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Game Theory Topic 6 Strategic Moves

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1 Game Theory Topic 6 Strategic Moves “The power to constrain an adversary depends upon the power to bind oneself.” - Thomas Schelling

2 Credibility Review But what is credibility?
Cooperation requires sacrificing immediate profits for a future relationship The sacrifice is only made if the punishment is both severe enough and credible But what is credibility? Mike Shor

3 Review Credible commitments require Strategic Moves:
Severe enough punishment to change behavior Irreversible and clear actions Strategic Moves: Changing the game for strategic advantage Being credible Overcoming the prisoner’s dilemma Mike Shor

4 The Winning Lottery Ticket
“It won’t change me one bit!” Mike Shor

5 What is Credibility? “ The difference between genius and stupidity is that genius has its limits.” – Albert Einstein Telling you I’m going to act in my best interest is not committing To commit to a suboptimal action, I need to: Change the game Change perceptions Mike Shor

6 How to be Credible? Reduce payoffs Remove strategies Replace players
from those strategies that may tempt you Make it costly to renege Remove strategies from among those that may tempt you in the future Destroy avenues of retreat Replace players by eliminating strategic control Remove “human meddling” Mike Shor

7 Commitment Must commit to be credible!
“ The difference between ‘involvement’ and ‘commitment’ is like an eggs-and-ham breakfast: the chicken was ‘involved’ – the pig was ‘committed.’ ” Mike Shor

8 Commitment vs. Involvement
Two firms considering market entry: Market potential is $10 million NPV profits Entry costs $7 million It is in our best interest to stay out if we think that the other firm will enter Them In Out Us -2 , -2 3 , 0 0 , 3 0 , 0 Mike Shor

9 Involvement We make an initial investment:
Invest first $1 million to deter entry It is still in our best interest to stay out if we think that the other firm will enter Them In Out Us -2 , -2 3 , 0 -1 , 3 -1 , 0 Mike Shor

10 Commitment We make an initial investment:
Invest first $3 million to deter entry Now, it is our dominant strategy to enter regardless of what the other firm will do Them In Out Us -2 , -2 3 , 0 -3 , 3 -3 , 0 Mike Shor

11 Credible Commitment By reducing our own payoffs from staying out, we have committed to entry It is credible because it is now in our own best interest! Mike Shor

12 Commitment & Competition
Consumers want companies to compete Companies prefer to cooperate Credible commitment by companies: Change payoffs to Maximize joint gains Promise higher prices Threaten competitors that lower prices Three practices consumers like but economists hate Mike Shor

13 Promises and Threats Getting the promise or threat right
Making it credible Firms want to promise each other high prices threaten rivals who lower prices Mike Shor

14 Getting the Threat Right
Monty Python’s Piranha Brothers The Operation Select a victim Threaten to beat him up if he pays the “protection” money The Other Operation Threaten not to beat him up if he pays the “protection” money The Other Other Operation Threaten to beat him up if he doesn’t pay the “protection” money Mike Shor

15 Making it Credible Promises can sometimes be credible through a contract with the party to whom you are making the promise Threats can never be credible through a contract with the party to whom you are making the threat Must contract with third party Mike Shor

16 The Bocchicchio Family
“ Once a particularly ferocious branch of the Mafia in Sicily, it had become an instrument of peace in America. ” How can Michael invite Don Tessio for a meeting and guarantee that Don Tessio will not be harmed? Mike Shor

17 Customers as Hostages Firms can contract with customers as a third party to make credible threats and promises Mike Shor

18 Customers as Hostages: Promises
“I promise to keep prices high” Most Favored Customer clause If I ever offer a lower price to any other customer, I will offer it to you as well Firm 2 High Firm 1 Low 65 , 35 65 $1 60 , 60 30 $2 Mike Shor

19 Most Favored Customer Clause
Say, in period 1, both firms charge high In period 2, pricing low requires a $1 refund to 30 customers from last period High Low 65 , 35 High Low 35 , 35 Firm 1: 65 – 30 = 35 Mike Shor

20 Most Favored Customer Clause
Firm 2 Low High Firm 1 40 , 40 65 , 35 35 , 65 60 , 60 Firm 2 Low High Firm 1 10 , 10 35 , 35 60 , 60 Mike Shor

