Business Journal 3

Spring 2018

Lecture 6

ECO 526: Business Strategy

Plan

 A quick tour of Game Theory II  Prisoner’s Dilemma wrap-up

 Sequential Games and Commitments

 Mini case: HSC vs. Nutrasweet

 Coopetition

Prisoner’s Dilemma

SILENT

CONFESS

SILENT

(-1,-1)

(-6,0)

CONFESS

(0,-6)

(-3,-3)

Bubba

Sly

Prisoner’s Dilemma

 Background

 Equilibrium: Rationality vs. Efficiency

 Assessing rationality

 Cooperation and Defection

 Applications

Ways out of the Dilemma: Changing the Game

Cooperation in repeated prisoner’s dilemma-type games

• Punishment/Reward (“stick and carrot”) strategies • Tit-for-Tat • Grim • Generalized trigger

• Stick and carrot strategies lead to cooperation if designed properly, and if players place enough value on the future (think De Beers…)

Changing the players incentives through repetition or creation of intertemporal linkages may lead to cooperation

• Players are accountable tomorrow for defections today • Repetition acts as a deterrent • Reputation is important

 If players play repeatedly, they can sustain a form of cooperation known as tacit collusion

 Not illegal!

 If incentives are set properly, and players are in for the long term, no player cheats (deviates) because this is expected to trigger future –negative- consequences

 Signaling is crucial  Tacit collusion is akin to agreeing to share a market w/o burning resources in fierce competition

 Market discipline

To Cheat or not to Cheat?

To Cheat or not to Cheat…?

Keys for Cooperation in Prisoner’s Dilemma-Type Games

 Shared interest

 Sufficiently long game horizons

 Sufficiently low discounting  Future is important

 Properly designed strategies  Clear signals

 Monitoring / detection of cheating

 Costly punishments

 Credibility and deterrence

 Forgiveness

 Multiple dimensions

 Identify the right partners (matching and sorting)

 Stability and transparency

Ex: Cooperation in the Water Meter Industry

 Four dominant producers of water meters Rockwell (35%), International Badger, Neptune, and Hersey (combined 50-55%)

 Most buyers are municipal utilities  Demand stability

 Demand elasticity and switching costs

 Procurement processes

 Scale economies

 Barriers to entry

 How to compete?

The Game of Adding Outlets

Burger King

McD’s

Z e ro O n e T w o

Z e ro ($ 9 0 , $ 9 0 ) ($ 7 5 , $ 1 0 0 ) ($ 4 5 , $ 9 0 )

O n e ($ 1 0 0 , $ 7 5 ) ($ 8 0 , $ 8 0 ) ($ 4 0 , $ 6 0 )

T w o ($ 9 0 , $ 4 5 ) ($ 6 0 , $ 4 0 ) ($ 0 , $ 0 )

Zero

One

Two

($90, $90)

($75, $100)

($45, $90)

Zero

One

Two

($100, $75)

($80, $80)

($40, $60)

Zero

One

Two

($90, $45)

($60, $40)

($0, $0)

McD’s

Zero

One

Two

BK

BK

BK

Sequential Game – Extensive Form

Equilibrium of a Sequential Game

 The backward induction/subgame perfect method

 Start at final subgame(s) of the game

 Find an equilibrium for each subgame

 Work back to previous subgame(s) until you reach the initial node

 Resulting path yields a subgame perfect equilibrium

Zero

One

Two

($90, $90)

($75, $100)

($45, $90)

Zero

One

Two

($100, $75)

($80, $80)

($40, $60)

Zero

One

Two

($90, $45)

($60, $40)

($0, $0)

McD’s

Zero

One

Two

BK

BK

BK

Adding Outlets – Subgame Perfect Equilibrium

Subgame Perfect Equilibrium - Discussion

 Channel crowding equilibrium

 First mover advantage  Preemption and strategic commitments (costly signals)

 General forms of preemption

 Securing superior scarce resources or position

 Investing in capital/knowledge intensive assets (often times specific or sunk)

 Preemption raises the cost, risk, and complexity that potential entrants will face, and thus discourages entry

Subgame Perfect Equilibrium - Preemption

 Strategic commitments  Must be credible/costly

 Must have persistent effects

 Must be hard to reverse

 Affect choices by rivals and potential rivals

 Paradox: Inflexibility can add value!

