View
215
Download
1
Embed Size (px)
Citation preview
Chapter 13
Game Theory and Competitive Strategy
Chapter 13 2©2005 Pearson Education, Inc.
Topics to be Discussed
Gaming and Strategic Decisions
Dominant Strategies
The Nash Equilibrium Revisited
Repeated Games
Chapter 13 3©2005 Pearson Education, Inc.
Topics to be Discussed
Sequential Games
Threats, Commitments, and Credibility
Entry Deterrence
Bargaining Strategy
Auctions
Chapter 13 4©2005 Pearson Education, Inc.
Gaming and Strategic Decisions
Game is any situation in which players (the participants) make strategic decisions Ex: firms competing with each other by
setting prices, group of consumers bidding against each other in an auction
Strategic decisions result in payoffs to the players: outcomes that generate rewards or benefits
Chapter 13 5©2005 Pearson Education, Inc.
Gaming and Strategic Decisions
Game theory tries to determine optimal strategy for each player
Strategy is a rule or plan of action for playing the game
Optimal strategy for a player is one that maximizes the expected payoff
We consider players who are rational – they think through their actions
Chapter 13 6©2005 Pearson Education, Inc.
Gaming and Strategic Decisions
“If I believe that my competitors are rational and act to maximize their own profits, how should I take their behavior into account when making my own profit-maximizing decisions?”(Text, p. 474)
Chapter 13 7©2005 Pearson Education, Inc.
Noncooperative vs. Cooperative Games
Cooperative Game Players negotiate binding contracts that allow
them to plan joint strategiesExample: Buyer and seller negotiating the price
of a good or service or a joint venture by two firms (i.e., Microsoft and Apple)
Binding contracts are possible
Chapter 13 8©2005 Pearson Education, Inc.
Noncooperative vs. Cooperative Games
Noncooperative Game Negotiation and enforcement of binding
contracts between players is not possibleExample: Two competing firms, assuming the
other’s behavior, independently determine pricing and advertising strategy to gain market share
Binding contracts are not possible
Chapter 13 9©2005 Pearson Education, Inc.
Noncooperative vs. Cooperative Games
“The strategy design is based on understanding your opponent’s point of view, and (assuming your opponent is rational) deducing how he or she is likely to respond to your actions.” (Text, p. 475)
Chapter 13 10©2005 Pearson Education, Inc.
Gaming and Strategic Decisions
An Example: How to buy a dollar bill1. Auction a dollar bill
2. Highest bidder receives the dollar in return for the amount bid
3. Second highest bidder must pay the amount he or she bid but gets nothing in return
4. How much would you bid for a dollar?
Typically bid more for the dollar when faced with loss as second highest bidder
Chapter 13 11©2005 Pearson Education, Inc.
Acquiring a Company
Scenario Company A: The Acquirer Company T: The Target A will offer cash for all of T’s shares
The value and viability of T depends on the outcome of a current oil exploration project
Chapter 13 12©2005 Pearson Education, Inc.
Acquiring a Company
Project failure: T’s value = $0Project success: T’s value = $100/shareAll outcomes in between equally likelyT’s value will be 50% greater with A’s
management
Chapter 13 13©2005 Pearson Education, Inc.
Acquiring a Company
Scenario A must submit the proposal before the
exploration outcome is known T will not choose to accept or reject until after
the outcome is known only to T Company T will accept any offer that is
greater than the per share value of the company under current management
How much should A offer?
Chapter 13 14©2005 Pearson Education, Inc.
Dominant Strategies
Dominant Strategy is one that is optimal no matter what an opponent does An Example
A and B sell competing productsThey are deciding whether to undertake
advertising campaigns
Chapter 13 15©2005 Pearson Education, Inc.
Payoff Matrix for Advertising Game
Fir
m A
Advertise
Don’tAdvertise
Advertise
Don’tAdvertise
Firm B
10, 5 15, 0
10, 26, 8
Chapter 13 16©2005 Pearson Education, Inc.
Payoff Matrix for Advertising Game
Observations A: regardless of B,
advertising is the best B: regardless of A,
advertising is best
Firm A
AdvertiseDon’t
Advertise
Advertise
Don’tAdvertise
Firm B
10, 5 15, 0
10, 26, 8
Chapter 13 17©2005 Pearson Education, Inc.
