Managerial Economics:Economics of Strategy Game Embedded Strategy Patrick McNutt wwww wwww wwww.... pppp aaaa tttt rrrr iiii cccc kkkk mmmm cccc nnnn uuuu.
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Managerial Managerial Economics:Economics Economics:Economics
of Strategyof Strategy
Managerial Managerial Economics:Economics Economics:Economics
of Strategyof StrategyGame Embedded StrategyGame Embedded Strategy
Patrick McNuttPatrick McNuttwww.patrickmcnutt.com
Abridged Abridged ©©
Workshop Lesson plan….
• Plan is to follow Besanko’s Economics of Strategy 5th Edition
• Day 1: Introduction and setting the scene using McNutt’s Game Embedded Strategy Chapters 1 and 2
• Day 1 : Revision of Chapters 3 and 5 (Used in Assignment No 1) and Introduce Chapter 2 (Economies of Scale and Scope)
• Day 1 Workshop Study Groups & Case Analysis• Break-out Sessions at 330-530pm Day 1 and Day 2 with group
Presentation Day 3 at 2pm start• Day 2 & 3: Focus on Chapters 8,9,10 and 11 and link into Units
3 and 4• Extra Chapters & Topics at the discretion of Workshop Director
Workshop Focus
• Signals, Management type and relevance of TCE..Unit 1. Besanko Ch 3 and 5, McNutt Ch 1
• Cost leadership and economics of capacity..commitment Unit 2. Besanko Ch 2 and McNutt Ch 5
• Market-as-a-game…market structure, oligopoly, and dynamic games of rivalry…Units 3 and 4. Besanko Ch 8,9,10 and 11 and McNutt Ch 6,7,8,9
• Real Time case Analysis…go to Page 45 of colour-coded Storybook
Workshop Case Study
• Case assignment and group allocation• Objective is to define game dimension,
construct a CTL, define near-rival and find NE• Focus on geography and on a product [to
include an innovation, technology, service]• Research ‘sum of competitors’ in the market-
as-a-game• Apply the course materials as discussed in
class as ‘filters’ to narrow research.
Strategy architecture:
Observe patterns over time
time period t = NOWtime period t+ 1 = WAY
FORWARD
dT/dt = -1
Q: Why the game theoretic focus? A: At the frontier of
economic analysis…..• Management observed as ‘they are’ not ‘assumed to
be’• Management can be ranked (by type) and are faced
with trade-offs => something must come ‘top of the menu’
• Firms are conduits of information flows (vertical chain)• Supply chain capacity constraints and technology-lag• Reducing price does not necessarily lead to an increase
in revenues (elasticity)• Prices are primarily signals (observed behavior)• Companies understand the competitive threat as
(recognised) interdependence (zero-sum and entropy)
Focus on signals and Focus on signals and type..Baumol type, Marris type..Baumol type, Marris type, CL type, Player typestype, CL type, Player types
Focus on signals and Focus on signals and type..Baumol type, Marris type..Baumol type, Marris type, CL type, Player typestype, CL type, Player types
Why? Key to understanding firm Why? Key to understanding firm behaviour & company strategy behaviour & company strategy
as observed in real timeas observed in real time
Costs of not being a Player in the market-as-a-
game• Agency costs can accrue..across the shareholders (esp
institutional)..changing CEOs• Bounded rationality and opportunity costs with trade-
offs• Make or Buy dilemma• First Mover Advantage (FMA) v Second Mover
Advantage (SMA)• Play to win v Play not to lose!• Follower status ‘behind the curve’• Technology lag and failure to differentiate ‘fast enough’
to sustain a competitive advantage
The competitive threat!• Traditional Analysis can be biased
towards answering this question for Company X: what market are we in and how can
we do better?• Economics of strategy (GEMS) asks:
what market should we be in?
