The Industrial Economy: Strategy

Revision Session – 28th April 2015

Revision Session

o Office Hour: Next Friday 8th May 10:30-12:00 (S1.114)

o Main Themes of the Module

o Recap on Seminar Topics

o Past Exam Questions

Main Themes of the Module

o What is a firm and why do they exist?

o Why do some firms succeed where others fail?

o How do strategic considerations influence their behaviour?

Much of the module (particularly the second half) used game theory to answer these questions.

Game Theory (1) A ‘game’ is a model of interactive decision making

Multiple parties making strategic decisions

Specify:» Parties with decisions to make (Players)» Different choices available (Strategies)» Outcomes for each combination of choices (Payoffs)

Strategy A2 Strategy B2

Strategy A1 * , * * , *

Strategy B1 * , * * , *

Game Theory (2) In some games we can find strategies which are always individually optimal for the players (e.g. Prisoner’s Dilemma).

Confess Stay Quiet

Confess -5 , -5 0 , -10

Stay Quiet -10 , 0 -1 , -1

» Dominant strategies are stable with respect to choice of other player

The strategy ‘Confess’ is always best. No matter what the other player does: Dominant Strategy

Game Theory (3) o Often there is no dominant strategyo We have to take a step back and instead look at stable

outcomes

o Concept used: Nash Equilibrium» Outcome where every player plays a best response

(E.g. Chicken)

Swerve Stick

Swerve 0 , 0 -2 , 10

Stick 10 , -2 -20 , -20

Three Canonical Games Studiedo Prisoner’s Dilemma Games

» Application: Pricing, Cartels, Team Production

o Coordination Games (Battle of the Sexes)» Application: Industry Standards

o Anti-Coordination Games (Chicken)» Application: Patent Race, Quality Game

Seminar Topics (1)

Seminar 1: Contracts Why are they needed?

Types and pros/cons

(Anti) Coordination Problem(Quality Game)

What will happen?

First mover advantage

Seminar 2: Innovation Free rider problem

Design of patents

(Anti) Coordination Problem(Raider Game)

How do we model this?

What will happen?

Seminar Topics (2)

Seminar 3: Cost of Capital Why is it important?

Calculation

Product Differentiation Outcome of Bertrand

(Beach Restaurants) Local monopoly

Seminar 4: Prisoner’s Dilemma Applications

Repeated game

Duopoly Models Bertrand assumptions

Cournot model

2010/2011 Exam – Q2

2010/2011 Exam – Q2 (a)A B

A x , y 2 , 2

B 1 , 1 y, x

o General features of Battle of the Sexes:» Players prefer to play the same strategy as the other player» No dominant strategy» Two equilibria*» In each equilibrium the person playing their ‘favourite’ strategy is

better off

o Need (A,A) and (B,B) to be equilibria, so adjust payoffs to make them so

2010/2011 Exam – Q2 (a)A B

A x , y 2 , 2

B 1 , 1 y, x

o Need x>1 and y>2 (so P1 wishes to coordinate with P2)o Need y>2 and x>1 o But we also need that x>y

So, x=4 and y=3 will work!

2010/2011 Exam – Q2

2010/2011 Exam – Q2 (b)A B

A 4, 3 2 , 2

B 1 , 1 3, 4

o This is a coordination game: No dominant strategy

o Hard to tell what will happen if the game is played once!» Players may try guess what the other will do and play the same» Possibility of miscoordination» Any outcome feasible

o Long run -> (A,A) or (B,B)

2010/2011 Exam – Q2

2010/2011 Exam – Q2 (c)Division A Division B

Division A 4 , 3 2 , 2

Division B 1 , 1 3, 4

o A firm has some free cash flow to allocate to either: Division A, Division B or Shareholders

o Managers of A and B must lobby for resources» If managers do not agree then cash flow released as dividend

o Managers incentivised by division and company bonuses» Would prefer to allocate resources to their own division but both

prefer for it to stay within the firm

o Other example: Format wars (E.g. HD DVD v Blu Ray)

2010/2011 Exam – Q2

2010/2011 Exam – Q2 (d)

How to solve the coordination problem:» Need some way to solidify expectations

1. Reputation2. Signalling / Communication3. Convention4. Commitment

A B

A 4 , 3 2 , 2

B 1 , 1 3, 4

2009/2010 – Q5

2009/2010 - Q5 (a) A B

A w , -4 3 , x

B -1 , y 0, z

o General features of Chicken:» Player prefer to do the opposite of the others’ action » No dominant strategy» Two equilibria*» In each equilibrium the person playing A has higher payoff

o Need (A,B) and (B,A) to be equilibria, so adjust payoffs to make them so

2009/2010 - Q5 (a)

o Need w<-1 for player 1 (B is better if 2 plays A)o Need x>-4 for player 2 (B is better if 1 plays A)o Need y>z (A is better if 1 plays B)o (Also know game is symmetric)

So, w=-4, x=-1, y=3 and z=0 will work!

A B

A w , -4 3 , x

B -1 , y 0, z

2009/2010 – Q5

2009/2010 - Q5 (b)

o There is no dominant strategy» No strategy which is always best

o If this game were played once, anything can happen» Any outcome can be rationalised e.g. (A,A)

o In the long run we would expect convergence to (A,B) or (B,A)

A B

A -4 , -4 3 , -1

B -1 , 3 0, 0

2009/2010 – Q5

2009/2010 - Q5 (c)

o Consider an innovation which is both ‘product’ & ‘process’

o Innovation allows innovator to:1. Produce existing product more cheaply2. Produce a new product which is a substitute to existing product

o If one innovates and other does not -> innovator dominanto If both innovate they incur cost but do not differentiate

o Other examples: Quality Game, Raider Game

Innovate Hold Back

Innovate -4 , -4 3 , -1

Hold Back -1 , 3 0, 0

2009/2010 – Q5

2009/2010 - Q5 (d)

How to solve the coordination problem:» Need some way to solidify expectations

1. Reputation2. Signalling / Communication3. Convention4. Commitment

A B

A -4 , -4 3 , -1

B -1 , 3 0, 0

2009/2010 – Q5

2009/2010 - Q5 (e)

Assume Player 1 goes first:o Whatever they pick, opponent will pick the oppositeo Optimal for Player 1 to select A, forcing other to select B

o Order of play tends to matter when there are multiple equilibria

A B

A -4 , -4 3 , -1

B -1 , 3 0, 0

2010/2011 Exam – Q4

2010/2011 Exam – Q4

o Quick discussion of Bertrand model » (2-3 paragraphs max)

o Move on to Hotelling model» Describe setting: Duopoly, differentiation along

one aspect, no fixed cost, consumers care about ‘position’, fix firms ‘position’ and choose price

o Give an example and show P=MC is not an equilibrium

o Find new equilibrium (if you have time): » D1 = Location of ‘Marginal Consumer’» Write profit function» Differentiate wrt price to get best responses» Solve for P1 and P2 (plug in to get profits)

2010/2011 Exam – Q4

o What if: » Entry? » Sequential moves? » Position also variable?

2010/2011 Exam – Q4

Final Advice

1. Get an overview of how the topics fit together (it will be difficult to study some parts and ignore others)

2. Become comfortable expressing points and examples in the form of diagrams and games

3. Make sure you clearly understand the techniques used in the seminars

4. Weigh up the pros and cons of different question types5. Past exam questions 6. Look at Daniel’s advice in lectures 10 and 20