Strategy
T. Kretschmer
MN3119
2013
Undergraduate study in
Economics, Management,
Finance and the Social Sciences
This is an extract from a subject guide for an undergraduate course offered as part of the
University of London International Programmes in Economics, Management, Finance and
the Social Sciences. Materials for these programmes are developed by academics at the
London School of Economics and Political Science (LSE).
For more information, see: www.londoninternational.ac.uk
This guide was prepared for the University of London International Programmes by:
T. Kretschmer, Professor of Business Studies, Ludwig-Maximilians-Universität, Munich,
Germany.
Acknowledgements
The author would like to thank Brooke Russell for her excellent assistance on the first
edition of the guide and especially her help with the extended activities. Thorsten Grohsjean,
Christina Finsterwalder and Sanja Rikanovic were very helpful in the revision of this guide,
in particular in putting together the guide to the in-chapter activities and the sample
examination questions.
This is one of a series of subject guides published by the University. We regret that due to
pressure of work the author is unable to enter into any correspondence relating to, or arising
from, the guide. If you have any comments on this subject guide, favourable or unfavourable,
please use the form at the back of this guide.
University of London International Programmes
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Published by: University of London
© University of London 2013
The University of London asserts copyright over all material in this subject guide except where
otherwise indicated. All rights reserved. No part of this work may be reproduced in any form,
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us know.
Contents
Contents
Chapter 1: Introduction........................................................................................... 1
1.1 Introduction to the subject........................................................................................ 1
1.2 Aims of this course................................................................................................... 1
1.3 Learning outcomes................................................................................................... 1
1.4 The structure of the course........................................................................................ 1
1.5 Use of the guide and hours of study.......................................................................... 2
1.6 Essential reading...................................................................................................... 2
1.7 Further reading......................................................................................................... 3
1.8 Online study resources.............................................................................................. 5
1.9 The examination and examination advice.................................................................. 6
1.10 The syllabus............................................................................................................ 7
Chapter 2: The evolution of strategic management as an interdisciplinary field... 9
Learning outcomes......................................................................................................... 9
Essential reading............................................................................................................ 9
2.1 Introduction............................................................................................................. 9
2.2 Early theories .......................................................................................................... 9
2.3 Michael Porter and the industrial organisation paradigm......................................... 10
2.4 Organisational economics....................................................................................... 10
2.5 Resource-based view, dynamic capabilities and leadership theory ........................... 11
2.6 A consensus definition of the field........................................................................... 11
2.7 Key concepts ......................................................................................................... 12
2.8 A reminder of your learning outcomes..................................................................... 12
Chapter 3: Analysis of market structure................................................................ 13
Learning outcomes....................................................................................................... 13
Essential reading.......................................................................................................... 13
Further reading............................................................................................................. 13
3.1 Introduction........................................................................................................... 13
3.2 Techniques of market definition............................................................................... 13
3.3 Market analysis with many firms............................................................................. 16
3.4 Key concepts.......................................................................................................... 18
3.5 A reminder of your learning outcomes..................................................................... 18
3.6 Sample examination questions................................................................................ 18
Extended activity: the commercial banking industry in the United States........................ 19
Chapter 4: Introduction to game theory and strategy.......................................... 21
Learning outcomes....................................................................................................... 21
Essential reading.......................................................................................................... 21
Further reading............................................................................................................. 21
4.1 Introduction........................................................................................................... 21
4.2 Static games........................................................................................................... 22
4.3 Dynamic games...................................................................................................... 27
4.4 Key concepts.......................................................................................................... 30
4.5 A reminder of your learning outcomes..................................................................... 30
4.6 Sample examination questions................................................................................ 30
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Chapter 5: Oligopolistic models of competition................................................... 33
Learning outcomes....................................................................................................... 33
Essential reading.......................................................................................................... 33
Further reading............................................................................................................. 33
5.1 Introduction........................................................................................................... 33
5.2 Preliminaries.......................................................................................................... 34
5.3 Bertrand competition.............................................................................................. 34
5.4 Cournot competition............................................................................................... 35
5.5 Comparing Bertrand and Cournot........................................................................... 36
5.6 Stackelberg leadership............................................................................................ 37
5.7 Product differentiation............................................................................................ 38
5.8 Key concepts.......................................................................................................... 39
5.9 A reminder of your learning outcomes..................................................................... 39
5.10 Sample examination questions.............................................................................. 39
Extended activity: articles on Airbus-Boeing competition ............................................... 40
Chapter 6: The resource-based view of the firm .................................................. 41
Learning outcomes....................................................................................................... 41
Essential reading.......................................................................................................... 41
Further reading............................................................................................................. 41
6.1 Introduction........................................................................................................... 41
6.2 Competitive advantages and resources................................................................... 42
6.3 Some examples of resources as sources of competitive advantage........................... 43
6.4 The dynamics of resource and capability building..................................................... 46
6.5 Key concepts.......................................................................................................... 47
6.6 A reminder of your learning outcomes..................................................................... 48
6.7 Sample examination questions................................................................................ 48
Extended activity: Dell Computer Corporation ............................................................... 48
Chapter 7: Strategic asymmetries – persistent dominance over time.................. 69
Learning outcomes....................................................................................................... 69
Essential reading.......................................................................................................... 69
Further reading............................................................................................................. 69
7.1 Introduction........................................................................................................... 69
7.2 Firm asymmetries – long- or short-term?................................................................. 69
7.3 Traditional sources of persistent dominance............................................................. 71
7.4 Dynamic capabilities............................................................................................... 75
7.5 Key concepts.......................................................................................................... 76
7.6 A reminder of your learning outcomes..................................................................... 76
7.7 Sample examination questions................................................................................ 76
Extended activity: competition in the wide-body aircraft market..................................... 76
Chapter 8: Organisation design............................................................................. 77
Learning outcomes....................................................................................................... 77
Essential reading.......................................................................................................... 77
Further reading............................................................................................................. 77
8.1 Introduction........................................................................................................... 77
8.2 Strategy and structure............................................................................................ 77
8.3 Organisation design and competitive advantage..................................................... 83
8.4 Key concepts.......................................................................................................... 83
8.5 A reminder of your learning outcomes..................................................................... 83
8.6 Sample examination questions................................................................................ 84
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Contents
Chapter 9: Value chain analysis: vertical relations................................................ 85
Learning outcomes....................................................................................................... 85
Essential reading.......................................................................................................... 85
Further reading............................................................................................................. 85
9.1 Introduction........................................................................................................... 85
9.2 Double marginalisation........................................................................................... 85
9.3 Vertical foreclosure................................................................................................. 88
9.4 Key concepts.......................................................................................................... 89
9.5 A reminder of your learning outcomes..................................................................... 90
9.6 Sample examination questions................................................................................ 90
Extended activity: outsourcing at Eriksson and Sony and Loews..................................... 90
Chapter 10: Vertical integration and transaction cost.......................................... 91
Learning outcomes....................................................................................................... 91
Essential reading.......................................................................................................... 91
Further reading............................................................................................................. 91
10.1 Introduction......................................................................................................... 91
10.2 Purchasing versus production costs....................................................................... 91
10.3 Coordination costs............................................................................................... 92
10.4 Proprietary knowledge.......................................................................................... 93
10.5 Transaction costs.................................................................................................. 94
10.6 Asset specificity.................................................................................................... 95
10.7 Alternatives to ‘make’ or ‘buy’............................................................................... 96
10.8 Key concepts........................................................................................................ 97
10.9 A reminder of your learning outcomes................................................................... 97
10.10 Questions for discussion..................................................................................... 97
Extended activity: athenahealth.................................................................................... 97
Chapter 11: Collusion.......................................................................................... 103
Learning outcomes..................................................................................................... 103
Essential reading........................................................................................................ 103
Further reading........................................................................................................... 103
11.1 Introduction....................................................................................................... 103
11.2 Stability of cooperation....................................................................................... 103
11.3 Extending the model........................................................................................... 105
11.4 Key concepts...................................................................................................... 107
11.5 A reminder of your learning outcomes................................................................. 107
11.6 Sample examination questions............................................................................ 107
11.6 Extended activity: the DeBeers diamond cartel.................................................... 107
Chapter 12: Strategic partnerships..................................................................... 115
Learning outcomes..................................................................................................... 115
Essential reading........................................................................................................ 115
Further reading........................................................................................................... 115
12.1 Introduction....................................................................................................... 115
12.2 Building capabilities........................................................................................... 115
12.3 Business and strategic partnerships..................................................................... 116
12.4 Equity ownership................................................................................................ 118
12.5 Key concepts...................................................................................................... 120
12.6 A reminder of your learning outcomes................................................................. 120
12.7 Sample examination questions............................................................................ 120
Extended activity: the EU aviation industry.................................................................. 120
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Chapter 13: Competitive dynamics..................................................................... 123
Learning outcomes..................................................................................................... 123
Essential reading........................................................................................................ 123
Further reading........................................................................................................... 123
13.1 Introduction....................................................................................................... 123
13.2 A framework to analyse competitive dynamics..................................................... 124
13.3 Key concepts...................................................................................................... 127
13.4 A reminder of your learning outcomes................................................................. 127
13.5 Sample examination questions............................................................................ 127
Chapter 14: Entry and entry deterrence.............................................................. 129
Learning outcome....................................................................................................... 129
Essential reading........................................................................................................ 129
Further reading........................................................................................................... 129
14.1 Introduction....................................................................................................... 129
14.2 Structural entry barriers...................................................................................... 130
14.3 Strategic entry barriers........................................................................................ 132
14.4 Summary............................................................................................................ 136
14.5 Key concepts...................................................................................................... 136
14.6 A reminder of your learning outcome.................................................................. 137
14.7 Sample examination questions............................................................................ 137
Extended activity: Dubai flowers and internet banking................................................. 137
Chapter 15: Research and development competition......................................... 143
Learning outcomes..................................................................................................... 143
Essential reading........................................................................................................ 143
Further reading........................................................................................................... 143
15.1 Introduction....................................................................................................... 143
15.2 Terminology........................................................................................................ 143
15.3 Innovation and market structure......................................................................... 146
15.4 Strategic issues in R&D....................................................................................... 151
15.5 Some further thoughts on R&D........................................................................... 155
15.6 Key concepts...................................................................................................... 156
15.7 A reminder of your learning outcomes................................................................. 156
15.8 Sample examination questions............................................................................ 157
Extended activity: discovering DNA............................................................................. 158
Chapter 16: Technology adoption........................................................................ 169
Learning outcomes..................................................................................................... 169
Essential reading........................................................................................................ 169
Further reading........................................................................................................... 169
16.1 Introduction....................................................................................................... 169
16.2 Adoption dependence......................................................................................... 169
16.3 Strategic technology adoption – option value...................................................... 170
16.4 Technology diffusion models............................................................................... 172
16.5 Key concepts...................................................................................................... 176
16.6 A reminder of your learning outcomes................................................................. 176
16.7 Sample examination questions............................................................................ 176
Extended activity: the adoption of Botox..................................................................... 177
Chapter 17: Network effects............................................................................... 181
Learning outcomes..................................................................................................... 181
Essential reading........................................................................................................ 181
Further reading........................................................................................................... 181
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Contents
17.1 Introduction....................................................................................................... 181
17.2 Network market structures.................................................................................. 182
17.3 Technology diffusion with network effects........................................................... 183
17.4 Generic strategies in network markets................................................................. 186
17.5 Fighting a standards battle................................................................................. 187
17.6 Key concepts...................................................................................................... 188
17.7 A reminder of your learning outcomes................................................................. 188
17.8 Questions for discussion..................................................................................... 188
Extended activity: Skype and digital cinema................................................................. 188
Appendix 1: Sample examination paper............................................................. 191
Appendix 2: Guidance on answering the Sample examination paper................ 193
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MN3119 Strategy
Notes
vi
Chapter 1: Introduction
Chapter 1: Introduction
1.1 Introduction to the subject
Let us begin this course with a wager: I bet you that, when opening
the business section of your local newspaper, you will find the word
‘strategy’ at least once per page. A Google search of ‘strategy’ throws up
1,010,000,000 hits. Narrowing this down to ‘business strategy’ leaves
us with 622,000,000 hits. That’s a lot of business strategy! There are a
large number of definitions of strategy, and I will not attempt to write my
own. There are also entire research fields of ‘business strategy’ ‘corporate
strategy’ ‘strategy content’ ‘strategy process’ ‘management strategy’
‘competitive strategy’ and so on, and I will not get into the fine distinctions
between one and the other. Much more, I will try to boil down ‘strategy’
to what most definitions have in common, and more importantly, I will
introduce a number of techniques that will be helpful in formulating,
analysing and implementing a strategy.
