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Decoding StrategyDecoding StrategyPatrick McNuttPatrick McNutt

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www.patrickmcnutt.comAbridged Abridged ©©

Why the game theory focus? Real companies at the frontier of economic

analysis…..• Understand management as ‘they are’ not as theory

‘assumed them’ to be• Management can be ranked (by type) and are faced with

indifference trade-offs => something must come ‘top of the menu’: the 3rd variable or z. Trade off (x, y) to max z.

• Firms are conduits of information flows (vertical chain)• Supply chain capacity constraints and technology-lag• Reducing price does not necessarily lead to an increase in

revenues (elasticity)• Prices are primarily signals (observed behaviour)• Companies understand the competitive threat as

(recognised) interdependence (zero-sum and entropy)• Predicting competitor reaction: price and entry strategies.

Lesson Plan Smurfit 2015

• Learning Plan is to follow McNutt’s Decoding Strategy and selected Chapters from Besanko’s Economics of Strategy

6th.• Theme A: Market-as-a-Game and Player types (Vertical

Boundaries of the Firm, Agency and Co-ordination) and Introduce capacity building (as Economies of Scale and Scope)

• Theme B: Game Dimension with Bertrand and Cournot Case Analysis

• Theme C: Economics of Strategy - from behavioural analysis to understanding and application of extensive form and normal form games.

Planned Case Focus

• What is game theory about? Relevance to MBA learning.

• Management as a player with type and relevance of TCE: Besanko Ch 3 & 4 and 5, McNutt Ch 1

• Cost leadership and economics of capacity: Besanko Ch 2 and McNutt Ch 5

• Dynamic price games, entry deterrence, market structure, oligopoly, signaling & Nash payoffs. Besanko Ch 5,6,7 and 8 and McNutt Ch 6-9.

• Patterns and Real Time case Analysis…go to Appendix in Decoding Strategy text.

What is game theory about?Visit www.patrickmcnutt.com

• Observed behaviour (inductive) in a game, G.• Identify the players in the game and the player’s type.

Finding the patterns in rival behaviour.• Game => information on opponent type, recognised

interdependence, action-reaction, belief systems.• Payoff depends on what each player believes about the

other.. Updating belief systems. • What is a player’s true payoff? Independence v

interdependence; one-shot v repeated play.• Consumers’ preferences as technology in a game.

Decoding Strategy & Pattern Sequencing

Complete knowledge on the type and complete information of the identity of a near rival:

Actionyou -> Reactionnear-rival ->…

..-> Reactions……NashReplyyou…..

Strategy defined in terms of an equilibrium: how well either player does in a game depends on

what each player believes the other player will do.

Example A: What is type?

If you believe it to be true that Leo the Liar will never tell the truth, how do you respond to his helping hand as you cling for your life over the precipice of a cliff? Do you ignore his helping? Do you rely instead on the many apps on your smartphone, so tightly grasped in your other hand, trying to make contact with your best friend to come and rescue you?

Define Strategy

Cooperation arises in this instance if you and Leo as players in a game can infer from past behaviour that both of you are likely to be trustworthy. Leo may forgo the short term gain of keeping to type for the long term benefit of your friendship. He rescues you from the cliff. You, however, will use the experience in order to determine whether or not to believe Leo in the future.

Example B:

Player’s belief system

Your company’s strategy is s1: delayed launch of a new innovative product for 2 years. Rumors do appear of an impending launch date. You do not deny such rumors. In the interim, an article appears a reputable trade journal reporting that a not dissimilar product is about to be launched by your competitor in the next few weeks.

Define Strategy

Do you stop and think about s1? Do you reshape your strategy to s2: launch the product as soon as possible?

Costs of not being a Player

• Agency costs can accrue across the shareholders (esp institutional & activist shareholders)..changing CEOs.

• Bounded rationality and opportunity costs with trade-offs

• Make or Buy dilemma• First Mover Advantage (FMA) v Second Mover

Advantage (SMA)• Play to win v Play not to lose!• Follower status ‘behind the curve’• Technology lag and failure to differentiate ‘fast enough’

to sustain a competitive advantage• Near rival will try to minimise your gains by playing a

minimax strategy

Payoffs reflect preference order. Guaranteed a 2 but there is an elusive 3

What if? Strategy I: cooperateWhat if? Strategy II: compete.

