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Managerial Economics:Economics of Strategy Game Embedded Strategy Patrick McNutt wwww wwww wwww.... pppp aaaa tttt rrrr iiii cccc kkkk mmmm cccc nnnn uuuu tttt tttt.... cccc oooo mmmmAbridged ©

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Workshop Lesson plan…. Plan is to follow Besankos Economics of Strategy 5 th Edition Day 1: Introduction and setting the scene using McNutts 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 pm 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

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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

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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.

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Strategy architecture: Observe patterns over time time period t = NOW time period t+ 1 = WAY FORWARD dT/dt = -1

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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)

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Focus on signals and type..Baumol type, Marris type, CL type, Player types Why? Key to understanding firm behaviour & company strategy as observed in real time

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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

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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?

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Unit 1Management Models Understand Penrose effect and GHM Theory (Besanko pp ) 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

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BehaviouralBaumolMarrisWilliamson ObjectiveMultiple goalsTR:SalesGrowth:gdManagerial Utility or Value ApproachSatisficing – subject to Profit Constraint Maximisation– subject to Profit Constraint Maximisation - subject to Security Constraint Maximisation - subject to Profit Constraint Principal Agent Issue Yes Short v Long Term VariesShort and also dynamic LongShort Reaction & Interaction YesPartial Decision Making Coalitions YesManagement and zero-sum Relevance of shareholders Yes,..TCE

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Baumol strategy or Maximising Market Share: MMS Recognise zero sum constaint and entropy (redistribution within market shares) Market Shares (before): Zero-sum (after): Entropy (after): Iff {qi/Q} > 0 market exhibits non- price competition: Check {q NOKIA /Q Smartphones } < 0

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Total Revenue Total Cost Profit/LossSales driven beyond the point of max profit but within the minimum profit constraint Min Profit Constraint Output £

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MMS-strategy Entropy when the industry elasticity η p is less than the firm-specific elasticity: η p < є p Player as market share equation: MSa = [η p + σ.MSb]/є p Market Penetration: є p < σ.MSb and Market poaching σ < 1

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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 = Tobins q ratio

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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 firms 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.

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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 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

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Focus on the cost technology, vertical chains and cost leadership Why? Need to observe the supply chain and a sustainable competitive advantage

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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)

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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

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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

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Sources of cost efficiency Measure of the level of resources needed to create given level of value 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?

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£ Q 0,0 SAC 1 SAC 2 SAC 3 LAC q1q1 q2q2 Lower per unit cost for more units sold qtqt Current plan of plant closures to lower cost base not completed Av.Cost = marginal cost MES Point: Production - demand - production to attain cost leadership

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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)..McNutts 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?

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Focus on player strategy set in a game dimension So: dark strategy S1: limit pricing strategy S2: credible threat strategy

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Oligopoly and Game Theory T3 + 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.

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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

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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

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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

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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

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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

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Limit Pricing Model in Besanko pp 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]

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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)

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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

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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 and also in Kaelo v2.0

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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

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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

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Prisoners Dilemma Apply Prisoners Dilemma to Pricing Policy: Elasticity and Threat of Entry Player 2 Strategy AStrategy B Player 1Strategy A2 0 3 Strategy B Firm 2 profit payoffs High Price $6 Low Price $4 Firm 1 payoffsHigh Price $610 x 13 Low Price $413 y2 Would outcome change if the game is repeated? The Folk Theorem

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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

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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 AStrategy B Strategy A3,32,4 Strategy B4,21,1

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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.

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GEMS and Strategic Analysis Knowledge of the identity of near rival: Action you -> Reaction rival -> NashReply you Fig 9.4 p115 McNutt & Fig 8.3 p231 Besanko

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Game Embedded Strategy: GEMS: Complete the Diagram What Market should Your Company be in? Games & Feedback

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Final Scenarios for YOUR Company…… The Rationale Markets evolve The Rationale Type, Technology and Time The Rationale Know your market The Strategy Non-binary The Strategy Game metrics and analytics The Strategy GEMS

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Thank you for participating……… Sapere aude That which one can know, one should dare to know

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