Unit 1Management Models
• Understand Penrose effect and GHM Theory (Besanko pp158-161) and incomplete contracting
• Explain the rule MC = MR• Understand Bounded Rationality• Go to Table 1.2 pp14 McNutt Game
Embedded Strategy Compare with Next Slide where you add in
Williamson/TCE
Behavioural Baumol Marris Williamson
Objective Multiple goals TR:Sales Growth:gd Managerial Utility or Value
Approach Satisficing – subject to Profit
Constraint
Maximisation– subject to
Profit Constraint
Maximisation - subject to
Security Constraint
Maximisation - subject to Profit Constraint
Principal Agent Issue
Yes Yes Yes Yes
Short v Long Term
Varies Short and also dynamic
Long Short
Reaction & Interaction
Yes Partial Partial Partial
Decision Making Coalitions
Yes Management and zero-sum
Relevance of shareholders
Yes,..TCE
Baumol strategy or Maximising Market
Share: MMS• Recognise zero sum constaint and
entropy (redistribution within market shares)
• Market Shares (before): 40+30+20+10• Zero-sum (after): 30+40+20+10• Entropy (after): 30+35+25+10• Iff {∆qi/∆Q} > 0 market exhibits non-
price competition:• Check {∆qNOKIA/∆QSmartphones} < 0
Total Revenue
Total Cost
Profit/LossSales driven beyond the point of max profit but within the minimum profit constraint
Min Profit Constraint
Output
£
MMS-strategy
• Entropy when the industry elasticity ηp is less than the firm-specific elasticity: ηp < єp
• Player a’s market share equation: MSa = [ηp + σ.MSb]/єp
• Market Penetration: єp < σ.MSb and Market poaching σ < 1
Precis on a Marris model…
• McNutt Ch 4: Understand balanced equation gc = gd to identify parameters of profitability
• Supply of capital: debt v equity• Demand for capital: R&D exp v dividends• Instrumental variables influencing growth
– visit Diageo case in Kaelo v2.0• KFIs: profits/output and output/capital• Marris v = Tobin’s q ratio
Marris equations:dividends paradox & operating gearing
• Understand the α = operating gearing…..how much extra profit earned from every $1 of extra revenue
gd = gc = αp
• P = eps/r : Static firm no growth opportunities• P = eps/r + PV(GO): Dynamic firm with growth
opportunities (GO)…this is a Marris firm’s focus on gd.
• McNutt p50: Alternative to Calculating share price by DCF formula : share price pattern embedded in BGP equation as quadratic function of vertex form (h,k), where k is the share price turning point on the BGP and h is proxy for gd.
Marris v and Tobin q
• Allow q = v, and if (mean reversion) v < mean v then share prices should increase
• Marris v is a long term tool not a short term tool
• If v < 1 BUY ..if v > 1 SELL: Common denominator is the plough-back ratio (PBR) = 1 – divs/eps.
• But more R&D from G1 to G2 can accrue an agency cost as Bayesian shareholders SELL as value falls V1 to V2.
• More dividends could signal an absence of R&D growth
U1 U2 U3 U4Valuation ratio Shareholders perference
xBest to management
V2 Valuation curve
G1 G2 Growth rate
V1
V(min)
y
0
Focus on the cost Focus on the cost technology, vertical chains technology, vertical chains
and cost leadershipand cost leadership
Focus on the cost Focus on the cost technology, vertical chains technology, vertical chains
and cost leadershipand cost leadership
Why? Need to observe the Why? Need to observe the supply chain and a sustainable supply chain and a sustainable
competitive advantagecompetitive advantage
Bridge Unit 1 and Unit 2
• Shareholder as principals expect max value• Management to minimise the agency costs• Positive Learning Transfer, PLT• Nomenclature on type: Baumol type (signal
= price), Marris type (signal = dividends).• Cost leadership type (McNutt Ch 5,
Besanko Ch 2 and link into Besanko Ch 13 on stategic cost advantage)
TCE & Co-ordination• Coase asked in ‘ The Nature of Firms’ in 1937:
• Transaction costs: costs of negotiating, monitoring and enforcing contracts.• Behavioural assumptions: bounded rationality & opportunism.• The relative cost of organising transaction through different forms of
governance determined by:• Extent to which complete contracts are possible. Where contract refers to
agreement between two parties which could be explicit or not.• Extent to which there is a threat of opportunism by parties in the
transaction.• Degree of asset specificity in the transaction.• Frequency with which the transaction is repeated.
Storybook p.12
Why are not all economic transactions coordinated by markets?
When transaction costs are too high, exchange to be coordinated by organisations
Emphasis in Unit 2: Cost leadership
as a type (of player)• Profitabiltiy v scale and (size and scope)• Production as a Cost-volume constraint
• Understanding the economcis of productivity as exemplar for incentives
• Normalisation equation• Sources of Cost Efficiency [next slide]
• Cost leadership type checklist..McNutt p61
Sources of cost efficiency
• Measure of the level of resources needed to create given level of value
Production-cost relationship
Production-cost relationship
Capacity utilisation
How much to produce given capital size?
