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Transcript of Business Economics Strategy and Games Decoding Strategy Patrick McNutt Follow @tuncnunc wwww wwww...
Business Economics Business Economics Strategy and GamesStrategy and GamesBusiness Economics Business Economics Strategy and GamesStrategy and Games
Decoding StrategyDecoding StrategyPatrick McNuttPatrick McNutt
Follow @tuncnuncFollow @tuncnunc
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’