1. MBMC Thinking Strategically

2. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 10: Thinking Strategically Slide 2 Thinking Strategically The payoff to many actions will depend on The actions themselves. When the actions are taken. How the actions relate to those taken by others.

3. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 10: Thinking Strategically Slide 3 The Theory of Games Basic Elements of a Game The Players Their Strategies The Payoffs

4. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 10: Thinking Strategically Slide 4 The Theory of Games Example Should United Airlines spend more on advertising?

5. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 10: Thinking Strategically Slide 5 The Payoff Matrix for an Advertising Game Raise ad spending Leave ad spending the same Raise ad spending Leave ad spending the sameAmerican gets $5,500 American gets $2,000 American gets $8,000 American gets $6,000 United gets $5,500 $8,000 $6,000 $2,000 American’s Choice United’s Choice

6. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 10: Thinking Strategically Slide 6 The Theory of Games Dominant Strategy One that yields a higher payoff no matter what the other players in a game choose

7. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 10: Thinking Strategically Slide 7 The Theory of Games Dominated Strategy Any other strategy available to a player who has a dominant strategy

8. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 10: Thinking Strategically Slide 8 The Theory of Games Nash Equilibrium Any combination of strategies in which each player’s strategy is her or his best choice, given the other player’s strategies

9. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 10: Thinking Strategically Slide 9 The Theory of Games Nash Equilibrium When each player has a dominant strategy, equilibrium occurs when each player follows that strategy

10. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 10: Thinking Strategically Slide 10 The Theory of Games Nash Equilibrium There can be an equilibrium when players do not have a dominant strategy

11. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 10: Thinking Strategically Slide 11 The Theory of Games Example Should United Airlines spend more on advertising?

12. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 10: Thinking Strategically Slide 12 Equilibrium When One Player Lacks a Dominant Strategy Raise ad spending Leave ad spending the same Raise ad spending Leave ad spending the sameAmerican gets $4,000 American gets $3,000 American gets $5,000 American gets $2,000 United gets $3,000 $8,000 $5,000 $4,000 American’s Choice United’s Choice

13. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 10: Thinking Strategically Slide 13 What Should United and American Do If Their Payoff Matrix is Modified? Raise ad spending Leave ad spending the same Raise ad spending Leave ad spending the sameAmerican gets $2,000 American gets $3,000 American American gets $4,000 United gets $3,000 $4,000 $3,000 $2,000 American’s Choice United’s Choice

14. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 10: Thinking Strategically Slide 14 The Prisoner’s Dilemma Prisoners Dilemma A game in which each player has a dominant strategy, and when each plays it, the resulting payoffs are smaller than if each had played a dominated strategy

15. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 10: Thinking Strategically Slide 15 The Prisoner’s Dilemma Example Should the prisoners confess?

16. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 10: Thinking Strategically Slide 16 The Payoff Matrix for a Prisoner’s Dilemma Confess Remain silent Confess Remain silent Jasper gets 5 years Jasper gets 20 years Jasper gets 0 years Jasper gets 1 years Horace gets 5 years Horace gets 0 years Horace gets 1 years Horace gets 20 years Jasper’s Choice Horace’s Choice

17. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 10: Thinking Strategically Slide 17 The Prisoner’s Dilemma Exercise Which of these games is a prisoner’s dilemma?

18. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 10: Thinking Strategically Slide 18 Which of These Games Is a Prisoner’s Dilemma? Don’t Invest Don’t Invest 10 for Chrysler 12 for Chrysler 4 for Chrysler 5 for Chrysler 10 for GM 4 for GM 5 for GM 12 for GM Chrysler’s Choice GM’s Choice GAME 1 Invest

19. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 10: Thinking Strategically Slide 19 Which of These Games Is a Prisoner’s Dilemma> 12 for Chrysler 5 for Chrysler 10 for Chrysler 4 for Chrysler GM 5 for GM 12forGM 10 for GM Chrysler’s Choice GM’s Choice GAME 2 Don’t Invest Don’t Invest

20. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 10: Thinking Strategically Slide 20 The Prisoner’s Dilemma Prisoner’s Dilemmas Confronting Imperfectly Competitive Firms Cartel  A coalition of firms that agrees to restrict output for the purpose of earning an economic profit

21. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 10: Thinking Strategically Slide 21 The Prisoner’s Dilemma Economic Naturalist Why are cartel agreements notoriously unstable?

22. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 10: Thinking Strategically Slide 22 The Market Demand for Mineral Water Price $/bottle) Bottles/day Assume 2 firms (Aquapure & Mountain Spring MC = 0 Cartel is formed & agree to split output and profits 2,000 D 1.00 1,000 MR 2.00 Impact of Cartel Q = 1,000 bottles/day P = $1/bottle Each firm makes $500/day

23. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 10: Thinking Strategically Slide 23 The Temptation to Violate a Cartel Agreement Price $/bottle) Bottles/day D 1.00 1,0002,000 MR 2.00 1,100 0.90 Aquapure lowers P P = $.90/bottle Q = 1,100 bottles/day Mountains Spring retaliates P = $.90/bottle Both firms split 1,100 bottles/day @ $.90 Profit = $495/day

24. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 10: Thinking Strategically Slide 24 The Payoff Matrix for a Cartel Agreement Charge $1Charge $0.90 Charge $1 Charge $0.90 Mountain Spring’s Choice Aquapure’s Choice $990/day for Mountain Spring $0/day for Mountain Spring $495/day for Mountain Spring $500/day for Aquapure $0/day for Aquapure $495/day for Aquapure $990/day for Aquapure $500/day for Mountain Spring

25. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 10: Thinking Strategically Slide 25 The Prisoner’s Dilemma Economic Naturalist When will the rival firms stop cutting prices?

26. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 10: Thinking Strategically Slide 26 The Prisoner’s Dilemma Economic Naturalist How did Congress unwittingly solve the television advertising dilemma confronting cigarette producers?

27. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 10: Thinking Strategically Slide 27 Cigarette Advertising as a Prisoner’s Dilemma Advertise on TVDon’t advertise on TV Advertise on TV Don’t Advertise on TV $10 million/year for Philip Morris $5 million/year for Philip Morris $35 million/year for Philip Morris $20 million/year for Philip Morris $10 million/ year for RJR $35 million/ year for RJR $20 million/ year for RJR $5 million/ year for RJR Philip Morris’s Choice RJR’s Choice

28. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 10: Thinking Strategically Slide 28 The Prisoner’s Dilemma Economic Naturalist Why do people stand at concerts, even though they can see just as well when everyone sits?

29. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 10: Thinking Strategically Slide 29 Standing versus Sitting at a Concert as a Prisoner’s Dilemma StandSit Stand Sit Other People’s Choice Your Choice -$2 for others -$2 for you $1 for you $0 for you -$3 for you -$3 for others $1 for others $0 for others

30. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 10: Thinking Strategically Slide 30 The Prisoner’s Dilemma Economic Naturalist Why do people shout at parties?

31. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 10: Thinking Strategically Slide 31 The Prisoner’s Dilemma Tit-for-Tat and the Repeated Prisoner’s Dilemma Cooperation between players will increase the payoff in a prisoner’s dilemma. There is a motive to enforce cooperation.

32. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 10: Thinking Strategically Slide 32 The Prisoner’s Dilemma Tit-for-tat strategy for repeated games Tit-for-tat strategy  Players cooperate on the first move, then mimic their partner’s last move on each successive move

33. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 10: Thinking Strategically Slide 33 The Prisoner’s Dilemma Tit-for-tat strategy for repeated games Tit-for-tat strategy requirements  Two players  A stable set of players  Players recall other player’s moves  Players have a stake in future outcomes

34. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 10: Thinking Strategically Slide 34 The Prisoner’s Dilemma Question Why is the tit-for-tat strategy unsuccessful in competitive, monopolistically competitive, and oligopolistic markets?

35. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 10: Thinking Strategically Slide 35 Games in Which Timing Matters The Ultimate Bargaining Game Should Michael accept Tom’s offer?  Rules of the game oExperimenter gives $100 to Tom oTom proposes how to divide $100 with Michael oTom must give Michael at least $1 (X = Tom and $100 - X = Michael) oMichael must accept the proposal oIf he does, Tom and Michael get the money oIf he does not, the money goes to the experimenter

36. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 10: Thinking Strategically Slide 36 Decision Tree for Tom A Michael accepts Michael refuses $X for Tom $(100 – X) for Michael $0 for Tom $0 for Michael Tom proposes $X for himself, $(100 – X) for Michael B Possible Moves and Payoffs

37. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 10: Thinking Strategically Slide 37 Tom’s Best Strategy in an Ultimatum Bargaining Game A Michael accepts Michael refuses $99 for Tom $1 for Michael $0 for Tom $0 for Michael Tom proposes $99 for himself, $1 for Michael B Tom can give Michael a take-it-or-leave-it offer Tom will propose $1 Michael will accept The outcome is a Nash Equilibrium

38. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 10: Thinking Strategically Slide 38 The Ultimatum Bargaining Game with an Acceptance Threshold A $X for Tom $(100 – X) for Michael $0 for Tom $0 for Michael Michael announces that he will reject any offer less than $Y B Tom proposes $X < $(100 - Y) for himself $(100 - X) > Y for Michael Tom proposes $X > $(100 - Y) for himself $(100 - X) < Y for Michael New Rule: Michael can specify in advance the minimum offer he will accept

39. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 10: Thinking Strategically Slide 39 Games in Which Timing Matters Credible Threats and Promises Credible Threat  A threat to take an action that is in the threatener’s interest to carry out

40. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 10: Thinking Strategically Slide 40 Games in Which Timing Matters Example Is it safe to steal Veronica’s briefcase? Hint.... What are the costs and benefits of filing charges in the theft of a briefcase?

41. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 10: Thinking Strategically Slide 41 Games in Which Timing Matters Credible Promise A promise to take action that is in the promiser’s interest to keep

42. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 10: Thinking Strategically Slide 42 Decision Tree for the Kidnapper Game A Kidnapper kills victim Victim goes to police Victim dies, kidnapper survives Victim promises to remain silent B Kidnapper sets victim free C Victim remains silent Victim remains in danger, kidnapper survives Victim is safe, kidnapper executed Will the kidnapper release his victim?

43. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 10: Thinking Strategically Slide 43 Decision Tree for the Remote Office Game A Owner does not open remote office Manager manages honestly; owner gets $1,000, manager gets $1,000 Managerial candidate promises to manage honestly B Owner opens remote office C Manager manages dishonestly; owner gets -$500, manager gets $1,500 Owner gets $0, manager gets $500 by working elsewhere Should a business owner open a remote office? Is the outcome an equilibrium?

44. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 10: Thinking Strategically Slide 44 Games in Which Timing Matters Commitment Problem A situation in which people cannot achieve their goals because of an inability to make credible threats or promises

45. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 10: Thinking Strategically Slide 45 Games in Which Timing Matters Commitment Device A way of changing incentives so as to make otherwise empty threats or promises credible

46. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 10: Thinking Strategically Slide 46 Games in Which Timing Matters Commitment Problems Prisoner’s dilemma Cartels Kidnapper Remote office

47. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 10: Thinking Strategically Slide 47 Games in Which Timing Matters Commitment Devices Underworld code, omerta Military arms control agreements Tips for waiters

48. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 10: Thinking Strategically Slide 48 Games in Which Timing Matters What do you think? How could the kidnap victim create a commitment device to remain silent?

49. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 10: Thinking Strategically Slide 49 Games in Which Timing Matters What do you think? Will Sylvester leave a tip when dining on the road?

50. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 10: Thinking Strategically Slide 50 The Strategic Role of Preferences Game theory assumes that the goal of the players is to maximize their outcome. In most games, players do not attain the best outcomes. Altering psychological incentives may also improve the outcome of a game.

51. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 10: Thinking Strategically Slide 51 The Strategic Role of Preferences Question In a moral society, will the business owner open a remote office?

52. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 10: Thinking Strategically Slide 52 The Remote Office Game with an Honest Manager A Owner does not open remote office Manager manages honestly; owner gets $1,000, manager gets $1,000 Managerial candidate promises to manage honestly B Owner opens remote office C Manager manages dishonestly; owner gets -$500, manager gets -$8,500 Owner gets $0, manager gets $500 by working elsewhere The value of dishonesty to the manager is $10,000

53. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 10: Thinking Strategically Slide 53 The Strategic Role of Preferences Are People Fundamentally Selfish? Do you tip at out-of town restaurants? What would be your first offer in the ultimatum bargaining game? Would you refuse a lopsided offer?

54. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 10: Thinking Strategically Slide 54 The Strategic Role of Preferences Are People Fundamentally Selfish? If narrow self-interest is not the only motive for making choices, then the other motives must be understood to predict and explain human behavior.

55. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 10: Thinking Strategically Slide 55 The Strategic Role of Preferences Preferences as Solutions to Commitment Problems Concerns about fairness, guilt, humor, sympathy, etc. do influence the choices people make in strategic interactions. Commitment to these preferences must be communicated for them to influence choices.

56. MBMC End of Chapter End of Chapter