21 Customers as Hostages: Threats
“I will punish you if you lower prices” Price Matching Guarantee If any competitor offers a lower price, I will match it High Low 65 , 35 Low 40 , 40 Mike Shor

22 Price Matching Guarantee
Firm 2 Low High Firm 1 40 , 40 65 , 35 35 , 65 60 , 60 Firm 2 Low High Firm 1 40 , 40 60 , 60 Mike Shor

23 Customers as Hostages Price matching guarantees and most favored customer clauses exploit: customer price sensitivity customer price awareness low customer switching costs Exactly the factors that make price competition brutal! Mike Shor

24 Other Price Guarantees
What is the impact of: “Drug companies should not be allowed to charge Americans more than Canadians” China requests a “Most Favored Nation” clause with the United States WalMart requires a price from suppliers that is no worse than its competitors Mike Shor

25 Increasing Search Costs: Theory
It costs a consumer a transportation cost, t, to “visit” another firm If consumers expect prices of pe, how much should you charge? Can charge up to pe + t But, if you iterate this If you charge pe+t, competitor can charge pe+t+t, but then you can charge pe+t+t+t Mike Shor

26 Increasing Search Costs: Implementation
Prevent price advertising Government regulation (liquor stores) Industry agreement (likely illegal) Professional trade groups (doctors) Limit store hours Closing laws (florists) Obfuscate price information (Dilbert “confusopolies”) Make comparison difficult (mattresses, insurance) Use multiple prices (banking, auto dealers) Mike Shor

27 Strategic Moves A strategic move is an action taken prior to the play of the game Transforms the original game into a two-stage game Setting the Rules Playing the Game "Victorious warriors win first and then go to war. Defeated warriors go to war first and then try to win.“ Sun Tzu Mike Shor

28 Strategic Moves A credible strategic move must be Observable
Irreversible Incentive-changing Change strategies, payoffs, or players Be creative Mike Shor

29 The Prisoner’s Dilemma
Equilibrium: $40 K Firm 2 Low High Firm 1 40 , 40 65 , 35 35 , 65 60 , 60 Cooperation: $60 K Mike Shor

30 Joint Ventures & Cross-Shareholding
If each firm acquires 20% of the other: Low High 35 , 65 Firm 2: (4/5) 65 + (1/5) 35 = 59 Firm 1: (4/5) 35 + (1/5) 65 = 41 Low High 41 , 59 Mike Shor

31 Joint Ventures & Cross-Shareholding
Firm 2 Low High Firm 1 40 , 40 65 , 35 35 , 65 60 , 60 Firm 2 Low High Firm 1 40 , 40 59 , 41 41 , 59 60 , 60 Mike Shor

32 Reducing Payoffs: Contracting
Takeover offer: $200 million You can “afford” $20 million / year Finance takeover for 20 years at 7% Add penalty: if amount greater than $200 million, +1.5 points on interest rate Annual Payments: $200 million: $18.6 million / year $210 million: $19.6 million / year with penalty: $21.9 million / year Mike Shor

33 Credible Threats Targeted threats are generally more credible than blanket threats But what if a blanket threat is exactly what we need? Assign responsibility to alter incentives Mike Shor

34 From Incredible to Credible
Ten suppliers each have two options: Deliver on time at a cost of $70,000 Deliver a week late at a cost of $20,000 Delivery results in $100,000 payment I need at least nine suppliers and the suppliers know this Mike Shor

35 A Non-Credible Threat I threaten not to deal with any supplier who delivers late But, suppliers know that I can punish at most one Two equilibria: All deliver on time All deliver late (the likely equilibrium) Even if I think that only one other supplier will deliver late, it is in my best interest to do so: ½ (80) > 30 Mike Shor

36 A Credible Threat I number the suppliers arbitrarily: 1…10 Result:
I refuse delivery from the lowest numbered supplier among those who are late Result: Supplier 1 delivers on time (better than getting nothing) Thus, supplier 2 delivers on time … Mike Shor

37 Removing Strategies I Delegation
You are not always better off with more options. Delegation Delegate decision to a disinterested third party In contract negotiation, can “squabble” over many details Instead, send an agent with power of attorney to “sign as is” or “walk away” Learn from government bureaucracy: “The rules won’t allow me to do what you ask!” Mike Shor