Payoff Matrix for Advertising Game
Observations Dominant strategy for
A and B is to advertise
Do not worry about the other player
Equilibrium in dominant strategy
Firm A
AdvertiseDon’t
Advertise
Advertise
Don’tAdvertise
Firm B
10, 5 15, 0
10, 26, 8
Chapter 13 18©2005 Pearson Education, Inc.
Dominant Strategies
Equilibrium in dominant strategies Outcome of a game in which each firm is
doing the best it can regardless of what its competitors are doing
Optimal strategy is determined without worrying about the actions of other players
However, not every game has a dominant strategy for each player
Chapter 13 19©2005 Pearson Education, Inc.
Dominant Strategies
Game Without Dominant Strategy The optimal decision of a player without a
dominant strategy will depend on what the other player does
Revising the payoff matrix, we can see a situation where no dominant strategy exists
Chapter 13 20©2005 Pearson Education, Inc.
10, 5 15, 0
20, 26, 8
Fir
m A
Advertise
Don’tAdvertise
Advertise
Don’tAdvertise
Firm B
Modified Advertising Game
Chapter 13 21©2005 Pearson Education, Inc.
10, 5 15, 0
20, 26, 8
Firm A
AdvertiseDon’t
Advertise
Advertise
Don’tAdvertise
Firm B
Modified Advertising Game
Observations A: No dominant
strategy; depends on B’s actions
B: Dominant strategy is to advertise
Firm A determines B’s dominant strategy and makes its decision accordingly
Chapter 13 22©2005 Pearson Education, Inc.
The Nash Equilibrium Revisited
A dominant strategy is stable, but in many games one or more party does not have a dominant strategy
A more general equilibrium concept is the Nash Equilibrium introduced in Chapter 12 A set of strategies (or actions) such that each
player is doing the best it can given the actions of its opponents
Chapter 13 23©2005 Pearson Education, Inc.
The Nash Equilibrium Revisited
None of the players have incentive to deviate from its Nash strategy, therefore it is stable In the Cournot model, each firm sets its own
price assuming the other firm’s outputs are fixed. Cournot equilibrium is a Nash Equilibrium.
Chapter 13 24©2005 Pearson Education, Inc.
The Nash Equilibrium Revisited
Dominant Strategy “I’m doing the best I can no matter what you
do. You’re doing the best you can no matter what I do.”
Nash Equilibrium “I’m doing the best I can given what you are
doing. You’re doing the best you can given what I am doing.”
Dominant strategy is a special case of Nash equilibrium
Chapter 13 25©2005 Pearson Education, Inc.
The Nash Equilibrium Revisited
Two cereal companies face a market in which two new types of cereal can be successfully introduced, provided each type is introduced by only one firm
Product Choice Problem Market for one producer of crispy cereal Market for one producer of sweet cereal Each firm only has the resources to introduce one
cereal Noncooperative
Chapter 13 26©2005 Pearson Education, Inc.
Product Choice ProblemF
irm
1
Crispy Sweet
Crispy
Sweet
Firm 2
-5, -5 10, 10
-5, -510, 10
Chapter 13 27©2005 Pearson Education, Inc.
Product Choice Problem
Firm 1
Crispy Sweet
Crispy
Sweet
Firm 2
-5, -5 10, 10
-5, -510, 10
If Firm 1 hears Firm 2 is introducing a new sweet cereal, its best action is to make crispy
Bottom left corner is Nash equilibrium
What is other Nash Equilibrium?
Chapter 13 28©2005 Pearson Education, Inc.
Beach Location Game
Scenario Two competitors, Y and C, selling soft drinks Beach is 200 yards long Sunbathers are spread evenly along the
beach Price Y = Price C Customer will buy from the closest vendor
Chapter 13 29©2005 Pearson Education, Inc.
Beach Location Game
Where will the competitors locate (i.e., where is the Nash equilibrium)?
Will want to all locate in center of beach Similar to groups of gas stations, car
dealerships, etc.
Ocean
0 B Beach A 200 yards
C
Chapter 13 30©2005 Pearson Education, Inc.
