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Managerial Economics:Economics of Strategy

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1 Managerial Economics:Economics of Strategy
Game Embedded Strategy Patrick McNutt Abridged ©

2 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 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

3 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

4 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.

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

6 Q: Why the game theoretic focus
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)

7 Focus on signals and type
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

8 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

9 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?

10 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

11 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 Short v Long Term Varies Short and also dynamic Long Short Reaction & Interaction Partial Decision Making Coalitions Management and zero-sum Relevance of shareholders Yes,..TCE

12 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 {∆qNOKIA/∆QSmartphones} < 0

13 Total Revenue Total Cost Profit/Loss Sales driven beyond the point of max profit but within the minimum profit constraint Min Profit Constraint Output

14 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

15 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

16 Marris equations:dividends paradox & operating gearing
Understand the α = operating gearing… 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.

17 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


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

20 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)

21 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. Why are not all economic transactions coordinated by markets? When transaction costs are too high, exchange to be coordinated by organisations Storybook p.12 21

22 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

23 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? Economies of scale How big should the scale of the operation be? Other X-inefficiencies, location, timing, external environment, organisation discretionary policies Transaction costs Which are the vertical boundaries of the firm? Economies of scope What product varieties to produce? Learning and experience factors How long to produce for? 23

24 MES Point: Production - demand - production
to attain cost leadership Lower per unit cost for more units sold SAC1 SAC2 SAC3 LAC Av.Cost = marginal cost Q 0,0 q2 q1 qt Current plan of plant closures to lower cost base not completed 24

25 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 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?

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

27 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. 27

28 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

29 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

30 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

31 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

32 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

33 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]


35 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)

36 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

37 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

38 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

39 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


41 Prisoners’ Dilemma Player 2 Strategy A Strategy B Player 1 Would outcome change if the game is repeated? The Folk Theorem Apply Prisoners’ Dilemma to Pricing Policy: Elasticity and Threat of Entry Firm 2 profit payoffs High Price $6 Low Price $4 Firm 1 payoffs x y - 41


43 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

44 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 3,3 2,4 4,2 1,1 44

45 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.

46 GEMS and Strategic Analysis
Knowledge of the identity of near rival: Actionyou -> Reactionrival -> NashReplyyou Fig 9.4 p115 McNutt & Fig 8.3 p231 Besanko

47 Game Embedded Strategy: GEMS: Complete the Diagram


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

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

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