1.2 Aims of this course
In this course, you will not learn ‘how-to’ recipes of how to react to specific
situations. What you will learn is a way of thinking about such situations.
In management, as in economics, the right answer to almost any question
is ‘it depends’. What you will learn in this course is what the right answer
depends on and, given a particular set of circumstances, how you can
analyse the situation.
1.3 Learning outcomes
Once you have completed the course and done the Essential reading and
activities, you should be able to:
• use tools of strategic analysis and game theory to value and analyse
strategic options in real life.
In particular, you should be able to:
• anticipate the actions of a rational (that is, individually profitmaximising) rival and act accordingly.
1.4 The structure of the course
The course is structured in six parts: after this and the following
introductory chapter, the basic building blocks of strategic analysis are
introduced: market analysis, game theory and oligopoly competition. We
will refer back to these chapters often in later chapters, so you are advised
to spend a significant amount of time on these and make sure you have
understood the basic principles and techniques of these chapters. The
third part introduces the sources of competitive advantage – resources and
capabilities, strategic asymmetries and organisation design. These chapters
will aim to explain why firms are different, in what way and what makes
some firms more successful than others. The fourth part will study firms
and their relations to other firms. Why are some firms vertically integrated
and some not, and what are the implications of this? When do firms
cooperate with rivals, and what do partnerships among firms typically look
like? The fifth part takes a closer look at competition among firms – over
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MN3119 Strategy
time, and in specific situations like entry or research and development.
This is where we will use the tools of game theory we introduced in the
second part of the guide very intensively. In the final part we will look at
some of the particularities of high-technology industries. This part of the
guide may be considerably more demanding technically than the previous
ones, but by then you should have had enough opportunity to study, revise
and practise the concepts from previous chapters. See this final part as the
‘icing on the cake’ – after you have looked at many techniques and topics
in isolation, these last chapters give you an opportunity to look at some of
them in combination.
1.5 Use of the guide and hours of study
To help you get the most out of this course, you will be given a number
of examples and activities throughout each chapter. These will vary in
difficulty and style. When you read a chapter, try and do these as you go
along, and go back to the ones you had problems with the first time round
once you have completed the chapter.
At the end of the chapter, you will find a list of questions or exercises
designed to challenge you and to check if you have read and understood
the chapter. They are titled Sample examination questions. These precise
questions are unlikely to come up, but they should give you a general
impression of the level that is required in this course. If you are studying
this text in a group, you might want to consider discussing these questions
in a tutorial-style session at the end of each chapter.
As a further test of your skills, most chapters will have an Extended
activity in a separate section. This is a longer text, case study, interview,
quote etc. that illustrates some of the concepts in the chapter, and gives
some concrete questions at the end. These activities will test your overall
grasp of the chapter and are often not limited to one chapter or one topic.
The advice normally given to International Programmes students is that
if they are studying one course a year, they should allow at least six hours
of study every week. Most of the chapters are relatively short compared to
regular textbook chapters. Therefore, a chapter should be read all in one
go to give you a general idea of what it is about. After that, you should set
some time aside to work through the chapter properly. Times will vary for
every student and every chapter.
Sample examination questions and extended activities will probably
take very little time if you just glance over them and sketch them out in
your mind. It is recommended, however, that you write out some of your
answers as you may find that a casual thought will not look as convincing
if you write them out on paper and you need to have a clear, coherent and
logical argument.
1.6 Essential reading
For many chapters, the Essential reading is:
Cabral, L.M.B. Introduction to Industrial Organization. (Cambridge, MA: MIT
Press, 2000) [ISBN 9780262032865].
The chapters in the book will often clarify points and go a little further,
but you will find most of the points covered in the subject guide chapters
are also covered in Cabral. Reading further often highlights some specific
aspects of the chapters or describes some of the research findings
explained in the chapter. If you would like to get another perspective on
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Chapter 1: Introduction
strategy from an economics viewpoint, you should have a look at
Besanko, D., D. Dranove, M. Shanley and S. Shaefer Economics of Strategy.
(New Jersey: Wiley, 2009) fifth edition [ISBN 9780470484838].
or
Saloner, G., A. Shepard and J. Podolny Strategic Management. (New Jersey:
Wiley, 2006) revised edition [ISBN 9780470009475].
Detailed reading references in this subject guide refer to the editions of the
set textbooks listed above. New editions of one or more of these textbooks
may have been published by the time you study this course. You can use
a more recent edition of any of the books; use the detailed chapter and
section headings and the index to identify relevant readings. Also check
the virtual learning environment (VLE) regularly for updated guidance on
readings.
Journals
Dierickx, I. and K. Cool ‘Asset stock accumulation and sustainability of
competitive advantage’, Management Science 35(12) 1989,
pp.1504–511.
Dyer, J. and H. Singh ‘The relational view: co-operative strategy and sources of
interorganisational competitive advantage’, Academy of Management Review
23(4) 1998, pp.660–79.
Haskel, J. and C. Martin ‘Capacity and competition: empirical evidence on UK
panel data’, Journal of Industrial Economics 42(1) 1994, pp.23–44.
Lexecon Ltd ‘An introduction to quantitative techniques in competition
analysis’, Lexecon Ltd. publication, mimeo. www.crai.com/ecp/assets/
quantitative_techniques.pdf
Swaminathan, A. ‘Entry into new market segments in mature industries:
endogenous and exogenous segmentation in the US brewing industry’,
Strategic Management Journal 19(4) 1998, pp.389–404.
1.7 Further reading
Please note that as long as you read the Essential reading you are then free
to read around the subject area in any text, paper or online resource. You
will need to support your learning by reading as widely as possible and by
thinking about how these principles apply in the real world. To help you
read extensively, you have free access to the VLE and University of London
Online Library (see below).
For your ease of reference here is a list of all the Further reading for this
course.
Angelmar, R. ‘Market structure and research intensity in high-technologicalopportunity industries’, Journal of Industrial Economics 34(1) 1985,
pp.69–79.
Arora, Alfonso Gambardella ‘Complementarities and external linkages: the
strategies of large firms in biotechnology’, Journal of Industrial Economics
38(4) 1990, pp.361–79.
Barney, J.B. ‘Firm resources and sustained competitive advantage’, Journal of
Management 17 1991, pp.99–120.
Barney, J.B. ‘Resource-based theories of competitive advantage: A tenyear retrospective on the resource-based view’, Journal of Management
6(2001a), pp.643–50.
Benkard, L. ‘Learning and forgetting: the dynamics of aircraft production’,
American Economic Review 90(4) 2000, pp.1034–54.
Bryson, A., R. Gomez and T. Kretschmer Catching a wave: the adoption of
voice and high-commitment workplace practices in Britain, 1984–1998. CEP
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MN3119 Strategy
discussion paper DP 0676. (London: Centre for Economic Performance,
2005) (http://cep.lse.ac.uk/pubs/download/).
Cabral, L. ‘R&D competition when firms choose variance’, Journal of Economics
and Management Strategy 12(1) 2003, pp.139–50.
Cabral, L. and M. Riordan ‘The learning curve, predation, antitrust, and
welfare’, Journal of Industrial Economics 45(2) 1997, pp.155–69.
Camerer, C. ‘Redirecting research in business policy and strategy’, Strategic
Management Journal 6(1) 1985, pp.1–15.
Chen, M.-J. ‘Competitor analysis and interfirm rivalry: towards a theoretical
integration’, Academy of Management Review 21(1) 1996, pp.100–34.
Chen, M.-J. and D. Miller ‘Competitive dynamics: themes, trends, and a
prospective research platform’, The Academy of Management Annals 6(1)
2012, pp.135–210.
Church, J. and R. Ware Industrial Organisation: A Strategic Approach. (New
York: McGraw-Hill, 2000) [ISBN 9780071166454] Chapter 8, Classic
Models of Oligopoly
Csaszar, F. ‘Organizational structure as a determinant of performance: evidence
from mutual funds’, Strategic Management Journal 33 2012, pp.611–32.
David, P. ‘Clio and the economics of QWERTY’, American Economic Review 75(2)
1985, pp.332–37.
Dixit, A. and S. Skeath Games of strategy. (London: Norton & Company, 2004)
second edition [ISBN 9780393924992].