Then if I is the consensus……..?

Strategy I Strategy II

Strategy I 2,2 0,3

Strategy II 3,0 1,1

Why the emphasis on behaviour (of players)?

• The Firm as a ‘nexus of contracts’• Vertical chains and agency costs

• Make-buy dilemma & incomplete contracting

=> embedded patterns of behaviour

• Type of management & Bounded rationality• Shareholders-as-principals and management-as-agent..

• The industry as a ‘market-as-a-game’

=> players with a playbook

KPIs, Trade-off function & Management Models

• Indifference and trade-off (X,Y): What is the 3rd variable, Z? Any KPI = Z by trial-and-error or player type reveals Z.

• Premise: knowledge on the type and information of the identity of a near rival translates into a Penrose effect with Bounded Rationality

• Go to Table 1.2 pp21 McNutt Decoding Strategy: Compare with Next Slide where we add in Williamson/TCE.

Behavioural Baumol Marris Williamson

Objective Multiple goals TR:Sales Growth:gd Managerial Utility or Value

Approach Satisficing – subject to Profit

Constraint

Maximisation– subject to

Profit Constraint

Maximisation - subject to

Security Constraint

Maximisation - subject to Profit Constraint

Principal Agent Issue

Yes Yes Yes Yes

Short v Long Term

Varies Short and also dynamic

Long Short

Reaction & Interaction

Yes Partial Partial Partial

Decision Making Coalitions

Yes Management and zero-sum

Relevance of shareholders

Yes,..TCE

Total Revenue

Total Cost

Profit/LossSales driven beyond the point of max profit but within the minimum profit constraint

Min Profit Constraint

Output

£

Cost leadership [CL]as a type (of player)

• Profitabiltiy v scale and (size and scope)• Production as a Cost-volume constraint

• Understanding the economcis of productivity as exemplar for incentives

• Normalisation equation• Sources of Cost Efficiency [next slide]

• Cost leadership 5 Steps Checklist..McNutt p78

Sources of cost efficiency• Measure of the level of resources needed to

create given level of value

Production-cost relationship

Production-cost relationship

Capacity utilisation

How much to produce given capital size?

Capacity utilisation

How much to produce given capital size?

Economies of scale

How big should the scale of the operation be?

Economies of scale

How big should the scale of the operation be?

Other

X-inefficiencies, location, timing, external environment, organisation discretionary policies

Other

X-inefficiencies, location, timing, external environment, organisation discretionary policies

Transaction costs

Which are the vertical boundaries of the firm?

Transaction costs

Which are the vertical boundaries of the firm?

Economies of scope

What product varieties to produce?

Economies of scope

What product varieties to produce?

Learning and experience factors

How long to produce for?

Learning and experience factors

How long to produce for?

£

Q0,0

SAC1SAC2

SAC3 LAC

q1q2

Lower per unit cost for more units sold

qt

Current plan of plant closures to lower cost base not completed

Av.Cost = marginal cost

MES Point: Production - demand - productionto attain cost leadership

Why? Capacity Constraints:

• Case A: Unexhausted economies of scale due to product differentiation

• Case B: Firm-as-a-player does not produce large enough output to reach MES

• Case C: Firm-as-a-player restraints production (deliberate intent)..McNutt’s dilemma as production drives demand…(Veblen monopoly type)

• Convergence of technology increases the firm-specific risk of Case C:

• Strategic Choice A or B or C?

Game type and signalling• Decisions are interpreted as signals• Observed patterns and Critical Time

Line (CTLs). Go to Appendix in McNutt• Recognition of market interdependence

(zero-sum and entropy)• Price as a signal v Baumol model of TR

max• Scale and size: cost leadership• Dividends as signals in a Marris model

Maximising Market Share: Table 1.1 p9 McNutt

• Recognise zero sum constaint and entropy (redistribution within market shares)

• Market Shares (before): 40+30+20+10• Zero-sum (after): 30+40+20+10• Entropy (after): 30+35+25+10• Hypothesis: Iff {∆qi/∆Q} > 0 market

exhibits non-price competition:• Check {∆qNOKIA/∆QSmartphones} < 0

Oligopoly,Games & T/3 Framework

• Study of strategic interactions: how firms adopt alternative strategies by taking into account rival behaviour

• Structured and logical method of considering strategic situations. It makes possible breaking down a competitive situation into its key elements and analysing the dynamics between the players.