The Nash Equilibrium Revisited
Maximin Strategies - Scenario Two firms compete selling file encryption
software They both use the same encryption standard
(files encrypted by one software can be read by the other - advantage to consumers)
Firm 1 has a much larger market share than Firm 2
Both are considering investing in a new encryption standard
Chapter 13 31©2005 Pearson Education, Inc.
Maximin StrategyF
irm
1
Don’t invest InvestFirm 2
0, 0 -10, 10
20, 10-100, 0
Don’t invest
Invest
Chapter 13 32©2005 Pearson Education, Inc.
Maximin Strategy
Firm 1
Don’t invest InvestFirm 2
0, 0 -10, 10
20, 10-100, 0
Don’t invest
Invest
Observations Dominant strategy
Firm 2: Invest Firm 1 should
expect Firm 2 to invest
Nash equilibriumFirm 1: investFirm 2: Invest
This assumes Firm 2 understands the game and is rational
Chapter 13 33©2005 Pearson Education, Inc.
Maximin Strategy
Firm 1
Don’t invest InvestFirm 2
0, 0 -10, 10
20, 10-100, 0
Don’t invest
Invest
Observations If Firm 2 does not
invest, Firm 1 incurs significant losses
Firm 1 might play don’t invest
Minimize losses to 10 – maximin strategy
Chapter 13 34©2005 Pearson Education, Inc.
Maximin Strategy
If both are rational and informed Both firms invest Nash equilibrium
If Player 2 is not rational or completely informed Firm 1’s maximin strategy is to not invest Firm 2’s maximin strategy is to invest If 1 knows 2 is using a maximin strategy, 1
would invest
Chapter 13 35©2005 Pearson Education, Inc.
Maximin Strategy
If Firm 1 is unsure about what Firm 2 will do, it can assign probabilities to each possible action Could use a strategy that maximizes its
expected payoff Firm 1’s strategy depends critically on its
assessment of probabilities for Firm 2
Chapter 13 36©2005 Pearson Education, Inc.
Prisoners’ DilemmaP
riso
ner
A
Confess Don’t Confess
Confess
Don’tConfess
Prisoner B
-5, -5 -1, -10
-2, -2-10, -1
Chapter 13 37©2005 Pearson Education, Inc.
Prisoners’ Dilemma
Prisoner A
Confess Don’t Confess
Confess
Don’tConfess
Prisoner B
-5, -5 -1, -10
-2, -2-10, -1
What is the: Dominant strategy Nash equilibrium Maximin solution
Dominant strategies are also maximin strategies
Both confess is both Nash equilibrium and maximin solution
Chapter 13 38©2005 Pearson Education, Inc.
Mixed Strategy
Pure Strategy Player makes a specific choice or takes a
specific action
Mixed Strategy Player makes a random choice among two or
more possible actions, based on a set of chosen probabilities
Chapter 13 39©2005 Pearson Education, Inc.
Matching PenniesP
lay
er
A
Heads Tails
Heads
Tails
Player B
1, -1 -1, 1
1, -1-1, 1
Chapter 13 40©2005 Pearson Education, Inc.
Matching Pennies
Pure strategy: No Nash equilibrium No combination of
head and tails leaves both players better off
Mixed strategy: Random choice is a Nash equilibrium
Player A
Heads Tails
Heads
Tails
Player B
1, -1 -1, 1
1, -1-1, 1
Chapter 13 41©2005 Pearson Education, Inc.
Matching Pennies
Player A might flip coin playing heads with ½ probability and tails with ½ probability
If both players follow this strategy, there is a Nash equilibrium – both players will be doing the best they can given what their opponent is doing
Although the outcome is random, the expected payoff is 0 for each player
Chapter 13 42©2005 Pearson Education, Inc.
Mixed Strategy
One reason to consider mixed strategies is when there is a game that does not have any Nash equilibriums in pure strategy
When allowing for mixed strategies, every game has a Nash equilibrium
Mixed strategies are popular for games like poker
A firm might not find it reasonable
Chapter 13 43©2005 Pearson Education, Inc.
The Battle of the Sexes
Jim
Wrestling Opera
Wrestling
Opera
Joan
2,1 0,0
1,20,0
Chapter 13 44©2005 Pearson Education, Inc.
