1. Managerial Economics Economics of Strategy and Games
Decoding Strategy
Patrick McNutt
Abridged ©

2. What is game theory? Observed behaviour in a game dimension. G
Identify the players in the game and the players type
Finding the patterns in rival behaviour
Updating belief systems.
Independent decision making v interdependence; one-shot v repeated play

3. Decoding Strategy and Strategic Analysis
Knowledge of the identity of near rival:
Actionyou -> Reactionrival
-> NashReplyyou

4. Why the focus?At the frontier of economic analysis…..
Understand management as ‘they are’ not as theory hitherto ‘assumed them’ to be
Management can be ranked (by type) and are faced with indifference trade-offs => something must come ‘top of the menu’: the 3rd variable or z. Trade off (x, y) to max z.
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 behaviour)
Companies understand the competitive threat as (recognised) interdependence (zero-sum and entropy)

5. Workshop Lesson plan….
Learning Plan is to follow Besanko’s Economics of Strategy 6th Edition ..selected Chapters and cases/examples.
Day 1 : Synopsis of E-Tutorials and Revision of Chapters 3 and 4 (Vertical Boundaries of the Firm, Agency and Co-ordination) and Introduce Chapter 2 (Economies of Scale and Scope)
Day 1: Game Dimension and Introduce Workshop Case Analysis
Day 1: Introduction and setting the scene using McNutt’s Decoding Strategy 2nd Edition Chapters 1 to 9 as required
Day 2 & 3: Focus on Besanko Part II: Chapters 5,6,7 and 8 and link into Units 3 and 4

6. Workshop Focus
Management type and relevance of TCE: Unit 1. Besanko Ch 3 & 4 and 5, McNutt Ch 1
Cost leadership and economics of capacity: Unit 2. Besanko Ch 2 and McNutt Ch 5
Market-as-a-game…market structure, oligopoly, and dynamic games…Units 3 and 4. Besanko Ch 5,6,7 and 8 and McNutt Ch 6,7,8 and 9
Real Time case Analysis…go to Page 45 of colour-coded Storybook

7. Example A: What is type?
If you believe it to be true that Leo the Liar will never tell the truth, how do you respond to his helping hand as you cling for your life over the precipice of a cliff? Do you ignore his helping? Do you rely instead on the many apps on your smartphone, so tightly grasped in your other hand, trying to make contact with your best friend to come and rescue you?
Define Strategy
Cooperation arises in this instance if you and Leo as players in a game can infer from past behaviour that both of you are likely to be trustworthy. Leo may forgo the short term gain of keeping to type for the long term benefit of your friendship. He rescues you from the cliff. You, however, will use the experience in order to determine whether or not to believe Leo in the future.

8. Example B:
Player’s belief system
Your company’s strategy is s1: delayed launch of a new innovative product for 2 years. Rumors do appear of an impending launch date. You do not deny such rumors. In the interim, an article appears a reputable trade journal reporting that a not dissimilar product is about to be launched by your competitor in the next few weeks.
Define Strategy
Do you stop and think about s1?
Do you reshape your strategy to s2: launch the product as soon as possible?

9. Minimax criteria.
If you look at examples in the book Decoding Strategy pp we discuss this for Samsung v Apple but it can be applied here also in any market-as-a-game
Strategy
Simply, identify the near rival [reacting first] and set up the game tree assuming that near-rival plays minimax, that is, confining you to the least of the greatest market shares in the game - so then you play maximin, to maximise the least loss.

10. The competitive threat!
Traditional Analysis is 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?

11. Compare with Next Slide where you add in Williamson/TCE
Management Models
Understand Penrose effect
Understand Bounded Rationality
Go to Table 1.2 pp21 McNutt DecodingStrategy
Compare with Next Slide where you add in Williamson/TCE

12. 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

13. Lets’ begin! Unit 1: Why the emphasis on behaviour (of players)?
The Firm as a ‘nexus of contracts’
Vertical chains and agency costs
Shareholders and management-as-agent
Make-buy dilemma and incomplete contracting
Type of management and Bounded rationality

14. 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 14

15. Companies as Players in a Market-as-a-game?
Principal-agent relationship
Shareholders as principals and management as agents
Who are decision makers?
Management ≈ firms ≈ companies =
PLAYERS (key decision makers)

16. Costs of not being a Player
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

17. Maximising Market Share: Table 1.1 p9 McNutt
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

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

19. 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
Tobins q and Marris v ratio

21. Marris equations/dividends paradox
Calculating share price by DCF formula
P = eps/r : Static firm no growth opportunities
P = eps/r + PV(GO): Dynamic firm with growth opportunities…this is a Marris firm
Common denominator is the plough-back ratio (PBR) = 1 – divs/eps…This is a Marris equation
More dividends can signal an absence of R&D growth
But more R&D from G1 to G2 can accrue an agency cost as Bayesian shareholders SELL as value falls V1 to V2.

22. 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 (link into Besanko Ch 11 & 13 on strategic cost advantage)

23. Unit 2: Cost leadership [CL] 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 checklist..McNutt p78

24. 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? 24

25. 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 25

26. Why? Capacity Constraints:
Case A: Unexhausted economies of scale due to product differentiation
Case B: Firm-as-a-player does not produce large enough output to reach MES
Case C: Firm-as-a-player restraints production (deliberate intent)..McNutt’s dilemma as production drives demand…(Veblen monopoly type)
Convergence of technology increases the firm-specific risk of Case C:
Strategic Choice A or B or C?

