SEQUENTIAL GAMES

● sequential game Game in which

players move in turn,
responding to each other’s
actions and reactions.

As a simple example, let’s return to the product

choice problem. This time, let’s change the payoff
matrix slightly.
Microeconomics (Game theory and competitive strategy,
Ch 13)

13.5 SEQUENTIAL GAMES

The Extensive Form of a Game

● extensive form of a game
Representation of possible
moves in a game in the form of
a decision tree.
Figure 13.2

Product Choice Game in Extensive Form

Microeconomics (Game theory and competitive strategy,
Ch 13)

13.5 SEQUENTIAL GAMES

The Advantage of Moving

First
Microeconomics (Game theory and competitive strategy,
Ch 13)

13.6 THREATS, COMMITMENTS, AND CREDIBILITY

Commitment and Credibility

Race Car Motors, Inc., produces cars, and Far Out Engines,
Ltd.,
produces specialty car engines.
Far Out Engines sells most of its engines to Race Car
Motors, and a few to a limited outside market.
Nonetheless, it depends heavily on Race Car Motors and
makes its
production decisions in response to Race Car’s production
plans.
Microeconomics (Game theory and competitive strategy,
Ch 13)

13.6 THREATS, COMMITMENTS, AND CREDIBILITY

Commitment and Credibility

Race Car Motors, Inc., produces cars, and Far Out Engines,
Ltd.,
produces specialty car engines.
Far Out Engines sells most of its engines to Race Car
Motors, and a few to a limited outside market.
Nonetheless, it depends heavily on Race Car Motors and
makes its
production decisions in response to Race Car’s production
plans.
Microeconomics (Game theory and competitive strategy,
Ch 13)

13.6 THREATS, COMMITMENTS, AND CREDIBILITY

Commitment and Credibility

Suppose Far Out threatens to produce big engines no matter
what Race Car does. If Race Car believed Far Out’s threat, it
would produce big cars: Otherwise, it would have trouble
finding engines for its small cars.
Far Out can make its threat credible by visibly and irreversibly
reducing some of its own payoffs in the matrix, thereby
constraining its own choices.
Far Out must reduce its profits from small engines. It might
do this by shutting down or destroying some of its small engine
production capacity.
Microeconomics (Game theory and competitive strategy,
Ch 13)

13.6 THREATS, COMMITMENTS, AND CREDIBILITY

Commitment and Credibility

The Role of Reputation

Developing the right kind of reputation can also give one a

strategic advantage.
Suppose that the managers of Far Out Engines develop a
reputation
for being irrational—perhaps downright crazy.
They threaten to produce big engines no matter what
Race Car Motors does.
Now the threat might be credible without any further action;
after all, you can’t be sure that an irrational manager will
always make a profit- maximizing decision.
In gaming situations, the party that is known (or thought) to
be a little crazy can have a significant advantage.
Microeconomics (Game theory and competitive strategy,
Ch 13)

13.6 THREATS, COMMITMENTS, AND CREDIBILITY

How did Wal-Mart Stores succeed where others

failed?
The key was Wal-Mart’s expansion strategy.
The conventional wisdom held that a discount
store could succeed only in a city with a
population of 100,000 or more. Sam Walton
disagreed and decided to open his stores in
small Southwestern towns.
The stores succeeded because
Wal- Mart had created ―local
monopolies.‖ Discount stores that
had opened in larger cities were
competing with other discount
stores. Other discount chains
realized that Wal-Mart had a
profitable strategy, so the issue
became who would get to each
Microeconomics (Game theory and competitive strategy,
Ch 13)

13.7 ENTRY DETERRENCE

Strategic Trade Policy and International Competition

The Commercial Aircraft Market
The development and production of a new line of aircraft
are subject to substantial economies of scale; it would not
pay to develop a new aircraft unless a firm expected to sell
many of them.
Suppose it is only economical for one firm to produce the
new aircraft.
Microeconomics (Game theory and competitive strategy,
Ch 13)

13.7 ENTRY DETERRENCE

Strategic Trade Policy and International Competition

The Commercial Aircraft Market
European governments, of course, would prefer that Airbus
produce the
new aircraft. Can they change the outcome of this game?
Suppose they commit to subsidizing Airbus and make this
commitment before Boeing has committed itself to produce. If
the European governments commit to a subsidy of 20 to Airbus
if it produces the plane regardless of what Boeing does, the payoff
matrix would change.
Microeconomics (Game theory and competitive strategy,
Ch 13)

13.7 ENTRY DETERRENCE

The disposable diaper industry in the United

States has been dominated by two firms: Procter
& Gamble, with an approximately 50-percent
market share, and Kimberly- Clark, with another
30–40 percent.

The disposable diaper industry in the United States has been

dominated by two firms: Procter & Gamble, with an approximately
50-percent market share, and Kimberly-Clark, with another 30–40
percent.
How do these firms compete?
And why haven’t other firms
been able to enter and take a
significant share of this $5-
billion-per-year market?
The competition occurs mostly in
the form of cost-reducing
innovation. As a result, both firms
are forced to spend heavily on
Microeconomics (Game theory and competitive strategy,
Ch 13)

Thank
You