Emmons, W. and R. Prager ‘The effects of market structure and ownership
on prices and service offerings in the US cable television industry’, Rand
Journal of Economics 28(4) 1997, pp.732–50.
Farrell, J. and G. Saloner ‘Standardization, compatibility, and innovation’, Rand
Journal of Economics 16(1) 1985, pp.70–83.
Ferrier, W.J., K.G. Smith and C.M. Grimm ‘The role of competitive action in
market share erosion and industry dynamics: a study of industry leaders
and challengers’, Academy of Management Journal 42(4) 1999, pp.372–88.
Fudenberg, D. and J. Tirole ‘Preemption and rent equalization in the adoption
of new technology’, Review of Economic Studies 52(3) 1985, pp.383–402.
Geroski, P. ‘Early warning of new rivals’, Sloan Management Review 40(3) 1999,
pp.107–16.
Geroski, P. ‘Models of technology diffusion’, Research Policy 29(4–5) 2000,
pp.603–25.
Geroski, P. ‘Thinking creatively about markets’, International Journal of
Industrial Organisation 16(6) 1998, pp.677–95.
Gilbert, R. and D. Newbery ‘Preemptive patenting and the persistence of
monopoly’, American Economic Review 72(3) 1982, pp.514–26.
Griliches, Z. ‘Hybrid corn: an exploration in the economics of technological
change’, Econometrica 1957. Reprinted in Z. Griliches (ed.) Technology,
Education, and Productivity. (New York: Basil Blackwell, 1988) [ISBN
9780631156147] pp.27–52.
Hamel, G. and C.K. Prahalad ‘The core competence of the corporation’, Harvard
Business Review 68(May–June) 1990, pp.79–93.
Hitt, M., H.I.R. Volberda, R. Morgan, R. Hoskisson and P. Reinmoeller Strategic
Management: Competitiveness and Globalization. (Hampshire: Cengage
Learning EMEA, 2011) [ISBN 9781408019184].
Katz, M. and C. Shapiro ‘Systems competition and network effects’, Journal of
Economic Perspectives 8(2) 1994, pp.93–115.
Kay, J. Foundations of Corporate Success: How Business Strategies Add Value. (Oxford:
Oxford University Press, 1995) [ISBN 9780198289883] Chapters 5–8.
Klette, T. ‘R&D, scope economics, and plant performance’, Rand Journal of
Economics 27(3) 1996, pp.502–22.
Koski, H and T. Kretschmer ‘Survey on competing in network industries: firm
strategies, market outcomes and policy implications’, Journal of Industry,
Competition and Trade 4(1) 2004, pp.5–31.
4
Chapter 1: Introduction
Kretschmer, T. and P. Puranam ‘Integration through incentives within
differentiated organisations’, Organization Science 19(6) 2008, pp.860–75.
Leonard, R. ‘Reading Cournot, reading Nash’ Economic Journal 104(424) 1994.
Lieberman, M. ‘Market growth, economies of scale, and plant size in the
chemical processing industries’ Journal of Industrial Economics 36(2) 1987,
pp.175–91.
McAfee, P., H. Mialon and M. Williams ‘What is a barrier to entry?’, American
Economic Review Papers and Proceedings (94) 2004, pp.461–65.
Monteverde, K. ‘Technical dialog as an incentive for vertical integration in the
semiconductor industry’, Management Science 41(10) 1995, pp.1624–38.
Ohashi, H. ‘The role of network effects in the US VCR market, 1978–86’,
Journal of Economics and Management Strategy 12(4) 2003, pp.447–94.
Peteraf, M.A. ‘The cornerstones of competitive advantage: A resource-based
view’, Strategic Management Journal 14(3) 1993, pp.179–91.
Porter, R. ‘A study of cartel stability: the Joint Executive Committee, 1880–
1886’, Bell Journal of Economics 14(2) 1983, pp.301–14.
Postrel, S. ‘Competing networks and proprietary standards: the case of
quadraphonic sound’, The Journal of Industrial Economics 39(2) 1990,
pp.169–85.
Sah R.K. and J.E. Stiglitz ‘The architecture of economic systems: hierarchies
and polyarchies’, American Economic Review 76(4) 1986, pp.716–27.
Saloner, G. ‘Modeling, game theory, and strategic management’, Strategic
Management Journal (12) 1991, pp.119–36.
Shapiro, C. and H. Varian Information rules. (Cambridge, MA: HBS Press, 1999)
[ISBN 97807875848631] Chapter 7 ‘Networks and Positive Feedback’.
Smith, K.G., W.J. Ferrier and H. Ndofor ‘Competitive dynamics research:
critique and future directions’ in M.A. Hitt, R.E. Freeman and J.S. Harrison
(eds), The Blackwell Handbook of Strategic Management. (Oxford: Blackwell
Publishing, 2001) pp.314–61.
Spence, A. ‘The learning curve and competition’, The Bell Journal of Economics
12(1) 1981, pp.49–70.
Wernerfelt, B. ‘The resource-based view of the firm’, Strategic Management
Journal 5(2) 1984, pp.171–80.
1.8 Online study resources
In addition to the subject guide and the Essential reading, it is crucial that
you take advantage of the study resources that are available online for this
course, including the VLE and the Online Library.
You can access the VLE, the Online Library and your University of London
email account via the Student Portal at:
http://my.londoninternational.ac.uk
You should have received your login details for the Student Portal with
your official offer, which was emailed to the address that you gave on
your application form. You have probably already logged in to the Student
Portal in order to register. As soon as you registered, you will automatically
have been granted access to the VLE, Online Library and your fully
functional University of London email account.
If you have forgotten these login details, please click on the ‘Forgotten
your password’ link on the login page.
The VLE
The VLE, which complements this subject guide, has been designed to
enhance your learning experience, providing additional support and a
sense of community. It forms an important part of your study experience
with the University of London and you should access it regularly.
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MN3119 Strategy
The VLE provides a range of resources for EMFSS courses:
• Self-testing activities: Doing these allows you to test your own
understanding of subject material.
• Electronic study materials: The printed materials that you receive from
the University of London are available to download, including updated
reading lists and references.
• Past examination papers and Examiners’ commentaries: These provide
advice on how each examination question might best be answered.
• A student discussion forum: This is an open space for you to discuss
interests and experiences, seek support from your peers, work
collaboratively to solve problems and discuss subject material.
• Videos: There are recorded academic introductions to the subject,
interviews and debates and, for some courses, audio-visual tutorials
and conclusions.
• Recorded lectures: For some courses, where appropriate, the sessions
from previous years’ Study Weekends have been recorded and made
available.
• Study skills: Expert advice on preparing for examinations and
developing your digital literacy skills.
• Feedback forms.
Some of these resources are available for certain courses only, but we
are expanding our provision all the time and you should check the VLE
regularly for updates.
Making use of the Online Library
The Online Library contains a huge array of journal articles and other
resources to help you read widely and extensively.
To access the majority of resources via the Online Library you will either
need to use your University of London Student Portal login details, or you
will be required to register and use an Athens login: http://tinyurl.com/
ollathens
The easiest way to locate relevant content and journal articles in the
Online Library is to use the Summon search engine.
If you are having trouble finding an article listed in a reading list, try
removing any punctuation from the title, such as single quotation marks,
question marks and colons.
For further advice, please see the online help pages: www.external.shl.lon.
ac.uk/summon/about.php
1.9 The examination and examination advice
Important: the information and advice given in the following section
are based on the examination structure used at the time this guide was
written. Please note that subject guides may be used for several years.
Because of this we strongly advise you to always check both the current
Regulations for relevant information about the examination, and the VLE
where you should be advised of any forthcoming changes. You should also
carefully check the rubric/instructions on the paper you actually sit and
follow those instructions.
The examination will be a three-hour unseen written examination covering
all aspects of the syllabus. In the examination, you will be asked to:
6
Chapter 1: Introduction
• reproduce some knowledge. (This will get you close to a pass grade,
although some application is needed).
• apply knowledge to new situations. (This will lift you to the high lower
second, or low upper second marks (assuming you get all the above
questions right)) and
• make new connections between topics and/or phenomena. (This will
enable you to obtain a first class mark in this course).
As with most examinations, try to allocate your time approximately
proportional to the marks available. If you are having problems with an
analytical question that worth very few points, it’s best to let that one go
and avoid losing time that you could use on another question.
Remember, it is important to check the VLE for:
• up-to-date information on examination and assessment arrangements
for this course
• where available, past examination papers and Examiners’ commentaries
for the course which give advice on how each question might best be
answered.
1.10 The syllabus
Basic game theory: Two-player games. Static and dynamic games and
some examples. Equilibrium concepts and solution mechanisms – Nash
equilibrium, dominant/dominated strategies, backward induction.
Oligopoly competition: Perfect competition and monopoly. Price
competition and the Bertrand paradox. Quantity competition. Reaction
functions. Bertrand versus Cournot.
Analysis of market structure: Describing market structure: C4-ratio,
Herfindahl index, Lerner index and market power. Market definition –
techniques and interpretation.
Collusion: Cartels and antitrust. Cartel stability and the discount factor.
Market dynamics and stability of collusion.
Strategic Alliances: Portfolio test. Strategic and business partnerships.
Sources of complementarity. Resource accumulation. Absorptive capacity.
Organisation design: Organisational fit, Strategy and structure, Functional
organisation, Multidivisional structure, Worldwide structure.
Competitive Dynamics: Competitive dynamics, Competitive action,
Resource similarity, Market commonality, Awareness, motivation and
capability.
Strategic asymmetries: Economies of Scale, sources and consequences.
Scope Economies: Airline Hubs. Learning or experience curve. Firm
strategies with EoScale/Scope/Learning. First-mover advantages. Market
structure with increasing returns.
Value chain analysis and vertical relations: Double marginalisation and
its remedies. Vertical foreclosure. Retailer competition and investment
externalities.
Vertical integration and transaction cost: Make or Buy. Contracts. RelationSpecific Assets and Hold-Up. Economic Rents and Quasi-Rents.
Entry and entry deterrence: Structural determinants of entry. Entry barriers
and exit barriers. Entry deterrence. Identifying entrants.
Research and Development: Market structure and R&D intensity. R&D
rivalry. Monopolists’ and entrants’ R&D incentives. Risk choice of R&D.
7
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Benefits of the patent system. Sleeping patents. Spillovers.
Technology adoption: Preemption games. Option value and future
technological generations. Technology diffusion: Heterogeneity, epidemic,
and population ecology approaches.