 Examples  Capacity expansion (especially in specific assets)

 Contracts (MFN/MCC/Low price guarantees)

 Public announcements that would greatly hurt reputation if not backed up

Subgame Perfect Equilibrium - Preemption

 Investment in capital intensive assets  Reduce subsequent returns on capital (“take up space”)

 Creates a more defendable position (“moats”)

 Tradeoff: Risk  How well will investments hold?

 Commitment vs. flexibility  Uncertainty can be the great equalizer

 Flexibility increases the value of alternative options

 Waiting preserves option value

 Second-mover advantages?

 Delay commitments to gain information on future profitability/refine concepts

Ex: NutraSweet vs. Holland Sweetener (HSC)

 Background  Aspartame was a chance discovery

 Significant market growth over time

 Monsanto secured contracts with Coke and Pepsi

 High gross margins!

 But…, patents were to expire in 1987 (Europe and Canada), and 1992 (US)

NutraSweet vs. HSC…

 HSC ready to enter in Europe in 1988: What response should they expect from NutraSweet?

 Aggressive  Limit competition

 Deep pockets

 Scale economies/Learning

 Signaling  Reputation

 Accommodating  Low perception of HSC capabilities

 Brand recognition/Cornered distribution channels

 Large minimum efficient scale

 Switching/Transaction costs

NutraSweet vs. HSC - Conclusion

 What happened?

 HSC entered and branded their own product (Senecta)

 NutraSweet’s response…

 HSC filed antitrust complaints against NutraSweet in both Europe and Canada

 The US market

 Developments in the sweetener industry

Coopetition: From Game Theory to Strategic Options

 Key: Understand the game and play it right

• Understand competitors’ payoffs – ‘What

makes your opponent tick?’

 Do not take the game as given; when possible try to

change it

• Consider potential new players, actions, order of moves

• Explore possibilities for signaling and commitment

• Incorporate competitors’ payoffs into your own

Coopetition: Emphasizing Cooperation in Strategy and Game Theory

•Non-Cooperative Game Theory often times stresses

gaining surplus at the expense of your opponent

•Coopetition recognizes that players often do better

by looking at competitive situations differently, i.e.,

• Can players change the game to improve joint profitability?

• Do rivals have common goals, and; can they work

together to achieve them?

• Can it pay to shift the focus from gaining surplus from each

other to expanding total surplus instead?

• Applies to both vertical and horizontal chains

Coopetition – Key Insights

 Playing is a choice: Play the right game!

 Focus on “free-wheeling” games, where you can do something to change the rules and parameters

 Recognize what you bring to the game (“added value”)  Principle: If competition is unrestricted (AKA “perfect”), you

cannot take away more than what you bring into the game

 Seek to improve your ability to extract surplus by making yourself more valuable or your opponents less valuable

 Examples

Added Value - Example

 A seasonal labor market (e.g., farming, construction)

 Landowner and 2 Farm Workers

 Landowner + One Worker: C

 Landowner + Two Workers: 2C

 One or Two Workers + No Landowner: 0

 Landowner alone: 0

 How much should each expect to get?

Added Value – Example…

 Assume parties arrive in random order, and market is competitive (i.e., each agent gets their marginal contribution)

ORDER MARGINAL CONTRIBUTION

(L,W,W) (0,C,C)

(W,L,W) (0,C,C) (W,W,L) (0,0,2C)

Landowner Avg =

Worker Avg =

 Changing the game to improve one’s position…

Game elements

 Players

 Added values

 Rules (soft/can be changed)

 Tactics: Moves used to shape opponents’ perception of the game

 Scope (limited/wide)

 Key: First assess, and then possibly change some of these elements

Changing the game elements: Examples

 Players  Pay to play  Provide complements

 Added values  Own  Others  Make yourself relatively scarce/unique

 Rules (strategic options)  Add alternatives  Turn simultaneous game into sequential  Make yourself non-threatening (Judo Economics)  Invest in vertical relations/use strategic contracting

Changing the game elements

 Tactics

 Reduce misperceptions

 Create uncertainty

 Information as a strategic substitute/complement

 Scope

 Create linkages to other games

 Sever linkages with other games

 Local vs. global games

Coopetition: Summing-up

 Don’t necessarily take a game as given

 Appreciate that your presence/absence may

generate value for other players, and seek to

extract as much of that value as possible

 Consider the possibility that you and your rivals may

have common interests and may work together to

increase surplus or achieve other common goals

Next Session

 Forever De Beers case

 Differentiation and strategic positioning:

Conceptual issues

 Strategy Journal 3 (GT and Coopetition) due

 Check syllabus D2L for readings