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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. WXYZ Ask Size BEST 77 100 ABSB 77¼ 100 DEAN 77½ 100 CHAS 77¾ 100 MIKE 78 100 NASDAQ Order Preferencing • 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?

  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 • Change in others’ behavior from your committing to some course of action generates value Value of flexibility • Keeping your options open and remaining flexible allows you to react to changing situations (option value)

  25. 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.”

  26. Calculating Option Value The science • Option Value: • Added profit from flexibility (can’t lose) The art • Countervailing forces: By waiting, the firm risks: • Failing to capitalize fully on an opportunity. • Having the opportunity preempted by competitors. • What to do?

  27. Philips, N.V. (continued) q probability of mass acceptance of CDs • Pure option value • In the absence of any competition Philips should wait if q < 0.380 • Commitment value • If Sony is as well informed about the market as Philips Philips should wait if q < 0.006 • Informational advantage • Because of proprietary market information obtained through its CD operations in Europe: Philips should wait if q < 0.130

  28. 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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