Network Effects: Direct and indirect network effects. Systems goods. Excess
inertia. Excess momentum. Firm strategies with network effects. Standards
Battles.
All topics are supplemented in the subject guide with specially written case
studies.
8
Chapter 2: The evolution of strategic management as an interdisciplinary field
Chapter 2: The evolution of strategic
management as an interdisciplinary field
Learning outcomes
By the end of this chapter, and having completed the Essential reading and
Activities, you should be able to:
• explain how the field of strategic management evolved over time
• discuss the elements of the shared meaning in the strategic
management field.
Essential reading
Hoskisson, R.E., M.A. Hitt and D. Wan W.P. Yiu, ‘Theory and research in
strategic management: swings of a pendulum’, Journal of Management,
25(3) 1999, pp.417–56.
Nag, R., D.C. Hambrick and M.-J. Chen, ‘What is strategic management,
really? Inductive derivation of a consensus definition of the field’, Strategic
Management Journal 28 2007, pp.935–55.
2.1 Introduction
Strategic management is a relatively young academic discipline. Among
the first publications are Alfred Chandler’s Strategy and structure (1962),
H. Igor Ansoff’s Corporate strategy (1965) and Kenneth Andrews’ The
concept of corporate strategy (1971). Since then the field has changed
its focus from business policy to strategic management and made the
transition from being a collection of toolkits developed by consulting
firms to a systematic, theory-driven academic field. In addition, right
from its beginning the area of strategic management was recognised as an
interdisciplinary research field. The field was – and is still – populated by
scholars from different disciplines like management, economics, finance,
marketing, psychology and sociology. For such a diverse field it might have
been difficult to develop a consensual meaning of what the discipline is all
about. However, such a shared understanding is important as all academic
fields are socially constructed and can only flourish if there is a shared
conception of its meaning. Thus, the purpose of this chapter is twofold:
first, we will sketch the evolution of the field before analysing the shared
understanding of the field.
2.2 Early theories
The field of strategic management or, to be more precise, the field of
business policy (as it was initially called) did not emerge before the 1960s
with the influential work of Alfred Chandler, Igor Ansoff and Kenneth
Andrews. These early writings were influenced by the work of Edith
Penrose, who developed a theory of the growth of the firm by emphasising
the importance of a firm’s resources and managerial capabilities for its
growth. Besides Penrose, these researchers were influenced by the work
of the Carnegie School, especially Herbert Simon, Richard Cyert and
James March, who developed the idea of bounded rationality to study the
decision-making process in firms. Deviating from standard economics,
Simon and his colleagues assumed that decision makers do not have
9
MN3119 Strategy
complete information and that the alternatives they are deciding upon
needs to be researched. The last important influence of the early writings
was the work by Philip Selznick and his idea on distinctive competences.
A distinctive competency is something that is unique to an organisation
and superior in some respects when compared with the competencies of
other organisations that offers some value to their customers. Influenced
by these ideas, Chandler, Ansoff and Andrews developed their theories of
strategy by placing an emphasis on the internal characteristics of a firm.
In Strategy and structure, for example, Alfred Chandler studied how large
organisations develop new administrative structures to accommodate
growth and how strategic change influences an organisation’s structure.
2.3 Michael Porter and the industrial organisation
paradigm
After relabelling the field ‘strategic management’ in the late 1970s, the
focus moved towards industrial organisation economics in both theory and
method. At this time research was aiming to develop and test hypotheses
derived from the structure-conduct-performance (SCP) paradigm. The
basic idea of this paradigm is that the performance of a firm is determined
by the industry in which it competes. The conduct of a firm is just a
reflection of the industry structure, so that the most important decision
a firm has to make is in which industry it wants to compete in. The SCP
paradigm led to a shift in focus from the firm to the industry or market
structure. The most influential scholar from this era is Michael Porter, who
is not only well known among researchers but also among practitioners.
He developed the so- called ‘five forces’ model that specified different
features of an industry and which determines its attractiveness and
facilitates competitor analysis. Porter also proposed the idea of generic
strategies – low cost leadership, differentiation and focus – to match the
characteristics of an industry and achieve a competitive advantage.
Besides the SCP paradigm, research at this time developed the idea of
strategic groups. Strategic groups are groups of firms in the same industry
who follow the same strategy, for example, all suitcase producers in the
high-price market like Louis Vuitton or Bottega Veneta.
A third important research theme, influenced by industrial organisation
economics, is competitive dynamics (which is subject of Chapter 13).
The basic interest of competitive dynamics is to investigate how firms
are jostling for competitive advantage by carrying out different types of
strategic and tactical actions.
2.4 Organisational economics
In the 1970s the field of strategic management was not only influenced
by the work of industrial economists but also by another subfield of
economics: organisational economics. Organisational economics tries to
open the ‘black box’ of the firm and looks at its inner structural logic and
functioning. Its most prominent theories are transaction cost economics
and agency theory.
Transaction cost economics, developed by the work of Oliver Williamson,
studies the question of why firms exist and which transactions are made
inside the market and which inside the firm. Building on the concept
of bounded rationality and asset specificity, Williamson argues that
transactions are made within the firm (or hierarchy, in the words of
Williamson) when the sum of all transaction costs is smaller than the price
10
Chapter 2: The evolution of strategic management as an interdisciplinary field
for the transaction in the market. He further argues that firms exit as an
efficient alternative to the market. Strategic management scholars have
applied transaction cost theory to study the make or buy decision of all
firms, including multidivisional and international firms.
Agency theory claims that the separation of ownership and control in
most organisations lead to a problem of divergence of interest between
shareholders (‘principals’ in the words of agency theory) and managers
(called agents). The idea is that managers try to maximise their utility,
which might not be in line with the maximisation of the long-term profits
of the firm. To avoid this problem, firms need contracts that rule the
relationship between principal and agents.
2.5 Resource-based view, dynamic capabilities and
leadership theory
One of the latest steps of the development in the field of strategic
management occurred with the emergence of the resource-based view and
its dynamic extension – the dynamic capability approach. This stream of
research is influenced by the work of Edith Penrose, who viewed the firm
as a collection of productive resources. The resource-based view further
argues that these resources are heterogeneously distributed among firms.
The differences in resources combined with the imperfect mobility of the
resources can explain the differences in performance among firms in the
same industry. The dynamic capability approach extends this logic and
argues that a firm needs dynamic capabilities to modify and extend its
resource base to achieve and sustain a competitive advantage or a series of
competitive advantages over time.
Finally, in 1984 Don Hambrick and Phylis Mason developed the strategic
leadership or upper echelons theory. They developed a theoretical
framework that proposed senior executives base their strategic choices
on their cognitive structures and values. Hence, strategic leadership
theory tries to explain differences in firms’ performance by, for example,
differences in past performances of their executives, top management
team size, composition and tenure.
2.6 A consensus definition of the field
As seen in this short historical overview, strategic management has been
advanced by researchers from different disciplines, especially economics,
organisation science or sociology. Such an interdisciplinary field often
lacks a clear understanding of or consensus on the subject. However,
without this consensus, a field is limited in its growth. As this is at odds
with the great success of the field of strategic management over the last 30
years, Nag et al. conducted a study among strategy scholars from different
disciplines asking them about their personal views of the field of strategic
management. In their large study among strategy researchers, they
found the following implicit definition of the field: The field of strategic
management deals with (a) the major intended and emergent initiatives;
(b) taken by general managers on behalf of owners; (c) involving
utilisation of resources; (d) to enhance the performance; (e) of firms; (f)
in their external environments. They therefore concluded that the success
of the field emerges from an underlying consensus that enables it to attract
multiple perspectives.
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MN3119 Strategy
2.7 Key concepts
• Strategic management
• Business policy
• Structure-conduct-performance paradigm
• Transaction cost economics
• Agency theory
• Resource-based view
• Dynamic capabilities.
2.8 A reminder of your learning outcomes
Having completed this chapter, and the Essential reading and Activities,
you should be able to:
• explain how the field of strategic management evolved over time
• discuss the elements of the shared meaning of the strategic
management field.
12
Chapter 3: Analysis of market structure
Chapter 3: Analysis of market structure
Learning outcomes
By the end of this chapter, and having completed the Essential reading and
Activities, you should be able to:
• discuss the most common techniques used to define a market
• describe a firm’s market power within a defined market.
Essential reading
Besanko, D., D. Dranove, M. Shanley and S. Shaefer. Economics of Strategy
(New Jersey: Wiley, 2009) pp.205–11.
or
Lexecon Ltd An introduction to quantitative techniques in competition analysis.
Lexecon Ltd. publication, mimeo. Available at: www.crai.com/ecp/assets/
quantitative_techniques.pdf.
Saloner, Shepard and Podolny Strategic Management. (New Jersey: Wiley,
2005) Chapter 6.
Further reading
Emmons, W. and R. Prager ‘The effects of market structure and ownership
on prices and service offerings in the US cable television industry’, Rand
Journal of Economics 28(4) 1997, pp.732–50.
Geroski, P. ‘Thinking creatively about markets’, International Journal of
Industrial Organisation 16(6) 1998, pp­.677–95.
3.1 Introduction
In this chapter we will first present techniques which are used when
defining markets, for instance, for policy or firm strategy analysis. In
the second part of this chapter we introduce some methods of analysing
markets with many firms.
The process of market definition and analysis will be an input for the later
chapters in the second part where we will learn how to analyse tightly
structured problems, for example, by solving games having identified the
players, the strategies, the pay-offs and the rules.
3.2 Techniques of market definition1
Why should we want to define the market for a particular product or firm?
Geroski (1998) states that there are three ways of ‘thinking creatively
about markets’: trading markets, antitrust markets and strategic
markets. Trading markets are defined as geographical areas and a set of
products for which the law of one price holds to a certain degree. That is,
taking into account transport costs and slight differences in the product
offerings, we would expect a similar price to be charged for similar
products. Market definition from an antitrust perspective looks at the
likelihood that the market can be monopolised by a single firm, or group
of firms. That is, if there was some change in the degree of the market’s
competitiveness (for example, through mergers or collusive agreements),
would it be possible to initiate a ‘small and significant increase in prices’,
This section is based
mainly on Lexecon
Ltd An introduction to
quantatative techniques
in competition analysis.
1
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MN3119 Strategy
or is market power restricted by other, closely related markets? Finally,
strategic market definition concerns itself with market boundaries
which are defined by firms’ product offerings. The argument here is that
companies not only adapt to but also create or segment markets in order
to maximise their profits.