• Key elements:• Players. Company or manager.• Strategies.• Payoffs

• Equilibrium. Every player plays her best strategy given the strategies of the other players.

• Objective. To explore oligopolistic industries from a game embedded strategy (GEMS) perspective.

• The use of T/3 framework, which considers 3 key dimensions (Type, Technology & Time), will allow players to better predict the likely strategic response of competitors when analysing rival competition.

Player Type & Game analysis

• Binary reaction; Will Player B react? Yes or No?

• If YES, decision may be parked

• If NO, decision proceeds on error

• Surprise

• Non-binary reaction: Player B will react. Probability = x%

• Decision taking on conjecture of likely reaction

• No Surprise

The competitive threat!• Traditional Analysis is focused on

answering this question for Company X:

what market are we in and how can we do better?

• Economics of strategy (T/3) asks: what market should we be in?

Describe (prices as signals) game

dimension• Players and type of players• Prices interpreted as signals• Understand (price) elasticity of demand and

cross-price elasticity• Patterns of observed behaviour• Leader-follower as knowledge• Accommodation v entry deterrence• Reaction, signalling and Nash equilibrium: ‘best

you can do, given reaction of competitor’

Perfect market: perfect competition

• Defining a perfect market as follows:If ΔPi increases, then the firm’s output = 0

or rivals follow the price increase.• In a perfect market price differences cannot

persist across time• Perfect competition = perfect market + near

rivalsSo perfect market ≠> perfect competition but

perfect competition => perfect market

Type of Players• Incumbent type v entrant type• Dominant type v predatory incumbent • De novo entrant type and geography of

the market• Potential entrant type and the threat of

entry as a credible threat• Contestable markets, newborn players

and extant (incumbent) type

Entry Deterrent Strategy & Barriers to entry

• Reputation of the incumbents• Capacity building• Entry function of the entrant• De novo and entry at time period t• Potential entrant - forces reaction at

time period t from incumbent• Coogan’s bluff strategy (classic poker

strategy) and enter the game.

Game Strategy• Nash premise: Action, Reaction and CV matrix• Non-cooperative sequential (dynamic) games• TR Test McNutt pp48..one-shot move• Limit price [to avoid entry] and predatory pricing to

force exit.• Near rival plays Minimax, so I play Maximin [focus on

my worst minimum payoff and try to maximise].• Segmentation strategy to obtain FMA• Relevance of ‘chain-store’ tumbling price paradox• Dark Strategy and 3 Mistakes in McNutt pp117-118

Game Dimension• Constructing an action-reaction sequence of

moves in search for a pattern.• Non-cooperative sequential (dynamic) games• Normal form game dimension with payoff

matrices, wherein payoffs reflect preference order.

• Dominant strategy, Prisoners’ dilemma, Nash equilibrium.

• Extensive form game dimension with decision tree and backward induction

Limit Pricing Model in Besanko pp207-211 and McNutt

pp85-88

• Outline the game dimension: dominant incumbents v camouflaged entrant type

• Define strategy set for incumbents: commitment and punishment

• Allow entry and define the equilibrium• Extensive form preference - entry

deterrent strategy v accommodation [next slide]

