MBA201a: Strategic Thinking

1. MBA201a: Strategic Thinking

2. Overview • Context: You’re in an industry with a small number of competitors. You’re concerned that if you cut your price, your competitors will, too. How do you act? • The same reasoning applies for pretty much any strategic decision: • Capacity expansion, • Entry and exit, • Product positioning, • Advertising expenditures, etc. MBA201a - Fall 2009

3. Short digression on the term “strategy” • Strategy includes: • Organizational structure and processes needed to implement the firm’s plan. • Boundaries of the firm: scale, scope, extent of outsourcing. • Formal analysis of interactions between competitors: game theory. MBA201a - Fall 2009

4. We will apply the tools of game theory • Informally, game theory reminds us to: • Understand our competitors. Our results depend not only on our own decisions but on our competitors’ decisions as well. • Look into the future. Decisions taken today may have an impact in future decisions, both by ourselves and by our competitors. • Pay attention to information. Who knows what can make a difference. • Look for win-win opportunities. Some situations are competitive, but others offer benefits to all. MBA201a - Fall 2009

5. The E.T. “chocolate wars” In the movie E.T. a trail of Reese's Pieces, one of Hershey's chocolate brands, is used to lure the little alien into the house. As a result of the publicity created by this scene, sales of Reese's Pieces tripled, allowing Hershey to catch up with rival Mars. MBA201a - Fall 2009

6. Chocolate wars…the details • Universal Studio's original plan was to use a trail of Mars’ M&Ms and charge Mars $1mm for the product placement. • However, Mars turned down the offer, presumably because it thought $1mm was high. • The producers of E.T. then turned to Hershey, who accepted the deal, which turned out to be very favorable to them (and unfavorable to Mars). MBA201a - Fall 2009

7. Formal analysis of the chocolate wars • Suppose: • Publicity from the product placement would have increased Mars’ profits by $800,000. • Hershey's increase in market share cost Mars $500,000. • Benefit to Hershey from having its brand featured is given by b. • Hershey knows the value of b. Mars knows only that b=$1,200,000 or b=$700,000 with equal probability. MBA201a - Fall 2009

8. Mars 1: decision approach [-200] buy M not buy [0] MBA201a - Fall 2009

9. Mars 2: naïve game theory Payoff to Mars Payoff to Hershey [-200, 0] buy Payoff to Hershey = .5x(1.2M-1M) + .5(.7M-1M) M buy [-500, -50] 0 not buy H [0, 0] not buy MBA201a - Fall 2009

10. Mars 3: real game theory [-200, 0] buy buy [-500, 200] -500 M H b = 1200 (50%) [0, 0] not buy not buy N -250 buy [-500, -300] 0 b = 700 (50%) H not buy [0, 0] MBA201a - Fall 2009

11. Mars: summary • Think about your competitor: Mars should think about Hershey, and vice versa. • Timing matters: Hershey had the last move. • Information matters: Hershey has more information than Mars, and in this example it made a difference. • Key business insight: part of the benefit to Mars was to keep the opportunity from Hershey. MBA201a - Fall 2009

12. Game theory: concepts • What are the elements of a game? • Players (in previous example: Mars and Hershey) • Rules (sequentially respond to Universal’s offer) • Strategies (Yes or No) • Payoffs (sales minus payment to Universal) • What can I do with it? • Determine how good each of my strategies is • Figure out what my rival is probably going to do MBA201a - Fall 2009

13. Normal-form games • A convenient way to represent games with two players who make simultaneous choices. • Imagine the Beauty Contest game with two players, and assume players can only choose 0 or 1. Player 2 0 1 Player 2’s payoff if player 1 chooses 0. P/2 0 0 Player 1 P/2 P P/2 P 1 Player 1’s payoff if player 2 chooses 1. 0 P/2 MBA201a - Fall 2009