We will introduce a number of techniques of market definition: estimating
the cross-price elasticity of demand, price correlation analysis, switching or
diversion ratio, shock analysis and bidding studies.
Example: Sony’s PlayStation 3 (PS3), a video game console
The PS3 was introduced in the year 2006 with the express intent of providing a successor
to the Playstation 2 and to challenge Microsoft’ s early mover position in the market for
256-bit game consoles. The simple definition of the market would suggest that the PS3’s
market is defined by ‘game consoles’. Hence, its main competitors are the Nintendo Wii,
the Microsoft X-Box 360, and Sony’s own Playstation 2 to some extent. Is this the whole
story? To start with, PCs nowadays have relatively advanced gaming features as well and
there is a large library of PC games available, which would suggest that PCs are also a
significant competitor also. Going even further, if young people no longer find playing
game consoles attractive, they could switch to other ways of entertaining themselves like
watching TV, reading books, playing board or ball games, etc. Another way of thinking
about the market for the PS3 is by looking at the buyers, who are more often than not
parents around Christmas time. What would they be spending their money on if not on
the PS3? This could be other consumer electronics as gifts or clothing, etc.
3.2.1 Cross-price elasticity of demand
You will recall the (own-price) elasticity of demand (e) from your
introductory microeconomics course: it is defined as the ‘relative change
in quantity (Q) demanded due to a price (P) change’. We can write the
own-price elasticity as:2
−
∂Qi
Qi
∂Pi
Pi
or −
∂Qi Pi
∂Pi Qi
The cross-price elasticity then measures the ‘relative change in quantity
demanded of one good, due to a one per cent price change of another
good’. We can write the formula as:
∂Qi Pj
∂Pj Qi
That is, if the price for another good goes up by one per cent, how will
demand for my own product change (in percentage terms)? If a product
is a close substitute, we would expect cross-price elasticity to be a large
positive number: a price increase of five per cent for a rival product will
redirect a lot of customers towards my own product, meaning that demand
goes up by more than five per cent. On the other hand, if a price decrease
for a potential substitute results in only small quantity losses, cross-price
elasticity is low and we can say that the products are distant substitutes.
This simple technique cannot be used to define or test a market. However,
it is a very powerful tool to assess the relationship of two products if the
data is available.
14
2
We leave out the
negative sign commonly
used in own-price
demand elasticity.
This is simply because
we expect cross-price
elasticity to be positive
for substitute products.
This is however just a
convention and nothing
should be read into it.
Chapter 3: Analysis of market structure
Activity 3.1
Give your estimates of the cross-price elasticities of the following product pairs and explain
why.
a. Two gas stations on opposite sides of the road
b. Coffee and tea
c. Hotels in Bahrain and New Zealand
Guidance on this activity can be found in the VLE.
3.2.2 Price correlation analysis
Quite often it is difficult to gather enough data to calculate the cross-price
elasticity of demand – in particular, obtaining a time series of quantity and
price data containing some small price changes and very little changes in the
general market parameters is typically difficult.
An (imperfect, but still acceptable) alternative may be tracking movements
of prices over an extended period of time. As we will see in Chapter 5, the
B and C competition model shows prices as strategic variables are strategic
complements, which means that, on the one hand, if one firm increases its
price, so will the other. In contrast, if quantities are the strategic variable
(and the strategies therefore are strategic substitutes), we expect market
prices emerging from the quantities set by the firms to move in unison for
related products. In the extreme case of perfect substitutes, the market price
for both will be the same, so an increase in price for one product implies a
price increase for the rival product.
A word of caution on the interpretation of price correlations: it is important
to rule out other explanations for the co-movement in prices. For example,
if the prices of ice cream and sunscreen are highly correlated, this does not
imply that the two are close substitutes – if anything, they are complements,
but demand for both of them is affected by the same (seasonal) components,
temperature and sun. Similarly, tyres and washing-up liquid are rarely
mistaken for substitutes, but changes in their prices are likely to occur at
somewhat similar times – both products use oil as a significant input3 and
are therefore likely to be affected by oil price changes in a similar way. The
point is that price correlations have to be interpreted with care and that
potential sources of ‘spurious correlation’ (i.e. correlation that is not down
to the reason stipulated) have to be taken into account. It is also important
to get a sense of the reasons for the price changes, even if they were not
‘spurious’ in the sense outlined above – were there any product or process
innovations (we will cover this later in the guide), was there a significant
shift in consumer preferences or did firms simply change their strategies?
A more comprehensive
list of products made
from oil is given on
www.anwr.org/features/
oiluses.htm
3
3.2.3 Switching/diversion ratio analysis
If a time series of prices is not available or if for some reason would not be
meaningful (for example, if one product is priced at zero, e.g. a software
programme available as freeware on the internet), it may be useful to ask
consumers directly for the products or services they perceive as the closest
substitutes to the products they are currently using.
Frequently, this will take the form of a survey of consumers of a particular
product or service who are asked a question to the tune of: ‘If the product
you have just purchased had not been available today, what other option
would you have chosen?’ Clearly, the more ‘votes’ a particular alternative
obtains, the closer a substitute it is likely to be.
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MN3119 Strategy
3.2.4 Shock analysis
Another reliable method of determining the closeness of two products
or services is their reaction to a ‘shock’. Technically, this is a natural
experiment observing a sudden and unexpected change in one market
and analysing the reaction in the (possibly) related market. Shocks can
take many forms: entry of a new product, technological change, price
concessions, a change in input prices, natural crises, etc. For example,
when Sony released the Playstation 3 in 2006, board game manufacturers
made only limited changes to their strategies (and probably experienced
only a limited impact on their sales), whereas Nintendo and Microsoft
were hit relatively hard, suggesting that the game consoles market consists
of closer substitutes than the broadly defined ‘leisure’ industry.
3.2.5 Bidding studies
Finally, there may be cases where prices are not transparent or not
publicised, or where the number of transactions is relatively low so that
no meaningful correlations can be gathered from the data. Sometimes
therefore, the best that can be done is to determine ‘who bids for the
same business’ as a proxy of who competes in the same market. For
example, when the ‘big four’ accounting firms were still the ‘big six’, the
effect of merging PriceWaterhouse and Coopers & Lybrand was assessed
using a bidding study. On the one hand, it was found that in addition to
PriceWaterhouse and Coopers & Lybrand, the other four accountancy
firms were bidding for very similar projects or accounts, which meant that
competition was likely to be intense even after the two merged. On the
other hand, if the two merging partners had been a duopoly in a submarket, say, large manufacturing accounts in the north-east of England,
the merger would have led to a monopoly in the north-east manufacturing
sector. So, while bidding studies are a relatively crude way of determining
one’s competitors, they are still a useful exercise.
3.3 Market analysis with many firms
Suppose now that we have defined the market using one (or multiple) of
the techniques introduced above. What next? We need to find some
proxies for determining whether the market is competitive or not, in-order
to judge, for instance, how attractive the market is likely to be in the near
future, how likely it is that antitrust action will be taken, and if entry or
exit by rivals can be expected.4
Figure 3.1 gives the four most commonly used measures of
competitiveness and concentration in an industry. Their quality and
accuracy increase from number one to four:
The simplest way to measure the competitiveness of a market is by
counting the number of firms in an industry. In a market with many
firms, it is less likely that a single firm will have a significant amount of
market power. Further, more firms suggest rather low entry barriers (the
more firms there are, the lower the average size or market share per
firm in the industry is lower the more firms there are), which is another
indicator for a competitive market. If there are some firms, however, that
do have significantly higher market power than others in the industry, a
simple count would not do the trick.
16
4
We will discuss
entry in more detail in
Chapter 14. For now it is
sufficient to know that a
less competitive market
is likely to be more
profitable for potential
entrants, which in turn
implies that incumbents
will try and build barriers
to entry to maintain
their profitable position.
Chapter 3: Analysis of market structure
1. #firms
2. C4/5/8
C≡
1
n
4
C4 ≡ ∑ si
i =1
3. Herfindahl index
n
H ≡ ∑ si2
i =1
n
4. Lerner index
L ≡ ∑ si
i =1
p-MC i
p
Figure 3.1: Measures of competitiveness and concentration.
A more useful method, particularly if there are several larger firms, is to
calculate the Cn-ratio (mostly C4, C5 or C8) – the sum of the market shares
of the n largest firms. This gives some information about how strong the
biggest firms are likely to be. Again, however, this measure is not fully
satisfactory: Imagine a market with 4 firms – the C4-ratio will be 100 per
cent regardless of the distribution of market shares between the four firms.
Similarly, if the n+1th largest firm is almost as big as the nth firm, the
Cn-ratio will not pick this up. So even though we can do a little better than
simply counting the firms, not all information is utilised in the Cn-ratio.
The Herfindahl-Hirschman index (HHI) takes the market shares
of all the firms in an industry into account and sums their squares. This
solves a lot of the problems of the previous two concentration indices:
first, information of all firms is taken into account,5 and second, larger
firms feature more prominently in the index. The HHI is a standard tool
for antitrust economists and the US Department of Justice guidelines state
that ‘…markets in which the HHI is between 1,000 and 1,800 points are
considered to be moderately concentrated, and those in which the HHI is
in excess of 1,800 points are considered to be concentrated. Transactions
that increase the HHI by more than 100 points in concentrated markets
presumptively raise antitrust concerns under the Horizontal Merger
Guidelines issued by the US Department of Justice and the Federal Trade
Commission.’6
The one remaining problem with the HHI is that while it says a lot about
the size distribution of firms within an industry, it does not say anything
about the way and intensity with which these firms compete, or, in
economists’ parlance, their conduct. The Lerner index, then, takes
the HHI one step further and looks at a firm’s profit margins (i.e. price
– marginal cost) and weighs them by the firm’s market share. In other
words, if the largest firm charges a high price relative to its marginal cost
while smaller ones price relatively aggressively, the Lerner index will be
higher than if a small firm charged high mark-ups (e.g. because it operates
in a niche market). Note, however, that it is still possible for margins to be
high and profits to be low due to fixed costs. The main problem with this
measure, however, is that it is almost impossible to gather the necessary
information on prices and particularly costs for each firm.
In practice, this is
often impossible with
a large number of very
small firms. Antitrust
practitioners mostly
ignore the market shares
of all firms with a market
share of <1 per cent.