38 Delegation Examples Human resource departments Collection agencies
Shield from requests for higher salaries HR execs not compensated based on employer value Collection agencies Shield from pleas or threats of the debtor Reinforce repayment to protect reputation Accounting firms overseeing contests Accountant’s payment not tied to outcome Concerned with reputation for fairness Mike Shor

39 Removing Strategies II
Sometimes, you should burn bridges. Burning Bridges Power comes from not being able to retreat Allow opponent to retreat (Sun Tzu) The nicotine patch Hunt for Red October Cortes upon arriving in Mexico Mike Shor

40 Burning Bridges Reputation Irreversibility
“I burn all cities about to be conquered” “We do not negotiate with terrorists” Takeover defenses Irreversibility Pressing the “send” button Turning off the phone Extreme form: Last Will and Testament Mike Shor

41 Burning Bridges Example
Semiconductor patent sharing “Mosaid Technologies, a designer and licensor of semiconductor chips and technologies, just announced a patent sharing deal with Mitsubishi Electric” Share patent with another competing firm Commit to chip supply to production plants Commit to no opportunistic behavior Mike Shor

42 Building Bridges Jimmy Hoffa’s negotiation lesson:
Build bridges for your opponents. “When you surround an enemy, you must leave an outlet for him to go free.” – Sun-Tzu Jimmy Hoffa’s negotiation lesson: What is the single most important thing for a negotiator to know? Mike Shor

43 Commitment Is Counterintuitive
Reduce your strategy space and decrease your own payoffs to commit. (Hurt yourself to help yourself) Increase your opponent’s strategy space to preclude the rival from committing. (Help your rival to help yourself) Mike Shor

44 Irrationality U.S. / U.S.S.R. nuclear deterrence
Mutually Assured Destruction (MAD) like Grim Trigger Strategy Proportional Response like Tit-for-Tat Want a lot of deterrence Want irrationality to be credible Dr. Strangelove & the Doomsday device Mike Shor

45 Dr. Strangelove The Credibility Checklist
Severity “Create fear in the mind of the enemy” Irreversibility “It is essential” Irrationality “Not something a sane man would do” Practicality “It wasn’t a practical deterrent” Clarity “Tell the world” Mike Shor

46 Commitment Under Uncertainty
An offer you can’t refuse After a seemingly successful interview, the interviewer asks where the firm ranks on your list of potential employees Before answering, you are told: The firm only hires applicants who rank it first If the firm is in fact your first choice, then you must accept a job offer in advance, should one be made Mike Shor

47 Commitment Under Uncertainty
Why make such proposals? Take advantage of your uncertainty Take advantage of your risk-aversion Make you commit before they do! Binding early-decision college applications Mike Shor

48 Flexibility vs. Commitment
Must balance: Value of commitment Change in others’ behavior from your committing to some course of action generates value Value of flexibility Keeping your options open and remaining flexible allows you to react to changing situations (option value) Mike Shor

49 Philips, N.V. Commitment in CD introduction
Philips: innovator’s advantage Initiate construction of plant ahead of competitors Decision problem of Philips in 1982: Build a disk-pressing plant in the U.S. and invest in a substantial amount of capacity to deter potentially entry (Sony, etc.) Delay decision until commercial appeal of CDs can be determined. Import CDs to the U.S. To “test the waters.” Mike Shor

50 Calculating Option Value
The science Option Value: Added profit from flexibility (can’t lose) The art Countervailing forces: By waiting, the firm risks: Failing to capitalize fully on an opportunity. Having the opportunity preempted by competitors. What to do? Mike Shor

51 Philips, N.V. (continued)
q  probability of mass acceptance of CDs Pure option value In the absence of any competition Philips should wait if q < 0.380 Commitment value If Sony is as well informed about the market as Philips Philips should wait if q < 0.006 Informational advantage Because of proprietary market information obtained through its CD operations in Europe: Philips should wait if q < 0.130 Mike Shor

52 Resolution Philips did not build a U.S. Plant in 1983
Its assessment of the likelihood of general acceptance did not meet the threshold Market realization (surprise!) Sony constructed a U.S. Plant in 1984 Terry Haute, Indiana Philips attempted to compete Increased capacity in Hanover, Germany plant Philips decided to invest in a U.S. Plant Only after the Sony plant was fully operational Mike Shor

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