Economic Concepts for Strategy

1. Economic Concepts for Strategy Learning Objectives: Appreciate that much of Strategy is grounded in Economic principles Enhance your ability to apply Economic and Game Theory principles to strategy formulation

2. Economic Costs • Costs may be sunk or avoidable • Costs may be fixed or variable – the difference often depends on the time-frame of the decision at hand • Marginal costs • Average cost = total cost / quantity • Average cost curves are often “U-shaped” or L-shaped”

3. Average Cost Curves AC1 Average cost AC2 Quantity

4. Demand and Supply Supply Price Demand Quantity

5. Price Elasticity of Demand Curve Db shows greater demand elasticity P1 P0 Price Db Da Q0 Quantity

6. Factors That Increase Demand Elasticity • Few product features that differentiate it from rivals • Purchase price represents a large share of buyers total cost and/or buyer’s customers are sensitive to price increases • Comparisons of substitute products is easy • Switching costs are low

7. Game Theory: The Science ofStrategic Decision Making When situations involve choices of two or more ‘rational’ decision makers, game theory offers a toolbox for modeling interactive decisions and a solution or normative prescription for choosing between alternatives. While a comprehensive understanding of the science of game theory could take a lifetime, some of the fundamentals that follow can be quickly learned and applied.

8. Basics of Game Theory • A game is a situation where: • Two or more players • Play is governed by a set of rules • Players have well defined outcomes • Outcomes are interdependent • Game Theory - study of games and their solutions. All games have solutions! • Solution - an outcome or intersection of strategies where no player has an incentive to change her decision (equilibrium).

9. What AssumptionsDo We Need to Make? • Players are rational • prefer more to less • preferences are transitive (if a>b, and b>c, then a>c) • preferences can be rank ordered • player cares only about his/her payoff • Although we say $, we mean U (utility) Are these controversial?

10. Why Study Game Theory? • Gain appreciation and understanding of interactive decision making • Learn to model decision situations • Learn new techniques to solve problems

11. Important Terms • Extensive v. Normal form - type of representation decision tree v. decision matrix • Simultaneous v. sequential games - refers to the order of decisions • Outcomes - terminal nodes or payoffs; the end of the game • Information set - node or group of nodes that indicate who’s turn it is, and what the player knows • Decision node - point where a player must take action, decide or choose • Value of game – what a player can expect to earn, given optimal play

12. Important Terms - cont’d. • Strategy - complete specification of play for the game; a plan that identifies a course of action for every decision point • Symmetric v. asymmetric games - refers to players’ relative payoffs and information • Zero sum games - payoffs are diametrically opposed, and together they sum to zero • Constant sum games - payoffs are diametrically opposed • Backward induction - solution concept for sequential games

13. Solution Technique - Extensive Form Games • Backward Induction - Look Forward, Reason backward Start at the payoff nodes and work backwards (backward induction), pruning the branches (alternatives) that will not be chosen.

14. (6, 6) P2 (2, 7) P1 (4, 3) P1 P2 (3, 6) (5, 2) Extensive Form Games – Sample Problem What is the solution to this game?

15. Extensive Form Games – Sample Problem (5, 4) P1 3/4 (4, 10) N (2, 8) P2 1/4 (3, 3) (1, 9)

16. Extensive Form Games – Sample Problem P1 What’s going on here? P2 P2 P1 P1 (0, 0) (4, 2) (2, 2) (3, 4) (3, 3) (2, 5) (4, 2) (2, 4)

17. Normal (Matrix) Form Games • Simultaneous decisions • Payoffs in each cell: (row, column) • 2 x 2 games, and beyond • Solution concepts: • successive elimination of dominated strategies • Pure strategy Nash Equilibrium • Mixed strategy Nash Equilibrium

18. Choosing a Cover StoryTime v. Newsweek News magazines choose cover stories based on what sells (% market share). Given these payoffs, which stories do the magazines cover?

19. Rational Pigs Imagine two pigs; one large and dominant, the other small and subordinate. One of them must push a lever at the end of the corral, then run to the trough for the food reward. Which one pushes the lever?

20. Exercise - TV Programming Two networks (HTV and DTV) are considering their programming options for a one-hour time slot. Each has a choice between a sitcom and sports. Past research has shown that if each choose sitcoms, HTV will get 55% of the market. If HTV chooses sports and DTV choose sitcom, each gets 50%. If each chooses sports, DTV get a 55% share. If HTV chooses sitcom and DTV chooses sports, DTV gets a 48% share. Given these payoffs, what choices does game theory predict?

21. Prisoner’s Dilemma (PD) Game • PD – a situation where each player has a dominant strategy and playing their dominant strategy leads to an outcome that is less-preferred by all. • Example:

22. OPEC Oil Production • Iran and Saudi Arabia each have a choice of low (2M barrels) or high (4M barrels) oil output. Their payoffs are given in the table below. What is the solution to this game? Is this the game these countries actually play?

23. Nash Equilibrium • Definition - a profile of strategies, one for each player, such that each strategy is the best response to that of the opponent(s). If every player plays his “Nash” equilibrium strategy, no player would have an incentive to deviate. • Nash proved that every game has at least one equilibrium, albeit in mixed strategies. • Problems with the Nash Equilibrium solution concept • Is it reasonable? • How do players arrive at a Nash Equilibrium? • How do player choose between multiple Nash equilibria?

24. Example of Nash Equilibrium

25. Example - Dating Game Jim and Nancy make a date for Monday night, however due to a confusing series of phone messages, neither knows where they agreed to meet - at the fight or ballet. Given their respective payoffs shown below, what would game theory predict as the outcome for the game?

26. Example - Chicken • James and Dean are playing the “hotrod” version of chicken, where each driver speeds toward each other, determined to “stay the course. What is the solution to this encounter, given that the payoffs are in ego-units?

27. Games With Only Mixed Strategy Solutions • Simplified football example – payoffs are yards from scrimmage (offense), yards to go for first down on next play (defense): How should each team play?

28. Exercise – Let’s Play Tennis Chris is serving to Pat, and can serve to the forehand (F) or backhand (B). Pat may anticipate F or B. When Chris serves to the forehand and Pat anticipates forehand, Pat wins 90% of the points; if Pat anticipates B, he wins only 30% of the points. If Chris serves B, and Pat anticipates B, Pat wins 60% of the points, and loses 80% of the points if he anticipates F. Based on game theory predictions, how should each play? Which player has an advantage in this game?

29. Successive Elimination WithMore Than Two Strategies • Sometimes strategies can be eliminated successively to find a Nash equilibrium.

30. Sample - Combined Techniques • Sometimes you can employ different techniques to arrive at the equilibrium of a game.

31. Location Games • Imagine two vendors are deciding where to setup their beer stands on a uniformly crowded beach. Assuming customer will always visit the closest stand, where do they setup?

32. More Complicated Games • Bargaining • Ultimatum bargaining • Queuing • Market entry

33. … In Summary … • We’ve examined several game-theoretic solution concepts, including • Backward induction • Elimination of dominated strategies • Pure strategy Nash equilibrium • Mixed-strategy Nash equilibrium • Game theory has been welcomed in many academic disciplines, including psychology, biology, anthropology and economics. • Why do we see so much resistance in the field of strategy? • What concerns or criticisms do you have?