This seems acceptable
since they would have
a minute effect on the
HHI anyway. On the
other hand, if the fringe
of small firms can be
expected to act jointly
(or at least to react in
the same way to, say, a
price increase of a larger
firm), there may be a
case for squaring the
joint market share of all
the fringe firms. This will
depend on the particular
case in question.
5
See www.usdoj.gov/
atr/public/ testimony/
hhi.htm
6
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MN3119 Strategy
3.4 Key concepts
• Cross-price elasticity of demand
• Price correlation analysis
• Switching/diversion ratio analysis
• Shock analysis
• Bidding studies
• Cn-ratio
• Herfindahl-Hirshman index
• Lerner index.
3.5 A reminder of your learning outcomes
Having completed this chapter, and the Essential reading and Activities,
you should be able to:
• discuss the most common techniques used to define a market
• describe firm’ market power within a defined market.
3.6 Sample examination questions
1. You are a product manager for a computer game and have been
asked to analyse whether a new game is a competitor and to suggest
techniques which could help inform your decision. The game you are
in charge of is called ‘Industry Giant’ and has the following product
description:
‘Begin in the year 1900 with little money but large ambitions and
through skilful decision-making you can build up an enormous business
empire. Make critical decisions on which of more than 200 products
you should manufacture, where to gather the best raw materials,
where to sell them and how to effectively transport them there.
Recommended Retail Price (RRP): £29.99’
Industry Giant has a multiplayer option, in other words, you can play
it against others on the same PC, but it has no internet capabilities.
Your competitors are a combination of computer-controlled teams and
(if you play with friends) ‘real’ players. Internet Industry Manager
(IIM) is a relatively new computer game where players get to ‘manage’
a firm in an interactive environment by choosing prices, quantities
and advertising efforts. It is played over the internet and all players
are ‘real’ players, that is, every firm is controlled by somebody on the
internet. It is free to download and to play.
Is IIM a competitor? Why or why not? What techniques would you use
specifically to analyse the degree of competition between the products?
2. You are working for a Japanese firm selling hot coffee in vending
machines. You have been asked to identify the market and the potential
competitors and substitutes for your product in Europe.
a. How would you design and conduct a study to do this (outline your
choice of techniques and the reason why you chose this particular
set of techniques)?
b. What is your first guess of your product’s relevant market?
Guidance on answering these Sample examination questions can be found
in the VLE.
18
Chapter 3: Analysis of market structure
Extended activity: the commercial banking industry in
the United States
Read the following and answer the questions at the end.
The US commercial banking industry consists of independent banks and
bank holding companies that provide firms and homes with depository
and lending products, as well as a range of other related financial services.
Simply put, the difference between the interest paid on deposits and the
interest earned on loans determines the profitability of commercial banks.
This sector provides a good example of how market structure affects
performance by influencing conduct – how the players compete with each
other.
Most banks are involved in retail banking, serving households and small
firms, as opposed to corporate banking, which serves large businesses and
offers more sophisticated financial services. The retail banking sector is
characterised by having many, relatively small and geographically local
markets. People tend to choose banks that are physically close to where
they work or live, and, once they become customers, they tend to view
their bank as a primary provider of a range of personal finance services.
Gaining customer trust and forming strong customer relationships are
critical to banks as access to and knowledge about customers enhances the
prospects of cross-selling other products and services.
Banks operating within markets with a higher concentration – where the
market is shared between fewer players – exercise a greater market power,
for example in setting fees and prices. Conversely, in local markets with
lower concentration – where the market is shared by many competitive
players – banks tend to have a lesser market power.
Historically, the banking industry has been shaped by regulations that
have restricted the geographical scope of operations. Banks, for example,
needed to maintain a head office in their local market where deposits were
collected and loans originated. Moreover, they were often not allowed
to form branches in other regions of their state, and were completely
restricted from establishing branches in other states.
In the 1990s many of these regulations were relaxed, prompting a
significant industry consolidation on a national scale. Forming these
larger banks was believed to yield many benefits including the ability to
reap greater returns on investments in technology and advertising, to
consolidate back-office functions, and to specialise employee functions in
conjunction with the diversification of products and services.
This merger activity within and across state boundaries had a great impact
on the concentration levels of banks on the national scale, where we have
seen much fewer – but significantly larger – players. In local markets,
however, the concentration levels did not change significantly due to
antitrust regulations that continued to restrict mergers between banks in
direct local competition. The changes in market structure on the national
level, however, do affect the competitive landscape of local markets in
that local branch players are often, through their larger bank parents, in
competition in several distinct local markets at the same time.
Industry consolidation has created a trend of ever-larger banks controlling
ever-larger market shares. Evidence shows that small banks are generally
less profitable than larger banks, but that there is little difference in
profitability within the large bank category. This suggests a threshold on
the spectrum of bank size beyond which further gains in efficiency and
ability to charge higher prices cannot be sustained.
19
MN3119 Strategy
Source
Pilloff, S.J. ‘Commercial banking’ in Adams W. and J. Brock (eds) The
structure of American industry. (New Jersey: Prentice Hall, 2001) [ISBN
9780130189166] pp.224–54.
Questions
1. How would different market concentration levels affect bank prices
and efficiency through the respective levers of market power and
competition? Map and describe the relationships between these factors.
If you were a bank owner, would you prefer to operate in a market with
high or low concentration? Why?
2. Analyse the factors influencing how banks compete in today’s local
markets. Consider market concentration levels, bank size, the types
of products and services that can be offered, the ‘stickiness’ of the
customer relationship, entry barriers.
3. What do you think are the potential implications of national banks
competing through branches in several distinct local markets where
the conditions and relative competitive positions may differ. How can
they exploit their national muscle for local gain, and what might the
limitations to this be?
20
Chapter 4: Introduction to game theory and strategy
Chapter 4: Introduction to game theory
and strategy
Learning outcomes
By the end of this chapter, and having completed the Essential reading and
Activities, you should be able to:
• describe simple games, for instance the prisoner’s dilemma, using the
normal form and extensive form
• define the concept of Nash equilibrium and find equilibria for a game.
Essential reading
Cabral, L.M.B. Introduction to Industrial Organization. (Cambridge, MA: MIT
Press, 2000) Chapter 4.
Further reading
Camerer, C. ‘Redirecting research in business policy and strategy’, Strategic
Management Journal 6(1) 1985, pp.1–15.
Dixit, A. and S. Skeath Games of strategy. (London: Norton & Company, 2004)
second edition Part II.
Saloner, G. ‘Modeling, game theory, and strategic management’, Strategic
Management Journal (12) 1991, pp.119–36.
Saloner, G., A. Shepard and J. Podolny Strategic management. (New Jersey:
Wiley, 2005) Appendix.
4.1 Introduction
There are about as many definitions of strategy as there are textbooks
on the topic. The definitions often have very little in common and are
frequently coloured by the preferences of the author. Instead of advancing
another definition with a claim for universal applicability, let us identify
a number of features the many definitions have in common. Specifically,
strategies are often:
• long-term
• about securing competitive advantage
• coupled with actions, not just a plan.
First of all, a strategy is supposed to have a long-lasting effect on a firm
– in other words, we are not talking about small, day-to-day transactions
(even though these may be in accordance with an overall strategy).
Second, a strategy is often aimed at securing an advantageous position
relative to other firms in the market. That is, there is an element of
competition in many of the definitions of strategy. Finally, strategies are
often a set of actions rather than a set of lofty ideas and visions.
What would count as a strategy? Surely, the most basic strategy must be
whether you want to enter a (geographical or product) market or not.
Once you have entered, setting capacities or production volumes
will determine the long-term success of your firm. Once this is settled, you
have to sell your product. How to sell? Setting prices, choosing (to the
extent that you can do this) qualities and advertising levels would
21
MN3119 Strategy
be the most obvious levers a firm can pull in order to sell its product.
There are other decisions a firm has to make, however: should the firm
integrate vertically (i.e. with suppliers or buyers) or horizontally
(with competitors), should the firm spend resources on research
and development, and if so, what kind of research should be done?
Common to these is that the profitability of these actions depends on
what your competitors do: lowering your price will only be successful if
your competitor does not lower his by the same amount. Introducing a
high-quality version of your product will only draw consumers from your
competitors if they do not counter this by launching their own high-end
version as well. Entering a market on your own is much more profitable
than with a competitor, and so on. For formulating a successful strategy,
it is therefore important to at least try and anticipate what (actual or
potential) competitors are going to do.
4.2 Static games
4.2.1 Anticipating rivals’ moves
In strategic analysis, it seems important to be able to figure out what one’s
rival is going to do, that is, to anticipate a rival’s moves. How can we do
this? Strategists (both professional ones (i.e. managers and consultants)
and ‘strategists in the making’ (i.e. students)) often assign probabilities
to the different actions a rival might take. But can we do better than this?
Game theory tells us we can (most of the time)! Let us use an example to
illustrate this.
Prisoner’s dilemma – Advertising wars
Consider the following situation. P&G and Colgate Palmolive sell
competing brands of toothpaste – Crest and Colgate – in a market. The
brands share the market equally, that is, both firms have a 50 per cent
market share. The overall market for toothpaste is fixed – let’s assume
total sales for toothpaste will be €10m per year. Both firms now have
the option of launching an advertising campaign for one year at a cost
of €2.5m. While advertising does not increase total sales for toothpaste,
advertising if the other firm does not advertise would increase market
share to 80 per cent. What should both firms do? In fact, can we use the
information above to make a prediction of what each of the players is
going to do?
The first step to take is identifying the players (which is typically a
simple but nonetheless important step). In this case, P&G and Colgate
Palmolive are the players. The second step is to identify their strategies,
that is, what are the choices they have? Here, P&G and Colgate Palmolive
decide whether to run an advertising campaign or not. Third, we have to
specify the rules of the game. We will go into this in more detail later on,
but here the rules are that both players have to decide simultaneously to
run or not to run an advertising campaign. Finally, we have to specify the
pay-offs for each of the possible outcomes of the game. In this case, both
firms not running an ad campaign results in them sharing the market and
making sales of €5m. If one of them runs an advertising campaign and the
other does not, the first makes sales of €8m (80 per cent of €10m), but has
to pay advertising costs of €2.5m, leaving net sales of €5.5m. The other
(non-advertising) firm makes sales of €2m. If both firms advertise, their
sales will be €5m again (as the market for toothpaste is fixed), but they
again incur an advertising cost of €2.5m, resulting in net sales of €2.5m.
