Economics of Organization Power Point Appendix (Chapter 2)

Game Theory and Strategy Key Concept: Preemption of Strategically Valuable Assets Access to raw materials (e.g. Alcoa) Wal-mart’s rural strategy

Game Theory and Strategy Creating Customer Switching Costs Establishing standards for a computer operating system Matsushita’s VHS format becoming dominant over Sony’s Beta Note: Given that a second mover’s product development costs can be much lower than the first mover’s product development costs, first-mover advantages must be substantial to justify first moving as a strategy.

Game Theory and Strategy Technological Leadership In the 1970s, DuPont built a dominant position in the titanium dioxide market by exploiting: superior technology scale economies accumulated experience for low costs Gillette competes with a differentiation strategy in disposable razors by exploiting: reputation broad distribution

Game Theory and Strategy Exit Barriers are Entry Barriers Emphasized by Professor Joe Bain, University of California, Berkeley in 1950s Specialized Assets Strategic Barriers (e.g., spillover effects) Government and Social Barriers

Game Theory and Strategy Exit Barriers High Low Entry Barriers Low Returns High Returns High, Uncertain Returns Worst Case

Analyzing Competitive Dynamics - Commitment Vs. Flexibility Game Theoretic preemption strategy Flexibility Real (Strategic) Options Analysis

Factors Affecting The Likelihood of Competitor Response: What are the payoffs relative to other actions the competitor could take? What prior strategic commitments has the competitor made? Does the potential market fit with the competitor’s existing strategy? How “reversible” is your action or the competitor’s potential response?

Game Theory - A Simple Example Tic Tac Toe What Happens Here?

Game Theory and Strategy Prisoners’ Dilemma Game Row Silence Fink Column -1 -10 -8

Game Theory and Strategy Prisoners’ Dilemma Game Row Player: Dominant Strategy: Fink Column Player: Dominant Strategy: Fink Dominant Strategy (Nash) Equilibrium: (-8, -8) Note: It is a dilemma since if they both cooperated by remaining silent: (-1, -1).

Game Theory and Strategy The prisoners’ dilemma game can occur in many contexts: What is best for an individual may not be best for a division. What is best for a division may not be best for a firm. What is best for a firm many not be best for an industry. What is best for an industry may not be best for a nation. What is best for a nation may not be best for the world.

Game Theory and Strategy Now that we have learned the concept of dominant strategy equilibrium, there is a second important equilibrium concept called a Nash equilibrium. Note: All dominant strategy equilibrium are Nash equilibrium, but not all Nash equilibrium are dominant strategy equilibrium.

Game Theory and Strategy Game with no dominant strategy equilibrium, but a Game with a Nash equilibrium. Row Cooperate Fink Column 5 4 1 9 -1

Game Theory and Strategy A cooperative game with conflict Game with 2 Nash equilibria. Man Prize Fight Ballet Woman 2 -1 1 -5

Game Theory and Strategy Suppose this game were played sequentially? Would it be better to go first or second? Man Prize Fight Ballet Woman 2 -1 1 -5

Game Theory and Strategy New game: Joe’s sad undergraduate days Man Prize Fight Ballet Woman 10 100 20 4 90 30 8 6

Game Theory and Strategy Would you want to move first or second? Man Prize Fight Ballet Woman 10 100 20 4 90 30 8 6

Game Theory and Strategy Initial Game (played simultaneously) Airbus No Launch Launch Boeing 400 300 200 -100 -200

How Can “Commitment” Affect A Competitor’s Response? Commitment = An Irreversible Action (Sunk Costs) Competition In The Commercial Aircraft Industry Airbus No Launch Launch Boeing 400 300 200 -100 -200

Game Theory and Strategy Joint Venture GM Cooperate L. Race Toyota 112 123 58 91

How Can “Commitment” Affect A Competitor’s Response? Commitment = An Irreversible Action (Sunk Costs) GM Cooperate L. Race Toyota 112 123 -28 58 91 -51

How Can “Commitment” Affect A Competitor’s Response? Mutual sunk cost commitments GM Cooperate L. Race Toyota 112 -28 58 -51

Game Theory and Strategy Lessons 1. Commitment (sunk costs) can be used to achieve cooperation. The importance of mutual economic hostages: The wise manager should think beyond Machiavelli’s myopic approach to contracting and should seek both to give and receive credible (sunk cost) commitments that facilitate ongoing relationships and adaptation.

Game Theory and Strategy: Lessons 2. Commitment (sunk costs) can be used to achieve competitive advantage. preemption strategy

Game Theory and Strategy Some key points on strategic commitment: Always give attention to how your competitors’ returns vary under different strategic scenarios; It is important to communicate the commitment to the other firms (for both competition and cooperation); “Sunk cost” investments can be used to pre-commit to a certain strategy and, thus, influence competitor response; and Understand what strategic investments are important in your business and how “sunk” those investments are.

Sources of First Mover Advantages Economies of Scale Experience or Learning Curve Effects Brand Equity “Network Externalities” - How are you going to use these effects to get a first mover advantage? - How does this lead to a sustainable advantage?

First Mover Disadvantages May Lead To Second Mover Advantages The Costs of Early Adoption - The “Bleeding Edge” of Technology Changing Product and/or Process Technology Changing Consumer Tastes Product Technology Process Technology