1

2

Enter

0,10

-7,2

5,8

Do Not Enter

Agressive

Accommodating

Nash Equilibria & Prisoners’ Dilemma

• Define the Nash equilibria [next slide]• Analyse the Payoff matrix

(B,Y) > (A, X)• Commitment and chat: one-shot and

repeated play• Punishment ‘grim’ strategy• Strategy Set in terms of credible

mechanisms

10,10

8,-50,0

-5,8

Strategy A

Strategy B

Strategy X Strategy Y

Player 1

Player 2

Continuing with Unit 4: Define a price war

• Determine the Bertrand reaction function:• Besanko Fig 5.3 pp190 and McNutt Fig 9.4

p143• Compute a Critical Time Line (CTL)from

observed signals..Examples of CTL in McNutt in the Appendix

• Find a price point of intersection• Case Analysis of Sony v Microsoft at

McNutt pp 141-144 and also in Kaelo v2.0

26 Oct 00

15 Nov 01

14 May 02

15 May 02

13 May 03

14 May 03

29 Mar 04

1 Nov 05

30 Oct 05

PS2 launched at $299

Microsoft Xbox launched at $299

PS2 at $199.99

Xbox at $149

22 million Xbox shipped

TIMELINE – Pre 2006

Xbox at $199

PS2 at $179.99

Xbox at $179

PS2 at $149.99

11 May 04

100 million PS2 shipped

Xbox 360 launched at $399

22 Nov 05

Xbox at $179

6 Feb 06

20 April 06

PS2 at $129.99

27 April 06

Revised production schedule for Xbox 360 to 5- 5.5 million units by 30th June 2006

8 May 06

Announcement PS3 production schedule to ship 6 million units by 31 Mar 07 at $499

Absence of (observed) price wars? Folk Theorem

Link into the HBR articles

• Hypothesis: Bertrand Price Wars occur due to a mis-match in price signals.

• Mismatch can occur due to (i) declining volumes ∆qi/∆Q < 0; (ii) uncompetitive cost structure; (iii) decreasing productivity; (iv) management type (predator); (v) calling-my-bluff

• Price hierarchy and ‘folk theorem’ on focal points.

The ‘no signalling’

payoffs• Simultaneous game between A & B but common interest in coordinating strategies.

Player A never choose ‘Bottom’ if rational, only ‘Top’, and Player C should play weakly dominant ‘Left’.

• Problem of coordination where players have different preferences but common interest in coordinating strategies.

• One key application includes the battles for standards: • VHS by JVC vs Betamax by Sony in the 1980s• BlueRay DVD by Sony vs HD DVD by Toshiba in 2008• In 2015 iOS v Android v Win v Others

B

Left Right

ATop 3,3 1,2

Bottom 2,0 0,0

Application of ‘no signalling’ game: is there a FMA?

• Two rival companies must simultaneously decide which products to research.

• Does this example illustrate the concept of ‘first mover advantage[FMA]?

• How could companies signal? Check the cases and examples in class with Folk theorem

Product A Product B

Product A -2,-2 20,10

Product B 10,20 -1,-1

Minimax criteria.

If you look at examples in the book Decoding Strategy pp148-151 we discuss this next slides for Near-rival v Apple but it can be applied here also in any market-as-a-game

Strategy

Simply, identify the near rival [reacting first] and set up the game tree assuming that near-rival plays minimax, that is, confining you to the least of the greatest market shares in the game - so then you play maximin, to maximise the least loss.

 n          

  Player BS4

 S5

 S6

 S7

Row MinimumMaximin strategy by A

Player A: S1

 95

 5

 50

 40

 5

S2 60 70 55 90 55S3 30 35 30 10 10

Column maximumMinimax strategy by B

 95

 70

 55

 90

 

Apple’s maximin = NR minimaxApple’s market shares

Near Rival Strategy A

Near Rival Strategy B

Row min

Apple Strategy 1

20 60 20

Apple Strategy 2

10 80 10

Column max

Minimax

20 80

20 Maximin

Apple’s ‘loading the dice’ strategy

Apple’s market shares adapted from pp152 in McNutt..camouflage, mixed strategy

Near Rival Strategy A

Near Rival Strategy B

Apple Strategy 1

20 60

Apple Strategy 2

80 10

Visit Kaelo v2.0 and www.patrickmcnutt.com

• Check Examples of Critical Time Line in the Appendix of McNutt’s text Decoding Strategy.

• Play the PD game and investment game in Kaelo v2.0 as outlined in class

• Selfish gene [one-shot], dominant strategy to cheat. Schelling move, ‘loading the dice’.

• Near rival will play minimax – repeated play/learning and mixed strategy.

• ..

Thank you for listening………

Sapere aude

‘That which one can know, one should dare to know’