Capacity utilisation
How much to produce given capital size?
Economies of scale
How big should the scale of the operation be?
Economies of scale
How big should the scale of the operation be?
Other
X-inefficiencies, location, timing, external environment, organisation discretionary policies
Other
X-inefficiencies, location, timing, external environment, organisation discretionary policies
Transaction costs
Which are the vertical boundaries of the firm?
Transaction costs
Which are the vertical boundaries of the firm?
Economies of scope
What product varieties to produce?
Economies of scope
What product varieties to produce?
Learning and experience factors
How long to produce for?
Learning and experience factors
How long to produce for?
£
Q0,0
SAC1SAC2
SAC3 LAC
q1q2
Lower per unit cost for more units sold
qt
Current plan of plant closures to lower cost base not completed
Av.Cost = marginal cost
MES Point: Production - demand - productionto attain cost leadership
Capacity Constraints: Why ? Sustainable competitive
advantage• Case A: Unexhausted economies of scale due to
lag in product differentiation ..excess capacity?• Case B: Firm-as-a-player cannot produce sufficient
output to reach MES ..zero-sum?• Case C: Firm-as-a-player restraints production
(deliberate intent)..McNutt’s dilemma as production drives demand…(Veblen monopoly type)
• Speed of technology increases the firm-specific risk of Case A..CLASS QUESTION: adopt Case C to solve A?
Focus on player Focus on player strategy set in a strategy set in a game dimensiongame dimension
Focus on player Focus on player strategy set in a strategy set in a game dimensiongame dimension
So: dark strategySo: dark strategy
S1: limit pricing strategyS1: limit pricing strategy
S2: credible threat strategyS2: credible threat strategy
Oligopoly and Game TheoryT3 + GEMS
• Study of strategic interactions: how firms adopt alternative strategies by taking into account rival behaviour
• Structured and logical method of considering strategic situations. It makes possible breaking down a competitive situation into its key elements and analysing the dynamics between the players.
• Key elements:• Players. (Management).• Strategies.• Payoffs
• Equilibrium. Every player plays her best strategy given the strategies of the other players.
• Objective. To explore oligopolistic industries from a game embedded strategy (GEMS) perspective.
• The use of T3 framework, which considers 3 key dimensions (Type, Technology & Time), will allow oligopolists to better predict the likely strategic response of competitors when analysing competition from game embedded strategy perspective.
Unit 3: Game type and signalling
• Decisions are interpreted as signals• Observed patterns and Critical Time Line.
Nissan CTL pp20 or Apple CTL p94 in McNutt• Recognition of market interdependence (zero-
sum)• Price as a signal v Baumol model of TR max• Scale, size and capacity: cost leadership
signals• Dividends as signals in Marris model
Bridging Unit 1 and Unit 3: Game analysis
• Binary reaction; Will Player B react? Yes or No?
• If YES, decision may be parked
• If NO, decision proceeds on error
• Surprise
• Non-binary reaction: Player B will react. Probability = x%
• Decision taking on conjecture of likely reaction
• No Surprise
What determines the intensity of rival competition?
• Price Bertrand games [strategic complements + elasticity] and non-price Cournot games [strategic substitutes + zero sum].
• Reaction, signalling and ‘best you can do, given reaction of competitor’
• Moonshots, noise and cheap talk in a signalling game (on rival costs, rival capacity)
• Patterns of observed behaviour & likely reaction• Leader-follower as ‘knowledge’ and trust• Accommodation v entry deterrence• ’
Link Units 3 and 4: Game Dimension
• What is a game – loss of independence?• Nash premise: Action, Reaction and Reply• Non-cooperative sequential (dynamic) games• Introduce oligopoly and players (companies) n
< 5• TR Test and Elasticity McNutt pp36• Single shot price reduction: (i) fail TR test and
revenues fall; (ii) near rival misreads the price as a signal
Type of Players• Incumbent type v entrant type• Dominant type v monopoly incumbent • De novo entrant type and geography of
the market• Potential entrant type and the threat of
entry• Newborn players and extant
(incumbent) type
Limit Pricing Model in Besanko pp310-318 and McNutt
pp71-76• Outline the game dimension:
dominant incumbents v camuflaged entrant type
• Define strategy set for incumbents• Allow entry and define the equilbrium• Preference - entry deterrent strategy
v accomodation [next slide]
1
2
Enter
0,10
-7,2
5,8
Do Not Enter
Agressive
Accommodating
Entry Deterrent Strategy• Reputation of the incumbents• Entry function of the entrant• De novo and entry at time period t• Potential entrant - forces reaction
at time period t from incumbent• Coogans bluff strategy (classic
poker strategy)
Describe (prices as signals) game
dimension• Focus on the Sony v Microsoft game in
McNutt Fig 9.3 and Fig 9.4 pp 115• Players and type of players• Speed and frequency of reaction in the CTL• Observe the pattern of observed behaviour• Identify a Nash equilibrium…sequence of price
reactions towards NE….sequence of non-price signals on output towards NE.