The Battle of the Sexes
Pure Strategy Both watch wrestling Both watch opera
Mixed Strategy Jim chooses
wrestling Joan chooses
wrestling
Jim
Wrestling Opera
Wrestling
Opera
Joan
2,1 0,0
1,20,0
Chapter 13 45©2005 Pearson Education, Inc.
Repeated Games
Game in which actions are taken and payoffs are received over and over again
Oligopolistic firms play a repeated gameWith each repetition of the Prisoners’
Dilemma, firms can develop reputations about their behavior and study the behavior of their competitors
Chapter 13 46©2005 Pearson Education, Inc.
Pricing Problem
Firm 1
Low Price High Price
Low Price
High Price
Firm 2
10, 10 100, -50
50, 50-50, 100
Chapter 13 47©2005 Pearson Education, Inc.
Pricing Problem
How does a firm find a strategy that would work best on average against all or almost all other strategies?
Tit-for-tat strategy Repeated game strategy in which a player
responds in kind to an opponent’s previous play, cooperating with cooperative opponents and retaliating against uncooperative ones
Chapter 13 48©2005 Pearson Education, Inc.
Tit-for-Tat Strategy
What if the game is infinitely repeated? Competitors repeatedly set price every
month, forever Tit-for-tat strategy is rational
If competitor charges low price and undercuts firm
Will get high profits that month but know I will lower price next month
Both of us will get lower profits if keep undercutting, so not rational to undercut
Chapter 13 49©2005 Pearson Education, Inc.
Tit-for-Tat Strategy
What if repeated a finite number of times? If both firms are rational, they will charge high prices
until the last month After the last month, there is no retaliation possible But in the month before last month, knowing that will
charge low price in last month, will charge low price in month before
Keep going and see that only rational outcome is for both firms to charge low price every month
Chapter 13 50©2005 Pearson Education, Inc.
Tit-for-Tat Strategy
If firms don’t believe their competitors are rational or think perhaps they aren’t, cooperative behavior is a good strategy
Most managers don’t know how long they will be competing with their rivals
In a repeated game, prisoner’s dilemma can have cooperative outcome
Chapter 13 51©2005 Pearson Education, Inc.
Repeated Games
Conclusion Cooperation is difficult at best since these
factors may change in the long run Need a small number of firms Need stable demand and cost conditions
This could lead to price wars if don’t have them
Chapter 13 52©2005 Pearson Education, Inc.
Oligopolistic Cooperationin the Water Meter Industry
Characteristics of the Market Four producers of water meters
Rockwell InternationalBadger MeterNeptune Water Meter CompanyHersey ProductsRockwell has about 35% of market shareBadger, Neptune, and Hersey combined have
about a 50 to 55% share
Chapter 13 53©2005 Pearson Education, Inc.
Oligopolistic Cooperationin the Water Meter Industry
Most buyers are municipal water utilitiesVery inelastic demand
Not a significant part of the budget for providing water
Demand is stable Demand grows steadily with population
Utilities have long-standing relationships with suppliers Reluctant to switch
Chapter 13 54©2005 Pearson Education, Inc.
Oligopolistic Cooperationin the Water Meter Industry
Significant economies of scaleBoth long term relationship and
economies of scale represent barriers to entry Hard for new firms to enter market
If firms were to cooperate, could earn significant monopoly profits
If compete aggressively to gain market share, profits will fall to competitive levels
Chapter 13 55©2005 Pearson Education, Inc.
Oligopolistic Cooperationin the Water Meter Industry
This is a Prisoners’ Dilemma – what should the firms do? Lower price to a competitive level Cooperate
Companies have been playing repeated game for decades
Cooperation has prevailed given market characteristics
Chapter 13 56©2005 Pearson Education, Inc.
Sequential Games
Players move in turn, responding to each other’s actions and reactions Ex: Stackelberg model (ch. 12) Responding to a competitor’s ad campaign Entry decisions Responding to regulatory policy
Chapter 13 57©2005 Pearson Education, Inc.
Sequential Games
Going back to the product choice problem Two new (sweet, crispy) cereals Successful only if each firm produces one
cereal Sweet will sell better Both still profitable with only one producer
Chapter 13 58©2005 Pearson Education, Inc.
