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Other Issues in Game Theory BusinessNegotiationsContracts

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Dominant Strategy Regardless of whether FIRM 2 chooses strategy A, B, or C, FIRM 1 is better off choosing “a”! “a” is Player 1’s Dominant Strategy! Dominance is a solution strategy --- but doesn’t always lead to “resting point” --- so we introduce the Nash solution --- Nash equilibrium FIRM 1 FIRM 2ABC A ------ 12, 1111,1214,13 b11,1010,1112,12 c11,1510,1313,14

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FIRM 1 FIRM 2ABC A ------ 12, 1111,1214,13 b11,1010,1112,12 c11,1510,1313,14 Putting Yourself in your Rival’s Shoes What should FIRM 2 do? – 2 has no dominant strategy! – But 2 should reason that 1 will play “a”. – Therefore 2 should choose “C”.

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FIRM 1 FIRM 2ABC A ------ 12, 1111,1214,13 b11,1010,1112,12 c11,1510,1313,14 The Outcome This outcome is called a Nash equilibrium: – “a” is player 1’s best response to “C”. – “C” is player 2’s best response to “a”.

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A NASH EQUILIBRIUM IN WHICH EVERY PLAYER PLAYS A PURE STRATEGY IS CALLED A PURE STRATEGY NASH EQUILIBRIUM ANY STRATEGY THAT IS NOT COMPLETELY DETERMINISTIC, BUT INSTEAD INVOLVES CHANCE (RANDOMIZATION), IS CALLED A MIXED STRATEGY --- SO A NASH EQUILIBRIUM IN WHICH AT LEAST ONE PLAYER PLAYS A MIXED STRATEGY IS CALLED A MIXED STRATEGY NASH EQUILIBRIUM COORDINATION GAMES USUALLY RESULT IN MIXED STRATEGIES AS WELL AS PURE NASH

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STRATEGIES ARE BASED ON 210 VOLT APPLIANCE VS 120 VOLT APPLIANCE Firm 2 210 v120 v Firm 1 210 v100, 1000, 0 120 v0,0100,100 A MORE SIMPLIFIED COORDINATION GAME

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Firm 2 210 v120 v Firm 1 210 v100, 1000, 0 120 v0,0100,100 There is 1 mixed strategy {1/2[210v], ½[120v]} for each firm There are 2 pure Nash {both firms choose 210 v} and { both firms choose 120 v }

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Both get 8 years Funk gets 2 yrs Naylor gets 10 years Funk gets 10 Naylor gets 2 Both get 4 years confess mum confess Naylor Funk Two stock brokers, Funk and alias, Naylor, are indicted by the N.Y. Attorney General for allegedly making use of illegal inside information --- but the evidence is weak The attorney general brings them in to interrogate, one at a time Both Funk and Naylor have two possible strategies, confess or remain mum 4 possible strategies are outlined in the normal form game below

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Both get 8 years Funk gets 2 yrs Naylor gets 10 years Funk gets 10 Naylor gets 2 Both get 4 years confess mum confess Naylor Funk SO, WHAT’S GOING TO HAPPEN HERE? THE DOMINANT STRATEGY FOR BOTH BROKERS IS TO CONFESS! BUT EACH IS DOING WORSE THAN IF THEY COULD TRUST EACH OTHER AND ONLY GET 4 YEARS BASED ON THE WEAK EVIDENCE BY REMAINING MUM ( OH,OH, HERE COMES THE ROLE OF THE DEFENSE ATTORNEYS!) THIS IS THE PRISONER’S DILEMMA GAME

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(5, 5)(-2, 8) (8, -2)(2, 2) Price = $2,000 Price = $1,000 Price = $2,000 Price = $1,000 Israelsen Simmons Now recall the problems with the “Sweezy” or Kinked demand curve oligopoly case we introduced in Ch. 9 If one firm reduces price, the rival firm will match this action by also reducing price, but will not match price increases Suppose now we have two firms, Simmons and israelsen who react on pricing of their product and reap the profits (in $millions) given in the normal form given below

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(5, 5)(-2, 8) (8, -2)(2, 2) Price = $2,000 Price = $1,000 Price = $2,000 Price = $1,000 Israelsen Simmons What is going to happen here? If Simmons and Israelsen form some sort of cartel --- then there is incentive to not follow through on the agreement, however supposed to be binding The Nash is that both lower their price from $2,000 to $1,000 in hopes of capturing the market

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(5, 5)(-2, 8) (8, -2)(2, 2) Price = $2,000 Price = $1,000 Price = $2,000 Price = $1,000 Israelsen Simmons Now suppose they offer a “most favored customer clause”, whereby a customer who buys early at a high price gets a rebate if price is later set at a lower price --- the rebate will lower profits ---- so the payoff is now given below

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(5, 5)(-2, 8) (8, -2)(2, 2) Price = $2,000 Price = $1,000 Price = $2,000 Price = $1,000 Israelsen Simmons We now get two pure Nash {both firms set price at $2,000} and {both firms set price at $1,000} And then we get a mixed strategy { both firms choose price = $2,000 with probability 4/5, and choose price = $1,000 with probability 1/5} So the weight on the choice suggest the most favored customer clause provides incentives to hold at the $2,000 price --- a possible way out of the kinked demand curve

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Suppose Dell and GE are considering engaging in a joint venture. Each will have to invest $12 million in assets that are of no value outside the project (specialized or specific investments and costs) If both firms act in accord with their promises, the annual “economic profit” to each firm is $3 million If one or both do not act in accord with promises, then the annual profit is as shown in the following normal form (3, 3)(6, -2) (-2, 6) (0, 0) Dell Accord No accord AccordNo accord GE Economic profit in $millions BOTH FIRMS HAVE THE OPTION TO NOT PLAY THE GAME

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Will a contract be drawn up and signed by both parties? Yes --- the Nash equilibrium is (3,3) Without such a contract, each firm would have incentive to go their separate ways after investment ---- managers may be reluctant to take the risk of investment --- so trust is what binds the contract --- coordination (3, 3)(6, -2) (-2, 6) (0, 0) Dell Accord No accord AccordNo accord GE Economic profit is profit above what could have been earned in alternative investment opportunities for the $12 million THIS IS NOT A PRISONER’S DILEMMA GAME

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WHEN IS A THREAT CREDIBLE? Firms often signal to each other to indicate intentions -- (2, 3)(3, -1) (7, 11) (11, 8) Youngberg Low price High price Low priceHigh price McKenna Youngberg announces it is moving to lower price --- McKenna then intends to significantly lower its own price signaling willingness to engage in price war {see the payoff matrix below} But McKenna’s threat is not credible --- profits at high price are more than profits at low price --- dominant strategy for McKenna is high price, irrespective of Youngberg’s price ---- Nash is (7,11)

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McGraw-Hill/Irwin Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved. GAME THEORY, STRATEGIC DECISION MAKING, AND BEHAVIORAL ECONOMICS.

McGraw-Hill/Irwin Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved. GAME THEORY, STRATEGIC DECISION MAKING, AND BEHAVIORAL ECONOMICS.

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