14. Dominant/dominated strategies • Dominant strategy: payoff is greater than any other strategy regardless of rival’s choice. • Rule 1: if there is one, choose it. • Dominated strategy: payoff is lower than some other strategy regardless of rival’s choice. • Rule 2: do not choose dominated strategies. MBA201a - Fall 2009

15. Outcomes of games • Sometimes a game can be “solved” just by looking at dominant and dominated strategies (e.g., example above). • However, there are many games for which this isn’t enough to produce an outcome. • Nash equilibrium: Combination of moves in which no player would want to change her strategy unilaterally. Each chooses its best strategy given what the others are doing. MBA201a - Fall 2009

16. Prisoner’s dilemma Iraq’s Output 2 4 Example: output setting (million barrels a day) by OPEC members 42 44 2 Iran’s Output 46 26 22 24 4 52 32 MBA201a - Fall 2009

17. Prisoner’s dilemma… • Dominant strategies: high output. • Equilibrium payoffs are (32,24), much worse than would be attained by low output, (46,42). • Conflict between individual incentives and joint incentives. • Typical of many business situations. • Are cartels inherently unstable? MBA201a - Fall 2009

18. Auctions • Remember we said that games involved players, rules and payoffs? • In auctions, the rules of the game, and how players’ choices affect their payoffs, are very well-defined. • Auctions have become relevant in a number of business contexts. MBA201a - Fall 2009

19. Common auction mechanisms • English auction (a.k.a. oral ascending auction). Price is successively raised until only one bidder remains. • Antiques, Artwork, Wine • Used cars • Sealed-bid first-price auction (or simply first-price auction). Highest/lowest bid is selected and pays/receives that value. • Mineral rights • Building contracts MBA201a - Fall 2009

20. More auction mechanisms • Dutch auction (a.k.a. oral descending auction). Price is successively decreased until one bidder calls. • Flowers, tobacco, fish • Privatizations • Second price auction (a.k.a. Vickrey auction). Just like first price auction, but: winner pays price equal to second highest bid. • eBay • Stamps and other collectibles • Radio spectrum rights in New Zealand MBA201a - Fall 2009

21. Bidding strategies vary by auction type • Optimal bidding strategy in second-price auction is to bid own value. • Optimal bidding strategy in English auction is to continue bidding up to own valuation. • What about in a Dutch or sealed-bid auction? • … beware the Winner’s Curse. MBA201a - Fall 2009

22. Winner’s Curse example • Example: bids for oil-track auction • True, common, value of object is X. • Each bidder i estimates that value is X + ei. • Average ei is zero: bidders’ estimates are unbiased. • Suppose each bidder bids his or her valuation minus some margin mi. • Winning bid will correspond to highest ei, i.e., winner will be the most “optimistic” bidder. • If mi is not sufficiently large, i.e., if mi < ei, then winner will lose money (bids more than true value). MBA201a - Fall 2009

23. The Winner’s Curse graphically value b2 s2= X + e2 X b1 s1= X + e1 X = true value si=signal received by bidder i bi= bidder i’s bid Winner’s Curse: Bidder 1 (winner), while bidding less than his/her value assessment ends up losing money. Should take this effect into account and bid even lower relative to signal. MBA201a - Fall 2009

24. Comparing auction mechanisms • If valuations are independent and bidders are similar and risk neutral, then all of the above auction mechanisms induce the same average seller revenue. • If valuations are correlated (extreme: common value), then the English auction implies higher average revenue than the sealed-bid auction. • Collusion among bidders easier with English auction. • Transactions costs vary across auctions. MBA201a - Fall 2009

25. Takeaways • Game theory is a formal approach to strategy. • Highlights impact of strategic interactions among firms or other “players.” • Forces you to consider your competitors’ choices. • Auctions lend themselves well to game-theoretic analysis. • Concepts: players, strategies, dominant and dominated strategies, best responses, Nash equilibrium. • Stay tuned for another example on Thursday… MBA201a - Fall 2009