Modified Product Choice Problem
If firms both announce their decisions independently and simultaneously, they will both pick sweet cereal and both will lose money
What if Firm 1 sped up production and introduced new cereal first? Now there is a sequential game Firm 1 will think about what Firm 2 will do
Chapter 13 59©2005 Pearson Education, Inc.
Modified Product Choice Problem
Fir
m 1
Crispy Sweet
Crispy
Sweet
Firm 2
-5, -5 10, 20
-5, -520, 10
Chapter 13 60©2005 Pearson Education, Inc.
Extensive Form of a Game
Extensive Form of a Game Representation of possible moves in a
game in the form of a decision tree Allows one to work backward from the best
outcome for Firm 1
Chapter 13 61©2005 Pearson Education, Inc.
Product Choice Game in Extensive Form
Crispy
Sweet
Crispy
Sweet
-5, -5
10, 20
20, 10
-5, -5
Firm 1
Crispy
Sweet
Firm 2
Firm 2
Chapter 13 62©2005 Pearson Education, Inc.
Sequential Games
The Advantage of Moving First In this product-choice game, there is a clear
advantage to moving first The first firm can choose a large level of
output, thereby forcing second firm to choose a small level
Can show the firm’s mover advantage by revising the Stackelberg model and comparing to Cournot
Chapter 13 63©2005 Pearson Education, Inc.
First Mover Advantage
Assume: Duopoly
Firm and
Production Total
/1001010
:
0
30
21
21
PQQ
Cournot
MC
QQ Q
QP
Chapter 13 64©2005 Pearson Education, Inc.
First Mover Advantage
Duopoly
25.56 50.112
50.7 and 5.7 15
rg)(StackelbeFirst Moves Firm
Firm/50.112 15 and 5.7
CollusionWith
21
21
21
PQQ
PQQ
Chapter 13 65©2005 Pearson Education, Inc.
Choosing OutputF
irm
1
7.5
Firm 2
112.50, 112.50 56.25, 112.50
0, 0112.50, 56.25
125, 93.75 50, 75
93.75, 125
75, 50
100, 100
10 15
7.5
10
15
Chapter 13 66©2005 Pearson Education, Inc.
Choosing Output
This payoff matrix illustrates various outcomes Move together, both
produce 10 If Firm 1 moves first
(Q=15), best Firm 2 can do is 7.5
Firm 1
7.5
Firm 2
112.50, 112.50 56.25, 112.50
0, 0112.50, 56.25
125, 93.75 50, 75
93.75, 125
75, 50
100, 100
10 15
7.5
10
15
Chapter 13 67©2005 Pearson Education, Inc.
Threats, Commitments, and Credibility
Strategic Moves What actions can a firm take to gain
advantage in the marketplace?Deter entryInduce competitors to reduce output, leave,
raise priceImplicit agreements that benefit one firm
Chapter 13 68©2005 Pearson Education, Inc.
Threats, Commitments, and Credibility
Strategic Move Action that gives a player an advantage by
constraining his behavior Firm 1 must constrain his behavior to the
extent Firm 2 is convinced that he is committed
Chapter 13 69©2005 Pearson Education, Inc.
Threats, Commitments, and Credibility
How to Make the First Move Demonstrate Commitment Firm 1 must do more than announce they will
produce sweet cerealInvest in expensive advertising campaignBuy large order of sugar and send invoice to
Firm 2 Commitment must be enough to induce Firm
2 to make the decision Firm 1 wants it to make
Chapter 13 70©2005 Pearson Education, Inc.
Threats, Commitments, and Credibility
Empty Threats If a firm will be worse off if it charges a low
price, the threat of a low price is not credible in the eyes of the competitors
When firms know the payoffs of each other’s actions, firms cannot make threats the other firm knows they will not follow
In our example, Firm 1 will always charge high price and Firm 2 knows it
Chapter 13 71©2005 Pearson Education, Inc.
Pricing of Computers and Word Processors
Firm 1
High Price Low Price
High Price
Low Price
Firm 2
100, 80 80, 100
10, 2020, 0
Chapter 13 72©2005 Pearson Education, Inc.
