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Game Theory

Game Theory. Mike Shor Lecture 8. “The power to constrain an adversary depends upon the power to bind oneself.”. - Thomas Schelling. Review. Credible commitments require Severe enough punishment to change behavior Irreversible and clear actions Today:

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Game Theory

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  1. Game Theory Mike ShorLecture 8 “The power to constrain an adversary depends upon the power to bind oneself.” - Thomas Schelling

  2. Review • Credible commitments require • Severe enough punishment to change behavior • Irreversible and clear actions • Today: • Changing the game for strategic advantage • Overcoming the prisoner’s dilemma

  3. Today Moving Beyond the Prisoner’s Dilemma • Why does the dilemma occur? • Interaction • No fear of punishment • Short term or myopic play • Firms: • Lack of monopoly power • Homogeneity in products and costs • Overcapacity • Incentives for profit or market share • Consumers • Price sensitive • Price aware • Low switching costs

  4. Altering Firm Behavior Not-so-useful advice • Firms: • Lack of monopoly power • Be a monopolist • Homogeneity in products and costs • Differentiate product • Lower costs

  5. Altering Firm Behavior • Firms: • Overcapacity • Reduce capacity • Eliminate the urge to lower prices • Incentives for profit or market share • Cross-shareholding • Incentives based on industry profits

  6. The Prisoner’s Dilemma Equilibrium: $40 K Cooperation: $60 K

  7. Cross-Shareholding • If each firm acquires 20% of the other:

  8. Cross-Shareholding Firm 2 Firm 2

  9. Altering Consumer Incentives • Consumers • Price sensitive • Use customers as hostages • Price aware • Less price information to customers • Increase search costs • Low switching costs • Increase lock-in

  10. Hostages • Promises can sometimes be credible through a contract with the party to whom you are making the promise • Threats can never be credible through a contract with the party to whom you are making the threat • Must contract with third party

  11. The Bocchicchio Family “ Once a particularly ferocious branch of the Mafia in Sicily, it had become an instrument of peace in America. ” • How can Michael invite Don Tessio for a meeting and guarantee that Don Tessio will not be harmed?

  12. Customers as Hostages:Promises “I promise to keep prices high” • Most Favored Customer clause • If I ever offer a lower price to any other customer, I will offer it to you as well Firm 2

  13. Most Favored Customer Clause • Say, in period 1, both firms charge high • In period 2, pricing low requires a $1 refund to 30 customers from last period Firm 1: 65 – 30 = 35

  14. Most Favored Customer Clause Firm 2 Firm 2

  15. You want to buy 100 shares of WXYZ Your broker must acquire shares at best available price What is MIKE’s incentive to undercut BEST? But, your broker has an agreement with DEAN to buy from him if he will match lowest price What’s MIKE’s incentive to undercut BEST? WXYZ Ask Size BEST 77 100 ABSB 77¼ 100 DEAN 77½ 100 CHAS 77¾ 100 MIKE 78 100 NASDAQ Order Preferencing

  16. Customers as Hostages:Threats “I will punish you if you lower prices” • Price Matching Guarantee • If any competitor offers a lower price, I will match it

  17. Price Matching Guarantee Firm 2 Firm 2

  18. Customers as Hostages • Price matching guarantees and most favored customer clauses exploit: • customer price sensitivity • customer price awareness • low customer switching costs • Exactly the factors that make price competition brutal!

  19. Increasing Search Costs:Theory • It costs a consumer a transportation cost, t, to “visit” another firm • If consumers expect prices of pe, how much should you charge? • Can charge up to pe + t • But, if you iterate this • If you charge pe+t, competitor can charge pe+t+t, but then you can charge pe+t+t+t

  20. Increasing Search Costs:Implementation • Prevent price advertising • Government regulation (liquor stores) • Industry agreement (likely illegal) • Professional trade groups (doctors) • Limit store hours • Closing laws (florists) • Obfuscate price information (Dilbert “confusopolies”) • Provide “one at a time” pricing (airlines) • Require visit (grocery stores) • Make comparison difficult (mattresses, insurance) • Use multiple prices (banking, auto dealers)

  21. Cooperation Summary • Question the assumptions • Firms: • Market power, differentiation • Capacity limits, firm incentives • Consumers • Price sensitivity, price awareness • Costs of switching and search • Interaction • Fear of punishment • Long-term relationships, uncertain duration

  22. Commitment Under Uncertainty • An offer you can’t refuse • After a seemingly successful interview, the interviewer asks where the firm ranks on your list of potential employees • Before answering, you are told: • The firm only hires applicants who rank it first • If the firm is in fact your first choice, then you must accept a job offer in advance, should one be made

  23. Commitment Under Uncertainty • Why make such proposals? • Take advantage of your uncertainty • Take advantage of your risk-aversion • Make you commit before they do! • Binding early-decision college applications

  24. Flexibility vs. Commitment • Must balance: Value of commitment • Strategic importance of commitment generates value Value of flexibility • The ability to keep your options open generates value • Option Value • The additional expected profit from remaining flexible above the expected profit earned from committing

  25. Example: Option Value • A firm can spend $100 million on an investment to enter a new market • Market demand uncertain: High acceptance: revenues of $300m (Probability=0.5) Low acceptance: revenues of $0m (Probability=0.5) • Two options: • Invest today in the presence of uncertainty • Wait a year for full revelation of information

  26. Calculating Option Value Immediate investment: Exp. Profit = (1/2)(300-100) + (1/2)(0-100) = $50 million Delayed investment: Only invest if high acceptance Exp. Profit = (1/2)(300-100) + (1/2)(0) = $100 million • Option Value: $100 - $50 = $50 million

  27. Calculating Option Value The science • Option Value: $100 - $50 = $50 million The art • Countervailing forces: • By waiting, the firm risks failing to capitalize fully on the opportunity. • By waiting, the firm risks having the opportunity pre-empted by competitors. • What to do?

  28. Philips, N.V. • Commitment in CD introduction • Philips: innovator’s advantage • Initiate construction of plant ahead of competitors • Decision problem of Philips in 1982: • Build a disk-pressing plant in the U.S. and invest in a substantial amount of capacity to deter potentially entry (Sony, etc.) • Delay decision until commercial appeal of CDs can be determined. Import CDs to the U.S. To “test the waters.”

  29. Option Value: Three Cases q probability of mass acceptance of CDs • Monopoly Benchmark: • Philips should wait if q < 0.380 • Sony competition, equal information • Philips should wait if q < 0.006 • Sony competition, better information • Philips should wait if q < 0.130

  30. Option Value: Summary • Pure option value • In the absence of competition, Philips is better off waiting and retaining flexibility if the probability of acceptance is less than 38%. • Commitment value • Faced with competitors who are as well informed, Philips is better off building the U.S. plant right away even in the presence of uncertainty. • Informational advantage • Given proprietary information obtained through its CD operations in Europe, Philips is better off remaining flexible if the probability of acceptance is less than 13%.

  31. Resolution • Philips did not build a U.S. Plant in 1983 • Its assessment of the likelihood of general acceptance did not meet the threshold • Market realization (surprise!) • Sony constructed a U.S. Plant in 1984 • Terry Haute, Indiana • Philips attempted to compete • Increased capacity in Hanover, Germany plant • Philips decided to invest in a U.S. Plant • Only after the Sony plant was fully operational

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