22
Chapter 4: Introduction to game theory and strategy
We can now represent the game in matrix, or normal form. First,
however, a word on convention: The first pay-off (or the leftmost) will be
the pay-off of the row player – that is, the player choosing the row (top or
bottom), Colgate in this case. The second pay-off (or the pay-off further to
the right) will be the column player’s pay-off (i.e. P&G).
P&G
No Ad
€5m
No Ad
€5m
Colgate
Ad
€5.5m
€2m
€2m
Ad
€5.5m
€2.5m
€2.5m
Figure 4.1: Advertising wars.
The situation P&G and Colgate are facing is what game theorists call a
prisoner’s dilemma: overall profits would be higher if both did not
advertise, but both have an individual incentive to go ahead and advertise
anyway – regardless of what the other player does (advertise or not
advertise).
This makes advertising a dominant strategy – a strategy that does
better than all others for any strategy chosen by the other player(s). This
gives us the first way of predicting our rival’s behaviour: if a strategy
always maximises my rival’s pay-offs, he will play it.
Eliminating dominated strategies – pizza wars
It would be nice if we could always make a clear prediction about our
rival’s behaviour. We can often simplify games by finding dominant
strategies as demonstrated above. However, consider the following game.
There are two restaurants in a small town, Dave’s Deep Dish and Paul’s
Pizza Pies. They are in competition with each other for customers and can
choose their prices: high (H), medium (M) or low (L). The city has 1,000
customers, of which 300 only ever buy at Dave’s, and 300 only buy at
Paul’s. The other 400 are price-sensitive and always buy the cheaper pizza
and choose at random if they charge the same price. Both places make a
margin of £12 per pizza if they charge high prices, £10 per pizza if they
charge medium prices, and £5 for low prices. Both Dave and Paul cannot
observe what the other player has chosen before they choose themselves.
Can we draw this in a pay-off matrix? We know players, strategies and
rules. What about calculating pay-offs? We can calculate profits by
multiplying the number of customers with the margin per customer. For
example, if Dave charges a medium price and Paul a high price, Dave will
sell to his 300 ‘loyal’ customers and the 400 ‘price sensitive’ customers at
a margin of £10 each, giving him pay-offs of £7,000. Paul only sells to his
300 loyal customers, but at a margin of £12 per pizza, giving him profits
of £3,600.
23
MN3119 Strategy
Paul
High Medium Low
High
Dave Medium
Low
60/60
36/70 36/35
70/36
50/50 30/35
35/36
35/30 25/25
Figure 4.2: Pizza wars.
Can we solve this game by finding dominant strategies? For none of the
players can we find one strategy that does better than the other two for
all strategies chosen by the rival. For example, M outperforms H if the
other price is H or M, but not if it if L. Dominant strategies will not get
us very far then. We can, however, find a strategy that never does better
than another one – a dominated strategy: charging L is worse than H or
M for all strategies chosen by the other player. So if Dave and Paul are (as
we assume) trying to maximise their profits, they will never charge lower
prices. We combine our outcomes on dominant and dominated strategies
for the following set of predictions.
Result
a. A dominant strategy should always be played.
b. A dominated strategy will never be played.
Let’s now go one step further. Having simplified the game, we can in fact
find a dominant strategy again. Playing M always does better than H,
knowing that L will never be played by either of the players. This process
is called the iterated elimination of dominated strategies. This
makes the game a good deal simpler, and you can now solve the simplified
game with just M and H for Dave and Paul. What is the solution?
4.2.2 Nash equilibrium
Hopefully you found that the solution to the simplified Pizza game is
(M,M) – that is, both players will charge a medium price. Looking for
dominant strategies in the simplified game gave you this outcome. This
combination of prices is a Nash equilibrium (NE). How did you try to ‘solve’
the game? Assuming that both players are interested in maximising their
pay-offs, you tried to predict what they would do given the other player’s
strategy. As it turned out, in the simplified game, playing M was the
best solution, regardless of the strategy of the other player – a dominant
strategy. This means that both players playing M is an equilibrium – none
of the players would want to change their behaviour given the other’s
strategy. Therefore, a Nash equilibrium can be formally defined as follows.
Nash equilibrium – definition
A Nash equilibrium is a combination of strategies such that no individual player can
deviate unilaterally from his/her current (equilibrium) strategy to improve his/her pay-offs.
This means that a game has a solution at a Nash equilibrium in the sense
that no player would change given the other player’s strategy. What does
this imply about the relationship between Nash equilibrium, dominant and
dominated strategies? Here are a few questions to consider.
24
Chapter 4: Introduction to game theory and strategy
Activity 4.1
Answer the following questions:
a. Is a Nash equilibrium the same as a dominant strategy?
b. Can a Nash equilibrium contain dominated strategies?
c. Will every Nash equilibrium contain dominant strategies?
Guidance on this activity can be found in the VLE.
Hopefully, your answer to all these questions was ‘No’. Why? As to the first
question, a Nash equilibrium refers to a combination of strategies, which
by definition means it’s more than just a single strategy by one player.
(Another objection is that not every Nash equilibrium must consist of a
combination of dominant strategies – as we discuss in c). The second ‘No’
comes directly from the first prediction we made: if a strategy is never
played, it cannot be a resting point – there is always something better for
the player to do. The final ‘No’ becomes clear when we study the Pizza
game. Looking at the full game, we could see that none of the strategies
is dominant, but we still found a Nash equilibrium in (M,M). Here are
another two questions.
Activity 4.2
Answer the following questions:
a. Will every game have a Nash equilibrium (in pure strategies)?
b. Can a game have more than one Nash equilibrium?
Guidance on this activity can be found in the VLE.
The answer to the first question is again ‘No’ (Hint: think of a game
of ‘matching pennies’, where one player wins if two pennies are both
heads or both tails, and the other wins if one is heads and the other is
tails.) Let us tackle the second question by using an example: Science
and Humanities faculties have to decide on the renovation of an unused
lecture hall. Both want something to be done with it, but have their own
preferences: Science prefers a laboratory, whereas Humanities prefers a
theatre. At the main meeting of all the faculties, both have to endorse one
of the projects. At the preliminary meetings within the individual faculties,
both have to decide which project to endorse. The meetings take place
simultaneously – or, if you are more comfortable with this interpretation,
the meetings take place without the faculties knowing what the other
faculty has decided.
First, let’s represent the game in matrix (or normal) form:
Humanities
Lab
Theatre
Lab
Science
Theatre
Figure 4.3: Coordination game.
25
MN3119 Strategy
(Try to put in sensible pay-offs in the four quadrants – remember
that what’s most important to both players is spending the evening
together, even though each of the two players has a preference for one
of the activities.) What will be the Nash equilibrium of the game? Well,
predicting the other player’s move is tough: putting ourselves in Science’s
shoes, if Science thinks that Humanities will endorse the lab, Science will
want to vote for the lab as well. But when would Humanities vote for the
lab? If it thinks that Science will vote for the lab as well – which will be
the case if Science thinks that Humanities will…the story could go on and
on, and we could run the same procedure for voting for the theatre!
So will this mean that the game has no Nash equilibrium? In fact, there
are two: (L,L) and (T,T) – both want to coordinate on one of the projects
and they have no incentive to deviate unilaterally (i.e. taking the other
player’s strategy as given) if they have coordinated. Note that this does
not mean that the faculties are indifferent between the two solutions –
Science would rather see a lab built than a theatre, but not at the expense
of risking any project being realised. We will deal with ways of solving the
conundrum of which of the two equilibria to choose shortly, but for now
we know that some games can have multiple Nash equilibria.
Activity 4.3
Represent the following situation as a strategic game and solve it, that is, look for the
Nash Equilibrium.
Two players, Arthur and Bob, drive towards each other in their cars. Both can swerve (i.e.
steer to the left or right) or go straight. Whoever swerves first loses and is considered
‘chicken’ (i.e. not very courageous) and the rival wins. If both swerve, they are both
chickens (but they do not face the abuse by the winner of the game). If they both go
straight, the cars collide and Arthur and Bob are seriously injured.1
Guidance on this activity can be found in the VLE.
Some games, as we have seen, have multiple Nash equilibria, with no
obvious way of selecting among them. Of course, one might think that
Scientists are a stubborn bunch who would only ever vote for a lab
anyway, but then who is to say that the Humanities faculty is not just as
stubborn? And if that is the case, would the Science faculty not want to
compromise instead of seeing the unused lecture theatre go unused for
another year?
We will now go through a few mechanisms or ways in which games
with multiple Nash equilibria can be approached. Note, however, that
most of these will imply changing the rules of the game in some way –
in other words, you have to make assumptions in addition to the initial
specifications of the game.
Hierarchy. If there is a ‘junior’ and a ‘senior’ player in a strategic game,
the game is played as if the senior player’s preferences are more important.
For example, if there is a merger or a takeover, firms will typically try and
agree on a common corporate culture (i.e. a coordination game). Although
it is possible in principle that either firm’s corporate culture will prevail, it
is most common that the larger or more powerful partner will dictate the
eventual culture.
Commitment. If one of the players commits to playing a certain strategy,
it is in the other’s interest to follow, that is, play the game as if the
committed player had already moved. For example, in a ‘chicken game’,
such as entry into a natural monopoly market, if one firm commits to
entering this market (for example, by building production facilities specific
26
1
This is a variant of the
'chicken game' played
in James Dean's Rebel
without a cause.
Chapter 4: Introduction to game theory and strategy
to this market or hiring experts for a particular technology on long-term
contracts), other firms might be deterred by this and refrain from entering
themselves.
History. If there has been a ‘traditional way’ of playing a particular game,
new versions of the game will automatically ‘converge’ on the historical
equilibrium. For example, there is no real method of choosing whether to
drive on the right side or the left side of the road – apart from selecting the
option others in the country choose.2 Also, if a coordination game between
players has traditionally been solved by taking turns of one party’s
preferred option and then the other party’s, future versions of the game
would take this into account.
Mixed strategies. If none of the above work, the best shot players
might have of ending up with an acceptable outcome is to randomise their
behaviour. We will not go into this in much detail, but the intuition is to
take into account the likely actions of the other player and one’s own payoffs and choose accordingly. For the moment, it is sufficient to recognise
that sometimes playing ‘randomly’ is the best way of maximising one’s
expected pay-offs from a game with multiple equilibria. In fact, mixing
behaviour such that each player is indifferent between the possible options
is another equilibrium concept – a mixed strategy equilibrium. This
is in contrast to the Nash equilibria we have been looking for so far – socalled pure strategy equilibria, which involve non-random behaviour,
but deterministic choice of one strategy.
