When the Other Firms React Discuss the incredible benefits of game theory and the paradox of the prisoner's dilemma.
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Chapter8WhenOtherFirmsReact.pptPowerPoint Slides prepared by: Andreea CHIRITESCU Eastern Illinois University
When Other Firms React
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CHAPTER 8
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Strategy as Game Theory
- Game theory
Defines strategic behavior as the interdependence of actions
What one does affects and is affected by what others do
Help managers to understand that
The world of business is one of interdependence
Strategic decisions cannot be made in isolation
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Strategy as Game Theory
- Game
Interaction of the firms
- Players
Decision-makers in the firms
- Strategies
Planned decisions of the players
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Strategy as Game Theory
- Payoffs to the players
Profits or losses that result from strategies
- Payoff to one player
Depends on
His strategy
Strategies employed by other players
Interdependence
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© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
One-Period Games
- Simultaneous-move game
Each player makes decisions without knowledge of the other players’ decisions
Rock-paper-scissors
- Sequential-move game
One player makes a move after observing the other player’s move
Chess, checkers
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One-Period Games
- One-period game
Interaction that occurs just once
- Repeated game
Interactions that are repeated a number of times
- Normal form representation of a game
Players in the game
Possible strategies of the players
Payoffs to the players
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Table 8.1
The payoffs for selecting one of two stories, S or GW, for each player are shown. Time’s payoffs are shown first and Newsweek’s second in each cell.
Magazine Cover Selections
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© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
One-Period Games
- Simultaneous-move, one-shot game
The players get to make one, and only one, decision
Must make their decision at the same time
Cannot make conditional decisions
- Dominant strategy
Optimal decision
It results in the highest payoff regardless of the action of the opponent
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Nash Equilibrium
- Nash equilibrium
Set of strategies
If, given the strategies of the other players, no player can improve his payoff by unilaterally changing his own strategy
Every player is doing the best he or she can given what other players are doing
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The Prisoner’s Dilemma
- The prisoner’s dilemma
Situations in which interaction can cause the players to select an inferior strategy
- Cigarette advertising
Dominant strategy: advertise
Even if both firms have lower profits
- Price war
Dominant strategy: low price
Even if both firms earn zero profits
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Table 8.2
The options available to each firm are to advertise or not advertise. In this case, both firms advertise even though both would be better off not advertising.
Prisoner’s Dilemma
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Table 8.3
Each firm is better off charging a low price if the other chooses a high price. The dilemma is that they each select the low price which is the worst outcome.
Pricing Strategies
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Standards: Cooperation Game
- Two Nash equilibria
The firms do the same thing
Both use HD or both use Blue-Ray
No collusion
Lobby the government to create a standard
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Table 8.4
The two players are better off agreeing to a standard or a similar technology. Without that, the solution is the possibility of selecting a result that is not a Nash equilibrium.
The Cooperation Game
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Repeated Games
- Repeated games
Players receive payoffs during each repetition of the game
Firms may “collude” without fear of being cheated on
Automatic penalties, trigger strategies
Strategies that are contingent on the past plays of players in a game
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Repeated Games
- Trigger strategy
A player continues to choose the same action
Until some other player takes an action that “triggers” a different action by the first player
- Collusion
Two or more firms agree to fix prices or otherwise reduce competition
Punishment - used to support collusion and prevent cheating
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Repeated Games
- Tit-for-tat strategy
Participants cooperate in the first period
And from then on mimic the rival’s action from the previous period
It never initiates cheating
It never lets cheating go unpunished
Problem: the slightest possibility of misperception can result in a complete breakdown
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Repeated Games
- Scorched-earth policy
Commitment
A strategic move is designed to alter the beliefs and actions of others
In a direction favorable to yourself
The move purposefully limits your freedom of action
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Credible Threats
- Collusion
Easier when few firms are involved
Many firms – many monitors
May fail if the monitoring threat used is not credible
Single enforcer - one player who is able to essentially monitor everyone
Make the credible threat that if cheating occurs, penalties will be severe
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Brand Name & Other Sunk Cost Investments
- Firm – continued business
It does not pay to cheat customers
If the one-time gain is more than offset by lost future sales
Satisfaction guaranteed
Back up the quality promises
- Expenditures
To back up quality promises - change the game from one of a one-period game to an infinitely repeated game
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Sequential Games
- Sequential Games
Players make decisions in sequence
Extensive form
Circles - decision nodes
At that stage of the game the particular player must choose a strategy
Beginning of the game – single point
Payoffs at the end of the game
Each player’s payoff depends on
Own action and actions of the other player
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Figure 8.1
Extensive Form
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When one player makes a decision before the other has to make a decision, the game is called a sequential game. The circles with letters are decision nodes, indicating who has to make a decision. The lines show the possible decisions. The payoffs are indicated at the end of the lines.
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Converting Simultaneous to Sequential
- Simultaneous game
Each firm – two strategies
Four possible outcomes
Equilibrium of the game
Intel’ s dominant strategy: low effort
AMD’s dominant strategy: high advertising
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Table 8.5
The payoffs to the game when the players must move at the same time
A Simultaneous Game
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Converting Simultaneous to Sequential
- Sequential game
Intel preempts – announces high advertising
Equilibrium
Intel – high advertising
AMD – low
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Table 8.6
Sequential Game
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Converting Simultaneous to Sequential
- Transform a simultaneous game into a sequential one
Commitment to an action or a response rule
Payoffs – unchanged
Dramatically different outcomes
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The Ultimatum Game
- Credible threat
Credible ultimatum
- Ultimatum game
In bargaining situations – people have in mind a division that is “fair” to them
If the share they are offered is not fair - they reject the offer
Even though they end up with zero
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Risk
- Decision in the face of uncertainty
Knowledge of the relative likelihood of the alternative possible outcomes
List all the possible outcomes that could follow a decision
Assign probabilities to them
Calculate the expected value of the outcome
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Figure 8.2
Go to the end and reason backward, outlining the branches that define the best path. These are known with certainty.
The Sequential Game with Certainty
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Risk
- Risk-adverse
People who prefer the sure thing over the bet when the expected return is the same
- Risk premium
Measure of how cautious you are toward this particular gamble
Difference between the expected return of the gamble
And the amount of money that, if received for sure, the individual regards as equivalent to the gamble
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