Threats, Commitments, and Credibility
Sometimes firms can make credible threats
Scenario Race Car Motors, Inc. (RCM) produces cars Far Out Engines (FOE) produces specialty
car engines and sells most of them to RCM Sequential game with RCM as the leader FOE has no power to threaten to build big
engines since RCM controls output
Chapter 13 73©2005 Pearson Education, Inc.
Production Choice Problem
Far Out Engines
Small cars Big cars
Small engines
Big engines
Race Car Motors
3, 6 3, 0
8, 31, 1
Chapter 13 74©2005 Pearson Education, Inc.
Threats, Commitments, and Credibility
RCM does best by producing small carsKnows that Far Out will then produce
small enginesFar Out prefers to make big enginesCan Far Out induce Race Car to produce
big cars instead?
Chapter 13 75©2005 Pearson Education, Inc.
Threats, Commitments, and Credibility
Suppose Far Out threatens to produce big engines no matter what RCM does? Not credible since once RCM announces
they are producing small cars, FOE will not have incentive to carry out threat
Can make threat credible by altering pay off matrix by constraining its own choices
Shutting down or destroying some small engine production capacity
Chapter 13 76©2005 Pearson Education, Inc.
Modified Production Choice Problem
0, 6 0, 0
8, 31, 1
Far Out Engines
Small cars Big cars
Small engines
Big engines
Race Car Motors
Chapter 13 77©2005 Pearson Education, Inc.
Modified Production Choice Problem
Strategic commitments can be effective but not without risk Rely heavily on accurate knowledge of payoff
matrix and industry May have competitors out there that they
don’t know about and lose sales
Chapter 13 78©2005 Pearson Education, Inc.
Role of Reputation
If Far Out gets the reputation of being irrational They threaten to produce large engines no
matter what Race Car doesThreat might be credible because
irrational people don’t always make profit maximizing decisions
A party thought to be crazy can lead to a significant advantage
Chapter 13 79©2005 Pearson Education, Inc.
Bargaining Strategy
Bargaining situation can depend on ability to affect relative bargaining position
Consider two firms introducing one of two complementary goods: Firm 1 has cost advantage in Good A Firm 2 has cost advantage in Good B
Chapter 13 80©2005 Pearson Education, Inc.
Bargaining Strategy
Firm 1
Produce A Produce B
Produce A
Produce B
Firm 2
40, 5 50, 50
5, 4560, 40
Chapter 13 81©2005 Pearson Education, Inc.
Bargaining Strategy
With collusion: Firm 1 Produces A
and Firm 2 produces B (50,50)
Without collusion: Firm 1 produces A
and Firm 2 produces B (50,50)
Nash equilibrium
Firm 1
Produce A Produce B
Produce A
Produce B
Firm 2
40, 5 50, 50
5, 4560, 40
Chapter 13 82©2005 Pearson Education, Inc.
Bargaining Strategy
Suppose each firm is also bargaining on the decision to join in a research consortium with a third firm
Dominant strategy is for both firms to enter consortium
Chapter 13 83©2005 Pearson Education, Inc.
Bargaining Strategy
Firm 1
Work alone Enter consortium
Work alone
Enterconsortium
Firm 2
10, 10 10, 20
40, 4020, 10
Chapter 13 84©2005 Pearson Education, Inc.
Bargaining Strategy
Linking the Bargaining Problem Firm 1 announces it will join the consortium
only if Firm 2 agrees to produce A and Firm 1 will produce B
Firm 2’s best interest is to produce A with Firm 1 producing B
Firm 1’s profit increases from 50 to 60
Chapter 13 85©2005 Pearson Education, Inc.
Bargaining Strategy
Strategic moves can be used in bargaining
Combining issues in bargaining can benefit one side at other’s expense
Chapter 13 86©2005 Pearson Education, Inc.
Wal-Mart Stores’ Preemptive Investment Strategy
How did Wal-Mart become the largest retailer in the U.S. when many established retail chains were closing their doors? Gained monopoly power by opening in small
towns with no threat of other discount competition
Preemptive game with Nash equilibrium
Chapter 13 87©2005 Pearson Education, Inc.
The Discount Store Preemption Game
Wal-Mart
Enter Don’t enter
Enter
Don’t enter
Company X
-10, -10 20, 0
0, 00, 20
Chapter 13 88©2005 Pearson Education, Inc.