2
Of course, there is also
a legal issue here, but
even without any legal
recourse, no individual
driver would have an
incentive to choose
a different side than
all others in the same
region.
4.3 Dynamic games
In the remainder of this chapter we will briefly discuss dynamic games,
and in particular the difference between static and dynamic games.
Dynamic games are, put simply, games with a time aspect in them.
For example, if one firm acts before the other, this has quite important
implications for playing the game: the second firm can play the game
knowing what the first firm has done, whereas the first firm has to make
its decision without the requisite knowledge about the follower. Some
games simply don’t make much sense to play sequentially – paper/scissor/
stones, for example, would not be very exciting if one player knew what
the other player has chosen.3 Some games, on the other hand, could be
played either simultaneously or sequentially. Setting prices, for example,
will be done without knowledge of rivals’ prices some of the time (making
it a simultaneous game), but in other situations sequential moves might be
more relevant.
Representing a sequential game is usually done by drawing a game
tree, where the first decision starts the game, and every decision point
represents a node from which the decisions of subsequent players branch
out accordingly. We illustrate this with an example. Assume that two
firms selling mineral water have to decide on their advertising budget.
For simplicity, there are only two levels of advertising, High and Low.
Harrogate Spa chooses its advertising level first, and Vittel chooses after
that. If both firms choose H, profits are zero (because all the money is
spent on advertising), if both choose L, their profits are £1m each, and if
one chooses H and the other L, the firm running an intensive advertising
campaign makes £1,250k, while the other one makes profits of £500k. A
game tree (or extensive form) of this situation would then look like
Figure 4.4.
For those unfamiliar
with paper/scissor/
stone, have a look at the
website www.netlaputa.
ne.jp/~tokyo3/e/
janken_e.html for an
explanation and its
equivalent in many
different cultures.
3
27
MN3119 Strategy
Game Tree
H
L
Harrogate Spa:
H or L?
Vittel:
H or L?
H
0/0
L
H
1,250k/500k 500k /1,250k
L
1m/1m
Figure 4.4: Game tree.
How should one analyse a sequential game? Analysing sequential games
has a very similar objective to analysing simultaneous ones: predict sensible
behaviour and an eventual outcome of the game. The way to do this in a
simultaneous game is by eliminating dominated strategies and/or playing
dominant strategies. (While this may enable us to simplify the game, it may
still not lead us to a Nash equilibrium. In this case we would have to look for
Nash equilibria after having simplified the game as much as we could.) One
way of simplifying a sequential game is by backward induction. Backward
induction works by eliminating strategies at the final node of the game (i.e.
the point when the last player makes a decision, based on the decisions
previously taken), and working one’s way forward, that is, closer to the
start of the game. The strategies we can eliminate are moves that would not
maximise an individual’s profit at that point. A rational player should never
select these moves, which means that a player anticipating rivals’ moves
should not expect these moves to be chosen.
Looking at the game referred to above we can see that Vittel would not
choose H if Harrogate Spa plays H, and they would not choose L if Harrogate
Spa chose L. This then enables Harrogate Spa to anticipate that playing H
gives profits of £1,250k, while playing L yields profits of £500k – Harrogate
Spa should then choose high advertising expenses, which Vittel will react to
by choosing low expenses.
Activity 4.4
Represent the previous game as a normal-form game, if Harrogate Spa and Vittel select
advertising expenses at the same time. What is/are the Nash equilibrium/a?
Guidance on this activity can be found in the VLE.
Commitment
We already mentioned commitment in the context of selecting among
different possible equilibria in a static game. Commitment, however, can also
be used by an agent to choose the preferred course of action that he would
not otherwise choose. Again, we use an example to illustrate this point.
28
Suppose a monopolist (M) in a market faces a potential entrant (E). The
entrant can choose whether to enter (e) or not (ne). If E does enter, the
monopolist can choose to fight (f) or to accommodate (a). If E does not
enter, M experiences business as usual. Suppose M currently makes profits of
PM = 50 (and E makes zero profits in this market), in the case of entry and
accommodation the entrant makes PE = 10, the incumbent PM = 20, and if
entry is followed up by fight (think of this as the monopolist starting a price
war flooding the market), profits are PM = PE = – 10.4 Figure 4.5 represents
this game in game tree form.
Note that the profits
should be considered
long-term profits and
the entry is a one-off
opportunity.
4
Chapter 4: Introduction to game theory and strategy
Game Tree
e
E: e or ne?
M: f or a?
f
-10/-10
ne
0/50
f
10/20
Figure 4.5: Game tree.
By backward induction we now find that the Nash equilibrium is for E to
enter and for M to accommodate – if entry does occur, M will choose payoffs of 20 over –10, and, knowing this, will prefer entering to not entering.
The monopolist will not be particularly happy with this outcome: of
course, given the choice, he would rather keep the entrant out – for
example, by committing to fight in the case of entry. To this end, M could
issue a statement along the following lines:
‘Should entry occur in our market, we will fight aggressively to
protect our market position.’
This seems sensible enough, and should go some way towards convincing
the entrant not to enter. Or should it? The entrant would have to believe
that M would indeed prefer to fight. This would imply, however, that in
the case of entry M would choose a sub-optimal action, namely one that
gives him pay-offs of –10 rather than 20. In game-theoretic terminology,
fighting after entry is not sub-game perfect – a sub-game starts at one
player’s decision node and covers all the decisions that follow on from this
node, and an action that does not maximise pay-offs at that decision node
should not be played. Since post-entry fighting is not sub-game perfect, the
entrant should not believe the monopolist if he makes this statement.
Let us now consider another strategy by M. Suppose that M sign and
publicise a long-term contract with one of suppliers that states: ‘if we, M,
ever purchase less than the current quantity, we will incur contractual
penalties of 40.’5 This seems like an odd move to begin with, since all
that it achieves is to lower pay-offs in some cases, but it never increases
pay-offs. However, it changes things around in the particular game we
are analysing. Accommodating implies sharing the market, that is, selling
less and consequently buying less from one’s supplier. This means that
it is now less attractive to accommodate, since M would have to incur
contractual penalties, taking down profits from accommodating from +20
to –20. This changes the pay-offs and the way the game is being played –
it is now sub-game perfect to fight after entry, which means that the
entrant has to choose entering and incurring losses or keeping out and
have unchanged profits. The entrant will choose to stay out, leaving the
incumbent with profits of PM = 50.
We assume here that
it is not possible to
renegotiate this contract.
5
What happened? By limiting his options, the monopolist was able to
commit to playing the game differently, which accordingly made the
entrant play the game differently as well, taking M’s expected reaction into
account. If we represent this in our game tree (Figure 4.6), the monopolist
changed the pay-offs in one game outcome and subsequently the sub-game
perfect equilibrium.
29
MN3119 Strategy
(New) Game Tree
No contract
Contract
e
e
ne
ne
0/50
f
-10/-10
a
10/20
0/50
f
a
-10/-10 -10/-20
Figure 4.6: (New) Game tree.
In this game, committing credibly was worth 30 – the difference between
the outcome of the game with commitment and the outcome without.
Committing can be done by limiting one’s options, or lowering pay-offs in
some (undesired) states of the game.
Activity 4.5
What are other examples of credible commitments? Explain how an organisation (or an
individual) limits his/her options by lowering pay-offs in one particular state of play.
Guidance on this activity can be found in the VLE.
4.4 Key concepts
• Prisoner’s dilemma
• Dominant/dominated strategies
• Iterated elimination of dominated strategies
• Nash equilibrium
• Backward induction
• Normal and extensive form games
• Sub-game perfect equilibrium.
4.5 A reminder of your learning outcomes
Having completed this chapter, and the Essential reading and Activities,
you should be able to:
• describe simple games, for instance the prisoner’s dilemma, using the
normal form and extensive form
• define the concept of Nash equilibrium and find equilibria for a game.
4.6 Sample examination questions
1. Can you find some examples from business life of coordination games?
Of ‘chicken’ games?
2. Simple coordination games have two pure-strategy Nash equilibria.
What are ways of selecting among these equilibria?
3. Consider the advertising game in Section 4.3. As you can see, there is a
first-mover advantage for Harrogate Spa. Develop an advertising game
in which there is a second-mover advantage.
4. Simultaneous games and Nash equilibria. Consider the
following games. The first two are zero-sum games in that one player’s
30
Chapter 4: Introduction to game theory and strategy
gain is the other’s loss, which is why we can write only player 1’s
pay-offs. The other two are non-zero sum. Find all pure-strategy
Nash equilibria, and demonstrate if you could identify dominant and
dominated strategies.
a)
b)
c)
d)
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MN3119 Strategy
5. Producing cars.6 Consider a normal form game between three major car
producers, C, F, and G. Each producer can produce either large cars or
small cars, but not both. That is, a car producer’s actions (strategies)
are ai = SM or LG. We denote profits for firm i as πi(aC, aF, aG), i.e. they
depend on the decisions of all three car producers. The profit function
is defined as follows:
γ if all firms play the same strategy (i.e. all SM or all LG)
a if i plays a strategy on its own (i.e. ai = SM,aj = LG or
πi = vice versa)
b if i play a strategy with one other firm, but the
remaining firm does not
{
Answer the following questions:
i. Does there exist a Nash equilibrium when a > b > g > 0?
Prove your answer.
ii. Does there exist a Nash equilibrium when a > g > b > 0?
Prove your answer.
6. Wage dispute. Consider a situation where an employer and a union
are involved in an industrial dispute – a union member is claiming
unfair dismissal and demands compensation of £10k. The case has
gone to a tribunal which will decide in favour of one or the other with
50 per cent probability. The tribunal can only award the full £10k to
either of the parties and cannot propose a compromise. Further, this
verdict is binding, that is, both parties have to abide by it. Both parties
now can choose a strategy (L) to increase their chances of winning
– hiring a lawyer, gathering evidence for or against unfair dismissal,
bribing the judge, etc. Playing L comes at a cost of £4k per player.
Choosing L gives a success probability of 100 per cent only if the other
player does not play L too. If both players choose L, the advantages
cancel out and the chances of winning are unchanged at 50 per cent.
Represent this game in normal form and find the Nash equilibrium.
Guidance on answering these Sample examination questions can be found
in the VLE.
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This exercise is
taken from Shy,
Industrial organization.
(Cambridge: MIT Press,
1995), p. 41.
6