• Identify intersection of reaction functions
Continuing with Unit 4: Define a price war
• Determine the Bertrand reaction function
• Compute a Critical Time Line (CTL)from observed signals..Examples of CTL in McNutt pp 20 Figure 2.1 and pp94 Fig 7.4
• Find a price point of intersection• Case Analysis of Sony v Microsoft at
McNutt pp 114-116 and also in Kaelo v2.0
Visit Kaelo v2.0 and Games/Signalling
• Example: Critical Time Line in Sony v Microsoft in Kaelo v2.0, Apple v Nokia game dimension McNutt pp92
• Play a PD game and investment game in Kaelo v2.0
• Altruism, fairness, selfish gene, dominant strategy, minimax
• Understand NE: if neither player would gain by unilaterally changing strategy
Nash Equilibria• Define the Nash equilibria [next slide]• Analyse the Payoff matrix
(B,Y) > (A, X)• Commitment and chat• Punishment strategy• Strategic ToolBox in terms of credible
mechanisms
10,10
8,-50,0
-5,8
Strategy A
Strategy B
Strategy X Strategy Y
Player 1
Player 2
Prisoners’ Dilemma
•Apply Prisoners’ Dilemma to Pricing Policy: Elasticity and Threat of Entry
Player 2
Strategy A Strategy B
Player 1 Strategy A 2 2 0 3
Strategy B 3 0 1 1
Firm 2 profit payoffs
High Price $6
Low Price $4
Firm 1 payoffs High Price $6 10 10 x 13
Low Price $4 13 y 2 2
•Would outcome change if the game is repeated? The Folk Theorem
10,10
13,02,2
0,13
Low Prices
High Prices
Low Prices High Prices
Player 1
Player 2
Games as Strategy: Strategic ToolBox
• Segmentation strategy to obtain FMA• Relevance of chain-store paradox• Dark Strategy and 3 Mistakes in McNutt
pp95-97• Second Mover Advantage, SMA: Play not
to lose v play to win (FMA)• Strategic ToolBox in terms of identifying
the competitive threat v cartel coordination on (High. High)..Cheating
Class Exercise: Find Nash Equilibrium?
• Two players must simultaneously decide which strategy to adopt.
• Does this example illustrate the concept of first mover advantage v second mover advantage
• Should the players chat to avoid (1,1)?.
Strategy A Strategy B
Strategy A 3,3 2,4
Strategy B 4,2 1,1
Absence of price wars?Link into the HBR
articles• Hypothesis: Price Wars occur due
to a mis-match in price signals.• Mismatch can occur (i) declining
volumes ∆qi/∆Q < 0; (ii) uncompetitive cost structure (productivity); (iii) technology & time; (iv) management type.
GEMS and Strategic Analysis
•Knowledge of the identity of near rival:
Actionyou -> Reactionrival
-> NashReplyyou
Fig 9.4 p115 McNutt
& Fig 8.3 p231 Besanko
Game Embedded Strategy: GEMS:
Complete the Diagram
What Market should Your Company be in?
Games & Feedback
Industry Analysis
Play-out Game Scenario B
e.g. change the gamenew
product development
Strategic Options (Identify the Games)
Play-out Game Scenario A e.g. market
entrycompetitors reactions
Play-out Game Scenario C
e.g. change the game
Consolidation
Strategic Decisions
Porter’s 5 Forces BCG Value Net
S.W.O.T. P.A.R.T.S. McKinsey
Game theory
Organizational Goals
Game theory Insights
Final Scenarios for YOUR Company……
• The RationaleMarkets evolve
• The RationaleType, Technology
and Time• The RationaleKnow your market
• The StrategyNon-binary
• The StrategyGame metrics and
analytics• The Strategy
GEMS
Thank you for participating………
Sapere aude
‘That which one can know, one should dare to know’
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