Introduction to Game Theory and Strategic Interactions

Introduction to Game Theory and
Strategic Interactions
Market Structure and Competition
• With
extreme market structures, no need to consider rival actions:
– Monopoly: no rivals
– Perfect competition
• Intermediate
case: Oligopoly or concentrated industry
– Need to consider rivals’ reactions
– Impossible to fully control your own destiny
• Can
be at competitor’s mercy no matter how good you are
– Can the current environment be made more attractive?
• If
the rules of the game change, the outcome can also change
(i.e. the structure of competition may not be fixed)
What is Game Theory?
• Game Theory:
– Formal study of strategic behavior, relation between
interdependent agents (firms, trade authorities, armies, litigation,
athletes, nuclear deterrence between countries,…)
– Teaches us how to think about strategic interactions
– Rivalry/cooperation, commitment, investment, signaling
• Provides insight into effect of changing/choosing the game
– Is the only formal tool for analyzing strategic interactions
• Requires explicit assumptions about timing and payoffs
• Provides predictions about behavior under full rationality
Important Principle: Anticipation
• Anticipate actions and reactions
– Must analyze competitors’ situation carefully
• i.e., put yourself in their shoes
– Must
consider whether they are going through the same
• acting rational
• determining the likely payoff structure
– When
these things hold, game theory can predict the likely
responses to various strategies
WARNING: Exercise Caution with Game Theory in
Business Situations
• Direct applicability for business strategic decision-making limited by
strong rationality assumptions
– Sometimes people behave irrationally
• Perhaps they do not think through their problem
• Their objectives may not be profit maximization
– However, rationality can be achieved by being empirically
• People may not solve complex optimization problems but
use heuristics that they update every so often.
• More successful agents are selected by markets
– survivor explanation
– Can be sensitive to information and timing structure
– Small change may make big difference
– Often there is not a unique answer
Applicability to Business Situations
• Use
game theory to think about strategic interactions on a
broad level
– Get insight into strategic interaction
• Explains many real world observations that cannot otherwise
be rationalized (e.g. both competitors would rather not be
undertaking their actions, but cannot help themselves)
– Get insight into effect of changing the game
• Adopt strategies that account for anticipated responses
when maximizing value
– Can you induce rivals to take actions beneficial to you?
– Can you change the game in a favorable way?
– If game is good now, can you prevent it from getting bad?
• Problems of technological innovation, mobile strategic assets
Fashion Pricing: Example of Strategic Interaction
– You are managing a line of fashion garment and it is
the end of the season
• Should I discount to liquidate stock?
– Decision: start discounting now or wait?
– Setup
• You face one competitor in exactly same situation you are in.
– Fashion Sensitive customers buy only the items they like
• 2m additional profits from fashion customers if you
keep prices high
• 1m if you discount now.
– Bargain Hunters buy any discounted item.
• Split 2m if both discount now or both wait
• 4m profits if you discount and competitor waits,
• 0m profits if competitor discounts and you wait
Game: A Model of Strategic Interactions
What is a game?
– Players (e.g. Store 1 and Store 2)
– Rules (e.g. simultaneously choose whether to start discounting)
– Strategies (Discount or wait)
– Payoffs (Profits from strategy)
• Convention has payoffs written as (Player on left, Player on
Fashion Pricing Game: Formal Approach To Analysis
Suppose Store 2 waits, what should 1 do?
Suppose Store 2 discounts, what should 1 do?
Fashion Pricing Game: Formal Approach To Analysis
Suppose Store 1 waits, what should 2 do?
Suppose Store 1 discounts, what should 2 do?
Fashion Pricing Game: Formal Approach To Analysis
Dominant strategy for both players is Discount.
(Nash) Equilibrium is Discount/Discount.
Dominant Strategies
• Idea: If the payoff for me under one action is highest for all
possible actions of my opponent, then this highest payoff strategy
is called a dominant strategy
• Discounting is the dominant strategy in this game for both players
• How to approach a game:
-- if you have a dominant strategy, use it
-- if there is a dominated strategy ignore it
Nash Equilibrium: Concept of a “Reasonable” Outcome
Definition: Given what other players are doing, no player would want to
change strategy unilaterally (i.e. each player’s strategy is an optimal
response to the other players’ strategies)
No Dominant Strategy but, Multiple Nash Equilibria
Sometimes no solution (i.e. no Nash Equilibrium)
Thinking Strategically
• Avoid thinking only in terms of ‘how does this move
affect me’ (direct effects)
– Need to consider strategic effects:
• How does this move affect me through the
impact on the game and on the other players?
– Can I change the game in a favorable way?
Strategic Commitment
• Strategic commitments are decisions that have long run
impact and are hard to reverse (Example: Installation of
additional production capacity)
• These differ from tactical moves which are easy to
reverse and have only a short run impact (Example: A
store cutting the price on certain items)
• To achieve the desired result, the commitment should be
– Visible
– Understandable
– Credible
• To be credible, the commitment should be irreversible
Two Effects of Commitments
• A commitment may have a direct and a strategic
effect on the firm’s profitability
– Direct effect is the change in the present value of
profits assuming that the rival’s tactics are unaffected
by the commitment
– The strategic effect is the further change in the
present value of the firm’s profits due to the rival
adjusting its tactics
Credible Commitments
Strategic moves signal competitors about behavior.
Moves must be meaningful, not seen as random.
Example: Wal-Mart opens stores in small towns that
can only support one store. If Wal-Mart enters
first, other firm will not, but Wal-Mart will enter
regardless of its competitor, to show commitment
even if it means taking a lose.
Wal-Mart Competitor
-- Action -Wal-Mart
Don’t Enter
-10, -10
20, 0
Don’t Enter
0, 20
0, 0
Politics Intrudes
Governments often engage in strategic behavior to try to create an
advantage over competitors, such as by giving a subsidy to
domestic producer.
Suppose the market for a new model of aircraft is expected to
support only one maker—Boeing or Airbus—but not both. If both
produce the aircraft, both will lose money as the matrix shows.
-- Action -Boeing
Don’t Produce
Produce Don’t Produce
-10, -10
0, 100
100, 0
0, 0
Politics Intrudes
Now, suppose European governments, for political reasons, want to
be sure Airbus does build aircrafts.
The governments announce a subsidy to Airbus of 20. The subsidy
will be paid regardless of what Boeing does.
This reduces the incentive for Boeing to build, Airbus cannot lose—
thanks to the subsidy.
Problem can be tit-for-tat—U.S. government gives Boeing subsidy or
retaliates elsewhere.
-- Action -Boeing
Don’t Produce
Produce Don’t Produce
-10, 10
0, 120
100, 0
0, 0
Jack and Jill Oligopoly Game
Jack’s Decision
Sell 40 Gallons
Jack gets
$1,600 profit
Sell 40
Jill gets
$1,600 profit
Sell 30 Gallons
Jack gets
$1,500 profit
Jill gets
$2,000 profit
Jack gets
$2,000 profit
Sell 30
Jill gets
$1,500 profit
Jack gets
$1,800 profit
Jill gets
$1,800 profit
What type of game is this?
Copyright©2003 Southwestern/Thomson Learning