1 Strategic Thinking

2 Medium-sized commercial jets  Why do manufacturers intensively publicize order book (especially for models under development)?  Should Embraer enter?

 Businesses with market power can influence buying/selling conditions;  need to consider interactions with suppliers/buyers/competitors/cooperators  use the framework for strategic thinking  Business applications  competitive business strategy  Pricing  corporate finance – takeover bidding and defense  industrial relations -- strike 3

4 Strategic situations  Parties actively consider the interactions with one another in making decisions.  Game theory – set of ideas and principles to guide strategic thinking  simultaneous actions – strategic form  sequential actions – extensive form

5 Learning objectives  Appreciate strategic situations.  Apply game in strategic form to situations with simultaneous moves.  Appreciate the use of randomization in competitive situations.  Distinguish zero-sum and non-zero sum games.  Apply game in extensive form to situations with sequential moves.  Plan strategic moves and conditional strategic moves, both threats and promises.  Appreciate strategy in repeated situations.

6 Outline  Nash equilibrium  Randomized strategies  Coordination / competition  Sequencing  Strategic move  Conditional strategic move  Repetition

Gasoline stations Saturn Maintain priceCut price Jupiter Maintain price J: 1000, S: 1000 J: 700, S: 1300 Cut price J: 1300, S: 700 J: 800, S: 800  What should Saturn do? 7

8 Nash equilibrium: Dominated strategy  Dominated strategy:  Generates worse consequences than another strategy, regardless of the choices of the other parties  Should never use dominated strategy

9 Nash equilibrium  Given that the other players choose their Nash equilibrium strategies, each party prefers its own Nash equilibrium strategy  No one should deviate unilaterally from a Nash equilibrium

10 Nash equilibrium: Solution  Conventional method:  eliminate dominated strategies, then  check remaining cells  “arrow” method

11 Nash equilibrium: Competitive dilemma Saturn Maintain priceCut price Jupiter Maintain price J: 1000, S: 1000 J: 700, S: 1300 Cut price J: 1300, S: 700 J: 800, S: 800  What should Saturn do?

 Nash equilibrium: for both parties, “maintain price” is dominated by “cut price”.  but cutting price is bad for both -- if only they could agree somehow to maintain price.  Similar situation – supermarkets competing by cutting prices 12 Nash equilibrium: Competitive dilemma

13 Embraer EnterDo not enter COMAC Enter C: ‒ 1, E: ‒ 2 C: 2, E: 0 Do not enter C: 0, E: 1 C: 0, E: 0

 Two Nash equilibria:  COMAC “enter” and Embraer “do not enter”  COMAC “do not enter” and Embraer “enter” 14

15 Out of Nash Equilibrium  Nash equilibrium is just one way to play in a strategic situation  What if another player doesn’t play Nash equilibrium strategy?  Still don’t use dominated strategy  Nash equilibrium strategy may not be best

16 Outline  Nash equilibrium  Randomized strategies  Coordination / competition  Sequencing  Strategic move  Conditional strategic move  Repetition

17 Randomized strategies: Supermarket competition  Two competing retailers – Jaya and Ming  Three segments  captive (loyal) to Ming  captive (loyal) to Jaya  switchers

Randomized strategies: Retail price competition Ming High priceLow price Jaya High priceJ: 60, M: 40 J: 40, M: 50 Low priceJ: 50, M: 40 J: 50, M: 30 18

 If competitor sets high price, then I can set lower price and grab business from competitor  Pricing trade-off:  high price to extract buyer surplus of loyal customers  low price to get store switchers  Note: situation is asymmetric – Jaya has larger loyal customer base 19 Randomized strategies: Supermarket competition

20 Randomized strategies: Supermarket competition  No Nash equilibrium in pure strategies  problem of infinite regress -- my best strategy depends on competitors, her best depends on mine, etc.  Solution: randomized discounts  Randomized strategies only work if they are random -- must be unpredictable

21 Outline  Nash equilibrium  Randomized strategies  Coordination / competition  Sequencing  Strategic move  Conditional strategic move  Repetition

 Prime time for news is 8:0pm; second best is 7:30pm;  since audience is limited, get maximum viewership if two channels schedule at different times.  Question: which station gets 8:0pm?  Situation has elements of coordination -- avoiding same time slot competition -- getting the 8:0pm 22 Coordination/competition: Evening news

Channel Z 7.30pm8.00pm TV Delta 7.30pm D: 1, Z: 1 D: 3, Z: pm D: 4, Z: 3 D: 2.5, Z:

