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,

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,

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.


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.


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).


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.


Mars 1: decision approach

[-200]buy

not buy

M

[0]


Mars 2: naïve game theory

[-200, 0]buy

not buy

M

[-500, -50]

[0, 0]not buy

buy

H

0


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


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.


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


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


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.


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.


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


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?


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.


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


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


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.


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).


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.


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.


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…


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,

Documents

mars payoff

charge mars

mars profits

rival mars

hershey payoff

trail of mars mms

professor wolframmba201a

competitors decisions