D.  Game Theory and Competitive Strategy

1.  Concepts

a.  Game - players make strategic decisions that take into account each other's actions and responses

b.  Payoff - value associated with a possible outcome

c.  Strategy - rule or plan of action for playing a game

d.  Payoff matrix - table showing payoffs to each player for each combination of decisions made

.

.

.

.

.

.

.

.

e.  Cooperative game - participants can negotiate binding contracts that allow them to plan joint strategies

f.  Noncooperative game  - negotiation and enforcement of binding contracts is not possible

.

2.  Dominant strategy

• Strategy that is optimal no matter what an opponent does

.

.

.

.

.

.

.

• Prisoners' Dilemma - players acting in their own self interest are worse off than if they had cooperated

.

.

.

.

.

.

.

.

3.  Nash equilibrium

• Each firm does the best it can given its competitors' actions

.

.

.

.

.

.

.

.

a.  Maximin strategy

• Maximize the minimum gain that can be earned

.

.

.

.

.

.

.

b.  Maximize expected payoff

• Assign probabilities to actions by competitors

.

.

.

.

.

.

c.  "Battle of the sexes"

• Competitors do the same thing

.

.

.

.

.

.

.

4.  Repeated games

• Actions taken and payoffs made over and over again

• Tit-for-tat strategy - player matches opponents last decision

.

.

.

.

a.  Infinitely repeated game

• Cooperative behavior is the rational response to tit-for-tat strategy

.

.

.

.

b.  Finite number of repetitions

• Game unravels as each competitor looks at last month

.

.

.

.

• Competition can break down due to:

- Too many firms - difficult to coordinate

- Rapidly shifting demand or cost conditions - difficult to agree on right course of action

.

5.  Sequential games

• One player can move first

• First mover may have an advantage

• Extensive form of a game - use a decision tree

.

.

.

.

.

.

.

.

.

.

6.  Competitive strategy

a.  Threats

• Threat must be credible to have impact

.

.

.

.

.

.

.

.

b.  Commitment and credibility

• Commitment can be used to increase credibility

• Reputation important in establishing credibility

.

.

.

.

.

.

.

.

c.  Bargaining strategy

• Might be able to link two or more bargaining problems

.

.

.

.

.

.

.

.

d.  Entry deterrence

• Incumbent firm must convince potential entrants that entry will be unprofitable

• Commitment is again important

.

.

.

.

.

.

.

.

7.  Auctions

• Auction market - products bought and sold through formal bidding

• Reservation price - the value an individual places on a product

.

a.  Types of auctions

(1)  English (oral) auction

• Seller solicits progressively higher bids from potential buyers

• Less risk to buyer as they can always up the bid

.

(2)  Dutch auction

• Price starts high and is then lowered until someone buys

• Risk to buyer of not getting product if they wait too long

. 

(3)  Sealed-bid auction

• All bids made simultaneously in sealed envelopes

(a)  First-price auction - sales price is the highest bid

(b) Second-price auction - high bid wins, but sales price is the second highest bid

.

b.  Value and information

(1)  Private-value auctions

• Each bidder knows their individual valuation

• Uncertain about value others place on product

• English auction and second-price sealed bid auctions yield similar results

• Dutch auction and first-price sealed bid auctions yield similar results

• Maximum bid should be the reservation price

.

(2)  Common-value auctions

• Item auctioned has approximately the same value to all bidders

• Estimates will still differ though

• Winner's Curse - winner of an auction worse off because of overvaluation

.

.

.

• Maximum bid should be below the estimated valuation to factor in the Winner's Curse