24 Coordination/competition: Zero/positive sum  Zero-sum games (pure competition): one party better off only if other is worse off  Positive-sum games (coordination): both can be better off or both worse off  Co-opetition: strategic situation that involves elements of both competition and coordination  Both stations will be better off if they schedule at different times  But one station will benefit relatively more

25 Outline  Nash equilibrium  Randomized strategies  Coordination / competition  Sequencing  Strategic move  Conditional strategic move  Repetition

26 Sequencing  Game in extensive form – depicts the sequence of moves and corresponding outcomes:  Nodes: a node represents a point at which a party must make a choice.  Branches: the branches leading from a node represent the possible choices at the node.  Outcomes

Sequencing: TV news 27

28 Sequencing: Extensive form – equilibrium  Backward induction  The procedure of looking forward to the final nodes and then reasoning backward toward the initial node  Equilibrium strategy: consists of a sequence of best actions, with each action decided at the corresponding node

COMAC vs Embraer 29

30 Sequencing: First/second mover advantage  Advantage doesn’t always go to first mover  In war, better to see opponent’s move, and then take action, eg, is enemy moving south or north?  New product category – let competitor test the market and educate the customers

 Uncertain consequences  One party may be uncertain about the consequence of the actions of the other party. 31 Sequencing: Uncertainty

32 Sequencing: Uncertainty

 TV Z can calculate expected profit from 7:30pm and 8:00pm  if choose 7:30pm, expected profit = [1/3 x 1] + [2/3 x 3] = 2.33  if choose 8:00pm, expected profit = [1/2 x 4] + [1/2 x 2.5] = Sequencing: Uncertainty

34 Outline  Nash equilibrium  Randomized strategies  Coordination / competition  Sequencing  Strategic move  Conditional strategic move  Repetition

35 Strategic move  Definition: Action to influence beliefs or actions of other parties in a favorable way  Action must be credible  Commitment  Contractual  Physical  Reputation

 Serial number  Destroy the plate  Other solution? Strategic move: Lithographer 36

Strategic move: Leveraged buyout 37

Competing for market share: When does it make sense?  Sunk costs become switching costs  learning  complementary investments  Lock-in strategy  initially, price low/free to lock in buyer  exploit later 38

39 Outline  Nash equilibrium  Randomized strategies  Coordination / competition  Sequencing  Strategic move  Conditional strategic move  Repetition

40 Sequencing: Conditional actions  Expand strategies – condition actions on  Actions of other parties  Other markets  Other times  External events

41 Conditional strategic move  Ideal: strategic move that doesn’t impose costs  Promise – if it succeeds, then needn’t be carried out  Threat – if it succeeds, then needn’t be carried out

Promise: Deposit insurance Should depositor maintain or withdraw deposit? 42

Promise: Deposit insurance 43

44 Promise: Controlling hyperinflation  Central Bank prints money => hyperinflation  How can government use promise to guard against hyperinflation?

Threat: Strike American professional sports: Why are strikes less common in football than baseball? 45

46 Threat: Shareholder rights plan (poison pill)

47 Outline  Nash equilibrium  Randomized strategies  Coordination / competition  Sequencing  Strategic move  Conditional strategic move  Repetition

48 Repetition: Cooperation without explicit agreement  Repeated situation: Tit-for-tat – punishment strategy  I will follow quota, but if you cheat, then in next period, I will also cheat  Can achieve cooperation (avoid price competition) depending on  time horizon  discounting of future profit relative to current profit

49 Repetition: Cooperation without explicit agreement  Tit-for-tat: Examples  Gasoline stations competing for drivers  Grocery stores competing for customers

50 Repetition: Cooperation without explicit agreement  Axelrod’s rules  do not strike first  reciprocate both good and bad  act simply and clearly  do not be envious (IPng: do not be greedy)

51 Key takeaways  A situation is strategic if the parties consider interactions with one another in making decisions.  Never use a dominated strategy.  In a situation of simultaneous moves, a Nash equilibrium strategy is stable in the sense that, if other parties choose their Nash equilibrium strategies, each party prefers its own Nash equilibrium strategy.  In competitive situations, it may help to randomize.  Zero-sum games characterize extreme competition: one party can be better off only if another is worse off.

52 Key takeaways, cont’d  In a situation of sequential moves, plan by looking forward to the final nodes and reasoning backward toward the initial node.  Use strategic moves to influence beliefs or actions of other parties in favorable way. To be effective, they must be credible.  If possible, use conditional strategic moves, both threats and promises, as they are more cost-effective than unconditional strategic moves.  In repeated situations, get better outcomes through strategies that condition actions on the actions of others.

53 Applicability  Competitive strategy  Pricing  Corporate finance – takeover bidding and defense  Industrial relations  Public policy