MBA201a: Strategic Thinking. Overview –Context: You’re in an industry with a small number of competitors. You’re concerned that if you cut your price,
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Overview
– Context: You’re in an industry with a small number of
competitors. You’re concerned that if you cut your price,
your competitors will, too. How do you act?
– The same reasoning applies for pretty much any strategic
decision:
• Capacity expansion,
• Entry and exit,
• Product positioning,
• Advertising expenditures, etc.
Professor Wolfram Page 2MBA201a - Fall 2009
Short digression on the term “strategy”
Strategy includes:
– Organizational structure and processes needed to
implement the firm’s plan.
– Boundaries of the firm: scale, scope, extent of outsourcing.
– Formal analysis of interactions between competitors: game
theory.
Professor Wolfram MBA201a - Fall 2009 Page 3
We will apply the tools of game theory
Informally, game theory reminds us to:
– Understand our competitors. Our results depend not only
on our own decisions but on our competitors’ decisions as
well.
– Look into the future. Decisions taken today may have an
impact in future decisions, both by ourselves and by our
competitors.
– Pay attention to information. Who knows what can make
a difference.
– Look for win-win opportunities. Some situations are
competitive, but others offer benefits to all.
Professor Wolfram Page 4MBA201a - Fall 2009
The E.T. “chocolate wars”
In the movie E.T. a trail of Reese's Pieces, one of Hershey's chocolate brands, is used to lure the little alien into the house. As a result of the publicity created by this scene, sales of Reese's Pieces tripled, allowing Hershey to catch up with rival Mars.
Professor Wolfram Page 5MBA201a - Fall 2009
Chocolate wars…the details
– Universal Studio's original plan was to use a trail of Mars’
M&Ms and charge Mars $1mm for the product placement.
– However, Mars turned down the offer, presumably because
it thought $1mm was high.
– The producers of E.T. then turned to Hershey, who accepted
the deal, which turned out to be very favorable to them (and
unfavorable to Mars).
Professor Wolfram Page 6MBA201a - Fall 2009
Formal analysis of the chocolate wars
Suppose:
– Publicity from the product placement would have increased
Mars’ profits by $800,000.
– Hershey's increase in market share cost Mars $500,000.
– Benefit to Hershey from having its brand featured is given by
b.
– Hershey knows the value of b. Mars knows only that
b=$1,200,000 or b=$700,000 with equal probability.
Professor Wolfram Page 7MBA201a - Fall 2009
Mars 2: naïve game theory
[-200, 0]buy
not buy
M
[-500, -50]
[0, 0]not buy
buy
H
0
Professor Wolfram Page 9MBA201a - Fall 2009
Payoff to MarsPayoff to Hershey
Payoff to Hershey =
.5x(1.2M-1M) + .5(.7M-1M)
Mars 3: real game theory
[-500, 200]
[0, 0]
[-500, -300]
[0, 0]
[-200, 0]buy
not buy
b = 1200(50%)
not buy
buy
not buy
buy
M
N
H
Hb = 700
(50%)
-500
0-250
Professor Wolfram Page 10MBA201a - Fall 2009
Mars: summary
– Think about your competitor: Mars should think about
Hershey, and vice versa.
– Timing matters: Hershey had the last move.
– Information matters: Hershey has more information than
Mars, and in this example it made a difference.
– Key business insight: part of the benefit to Mars was to
keep the opportunity from Hershey.
Professor Wolfram Page 11MBA201a - Fall 2009
Game theory: concepts
– What are the elements of a game?
• Players (in previous example: Mars and Hershey)
• Rules (sequentially respond to Universal’s offer)
• Strategies (Yes or No)
• Payoffs (sales minus payment to Universal)
– What can I do with it?
• Determine how good each of my strategies is
• Figure out what my rival is probably going to do
Professor Wolfram Page 12MBA201a - Fall 2009
Normal-form games
– A convenient way to represent games with two players who
make simultaneous choices.
– Imagine the Beauty Contest game with two players, and
assume players can only choose 0 or 1.
Player 2
0 1
0
1
P/2 P
0 P/2
P/2 0
P P/2Player 1
Professor Wolfram Page 13MBA201a - Fall 2009
Player 2’s payoff if player 1 chooses 0.
Player 1’s payoff if player 2 chooses 1.
Dominant/dominated strategies
– Dominant strategy: payoff is greater than any other strategy
regardless of rival’s choice.