27. Unit 3: Game type and signalling
Decisions are interpreted as signals
Observed patterns and Critical Time Line (CTLs). Go to Appendix in McNutt
Recognition of market interdependence (zero-sum and entropy)
Price as a signal v Baumol model of TR max
Scale and size: cost leadership
Dividends as signals in a Marris model

28. 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. Company or manager.
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. 28

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. Describe (prices as signals) game dimension
Players and type of players
Prices interpreted as signals
Understand (price) elasticity of demand and cross-price elasticity
Patterns of observed behaviour
Leader-follower as knowledge
Accommodation v entry deterrence
Reaction, signalling and Nash equilibrium: ‘best you can do, given reaction of competitor’

31. Type of Players Incumbent type v entrant type
Dominant type v predatory incumbent
De novo entrant type and geography of the market
Potential entrant type and the threat of entry as a credible threat
Contestable markets, newborn players and extant (incumbent) type

32. Entry Deterrent Strategy & Barriers to entry
Reputation of the incumbents
Capacity building
Entry function of the entrant
De novo and entry at time period t
Potential entrant - forces reaction at time period t from incumbent
Coogan’s bluff strategy (classic poker strategy) and enter the game.

33. Limit Pricing Model in Besanko pp207-211 and McNutt pp85-88
Outline the game dimension: dominant incumbents v camouflaged entrant type
Define strategy set for incumbents
Allow entry and define the equilibrium
Preference - entry deterrent strategy v accommodation [next slide]

35. Game Strategy When in a game? – recognise interdependence?
Nash premise: Action, Reaction and CV matrix
Non-cooperative sequential (dynamic) games
TR Test McNutt pp48..one-shot move
Limit price [to avoid entry] and predatory pricing to force exit.
Near rival plays Minimax, so I play Maximin [focus on my worst minimum payoff and try to maximise].

36.  n
Player B S4 S5 S6 S7
Row Minimum
Maximin strategy by A
Player A: S1 95 5 50 40 S2 60 70 55 90 S3 30 35 10
Column maximum
Minimax strategy by B

37. Continuing with Unit 4: Define a price war
Determine the Bertrand reaction function:
Besanko Fig 5.3 pp190 and McNutt Fig 9.4 p143
Compute a Critical Time Line (CTL)from observed signals..Examples of CTL in McNutt in the Appendix
Find a price point of intersection
Case Analysis of Sony v Microsoft at McNutt pp and also in Kaelo v2.0

38. Nash Equilibria Define the Nash equilibria [next slide]
Analyse the Payoff matrix
(B,Y) > (A, X)
Commitment and chat: one-shot and repeated play
Punishment ‘grim’ strategy
Strategy Set in terms of credible mechanisms

40. Prisoners’ Dilemma Would outcome change if the game is repeated?
Player 2
Confess
Don’t Confess
Player 1
Don’t confess
Would outcome change if the game is repeated?
Apply Prisoners’ Dilemma to Pricing Policy: Independent v Interdependent
Firm 2
High Price
Low Price
Firm 1 - 40

41. Visit Kaelo v2.0 and Games/Signalling
Examples: Critical Time Line the Appendix of McNutt’s text Decoding Strategy.
Play a PD game and investment game in Kaelo v2.0
Selfish gene [one-shot], dominant strategy to cheat.
Altruism, fairness – repeated play/learning.
Understand the ‘no signalling’ payoff matrices [next slide]

42. The ‘no signalling’ payoffs
Simultaneous game between A & B who must decide on how to spend the evening.
Problem of coordination where players have different preferences but common interest in coordinating strategies.
One key application includes the battles for standards:
VHS by JVC vs Betamax by Sony in the 1980s
BlueRay DVD by Sony vs HD DVD by Toshiba in 2008
Effect of sequentialisation? Solution. Commitment? Signalling? B in
out A
10,5
2,4
0,1
4,8 42

43. Application of ‘no signalling’ game
Two pharmaceutical companies must simultaneously decide which products to research.
Does this example illustrate the concept of ‘first mover advantage[FMA]?
How could companies signal? Signing contracts with leading universities, hiring expert. A O
-2,-2
20,10
10,20
-1,-1 43

44. Games as Strategy: Strategic ToolBox
Segmentation strategy to obtain FMA
Relevance of chain-store paradox
Dark Strategy and 3 Mistakes in McNutt pp
Second Mover Advantage, SMA v FMA
Fig 9.7 pp161 McNutt Strategic ToolBox in terms of identifying the competitive threat v cartel coordination on (High. High)..Cheating

46. Absence of price wars? Link into the HBR articles
Hypothesis: Bertrand Price Wars occur due to a mis-match in price signals.
Mismatch can occur due to (i) declining volumes ∆qi/∆Q < 0; (ii) uncompetitive cost structure; (iii) decreasing productivity; (iv) management type (predator); (v) calling-my-bluff

47. Final Scenarios for YOUR Company……
The Rationale
Markets evolve
Type, Technology and Time
Know your near-rival
The Strategy
Non-binary
Game metrics, feedback & analytics
GEMS

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