• Rule 1: if there is one, choose it.
– Dominated strategy: payoff is lower than some other
strategy regardless of rival’s choice.
• Rule 2: do not choose dominated strategies.
Professor Wolfram Page 14MBA201a - Fall 2009
Outcomes of games
– Sometimes a game can be “solved” just by looking at
dominant and dominated strategies (e.g., example above).
– However, there are many games for which this isn’t enough
to produce an outcome.
– Nash equilibrium: Combination of moves in which no
player would want to change her strategy unilaterally. Each
chooses its best strategy given what the others are doing.
Professor Wolfram Page 15MBA201a - Fall 2009
Prisoner’s dilemma
Iraq’s Output
2 4
2
4
Iran’s Output46 26
52 32
42 44
22 24
Example: output setting (million barrels a day) by OPEC members
Professor Wolfram Page 16MBA201a - Fall 2009
Prisoner’s dilemma…
– Dominant strategies: high output.
– Equilibrium payoffs are (32,24), much worse than would be
attained by low output, (46,42).
– Conflict between individual incentives and joint incentives.
– Typical of many business situations.
– Are cartels inherently unstable?
Professor Wolfram Page 17MBA201a - Fall 2009
Auctions
– Remember we said that games involved players, rules and
payoffs?
– In auctions, the rules of the game, and how players’ choices
affect their payoffs, are very well-defined.
– Auctions have become relevant in a number of business
contexts.
Professor Wolfram Page 18MBA201a - Fall 2009
Common auction mechanisms
– English auction (a.k.a. oral ascending auction). Price is
successively raised until only one bidder remains.
• Antiques, Artwork, Wine
• Used cars
– Sealed-bid first-price auction (or simply first-price auction).
Highest/lowest bid is selected and pays/receives that value.
• Mineral rights
• Building contracts
Professor Wolfram Page 19MBA201a - Fall 2009
More auction mechanisms
– Dutch auction (a.k.a. oral descending auction). Price is
successively decreased until one bidder calls.
• Flowers, tobacco, fish
• Privatizations
– Second price auction (a.k.a. Vickrey auction). Just like first
price auction, but: winner pays price equal to second highest
bid.
• eBay
• Stamps and other collectibles
• Radio spectrum rights in New Zealand
Professor Wolfram MBA201a - Fall 2009 Page 20
Bidding strategies vary by auction type
– Optimal bidding strategy in second-price auction is to bid
own value.
– Optimal bidding strategy in English auction is to continue
bidding up to own valuation.
– What about in a Dutch or sealed-bid auction?
– … beware the Winner’s Curse.
Professor Wolfram MBA201a - Fall 2009 Page 21
Winner’s Curse example
– Example: bids for oil-track auction
– True, common, value of object is X.
– Each bidder i estimates that value is X + ei.
– Average ei is zero: bidders’ estimates are unbiased.
– Suppose each bidder bids his or her valuation minus some
margin mi.
– Winning bid will correspond to highest ei, i.e., winner will be
the most “optimistic” bidder.
– If mi is not sufficiently large, i.e., if mi < ei, then winner will
lose money (bids more than true value).
Professor Wolfram Page 22MBA201a - Fall 2009
The Winner’s Curse graphically
X s1 = X + e1s2 = X + e2 b1b2
value
X = true valuesi = signal received by bidder i
bi = bidder i’s bid
Winner’s Curse: Bidder 1 (winner), while bidding less than his/her value assessment ends up losing money. Should take this effect into account and bid even lower relative to signal.
Professor Wolfram Page 23MBA201a - Fall 2009
Comparing auction mechanisms
– If valuations are independent and bidders are similar and
risk neutral, then all of the above auction mechanisms
induce the same average seller revenue.
– If valuations are correlated (extreme: common value), then
the English auction implies higher average revenue than the
sealed-bid auction.
– Collusion among bidders easier with English auction.
– Transactions costs vary across auctions.
Professor Wolfram Page 24MBA201a - Fall 2009
Takeaways
– Game theory is a formal approach to strategy.
– Highlights impact of strategic interactions among firms or
other “players.”
– Forces you to consider your competitors’ choices.
– Auctions lend themselves well to game-theoretic analysis.
– Concepts: players, strategies, dominant and dominated
strategies, best responses, Nash equilibrium.
– Stay tuned for another example on Thursday…
Professor Wolfram Page 25MBA201a - Fall 2009
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