The Discount Store Preemption Game
Two Nash equilibrium Low left Upper right
Must be preemptive to win
Wal-Mart
Enter Don’t enter
Enter
Don’t enter
Company X
-10, -10 20, 0
0, 00, 20
Chapter 13 89©2005 Pearson Education, Inc.
Entry Deterrence
Barriers to entry important for monopoly power Economies of scale, patents and licenses,
access to critical inputs Firms can also deter entry
To deter entry, the incumbent firm must convince any potential competitor that entry will be unprofitable
Chapter 13 90©2005 Pearson Education, Inc.
Entry Possibilities
Incumbent (I)
Enter Stay out
High price(accommodation)
Low Price(warfare)
Potential Entrant (X) ($80 fixed costs)
100, 20 200, 0
130, 070, -10
Chapter 13 91©2005 Pearson Education, Inc.
Entry Deterrence
Scenario If X does not enter, I makes a profit of $200
million If X enters and charges a high price, I earns
a profit of $100 million and X earns $20 million
If X enters and charges a low price, I earns a profit of $70 million and X earns $-10 million
Chapter 13 92©2005 Pearson Education, Inc.
Entry Deterrence
Could threaten X with warfare if enters market Not credible because once X has entered, it
is in your best interest to accommodate and maintain high price
Chapter 13 93©2005 Pearson Education, Inc.
Entry Deterrence
What if firm I makes an investment before entry to increase capacity? Irrevocable commitment
Gives new payoff matrix since profits will be reduced by investment
Threat is completely credibleRational for Firm X to stay out of market
Chapter 13 94©2005 Pearson Education, Inc.
Entry Deterrence
Incumbent (I)
Enter Stay out
High price(accommodation)
Low price(warfare)
Potential Entrant (X)
50, 20 150, 0
130, 070, -10
Chapter 13 95©2005 Pearson Education, Inc.
Entry Deterrence
If incumbent has reputation of price cutting competitors even at loss, then threat will be credible
Short run losses may be offset by long run gains as monopolist
Chapter 13 96©2005 Pearson Education, Inc.
Entry Deterrence
Production of commercial airlines exhibit significant economies of scale
Airbus and Boeing considering new aircraft
Suppose it is not economical for both firms to produce the new aircraft
Chapter 13 97©2005 Pearson Education, Inc.
Development of a New Aircraft
Boeing
Produce Don’t produce
Airbus
-10, -10 100, 0
0, 00, 120
Produce
Don’t produce
Chapter 13 98©2005 Pearson Education, Inc.
Development of a New Aircraft
Boeing has head start
Boeing will produceAirbus will not
produce
Boeing
Produce Don’t produce
Airbus
-10, -10 100, 0
0, 00, 120
Produce
Don’t produce
Chapter 13 99©2005 Pearson Education, Inc.
Development of a New Aircraft
Governments can change outcome of game
European government agrees to subsidize Airbus before Boeing decides to produce
With Airbus being subsidized, the payoff matrix for the two firms would differ significantly
Chapter 13 100©2005 Pearson Education, Inc.
Development of an AircraftAfter European Subsidy
Boeing
Produce Don’t produce
Airbus
-10, 10 100, 0
0, 00, 120
Produce
Don’t produce
Chapter 13 101©2005 Pearson Education, Inc.
Boeing
Produce Don’t produce
Airbus
-10, 10 100, 0
0, 00, 120
Produce
Don’t produce
Development of an AircraftAfter European Subsidy
Airbus will produceBoeing will not
produce
Chapter 13 102©2005 Pearson Education, Inc.
Diaper Wars
Even though there are only two major firms, competition is intense
The competition occurs mostly in the form of cost-reducing innovation
Small cost savings can lead to capturing of market share
Both firms spend significantly on R&D
Chapter 13 103©2005 Pearson Education, Inc.
Competing Through R & D
P&G
R&D No R&D
R&D
No R&D
Kimberly-Clark
40, 20 80, -20
60, 40-20, 60
Chapter 13 104©2005 Pearson Education, Inc.
Competing Through R & D
Both spend on R&D Dominant strategy
Why not cooperate?Strengthening
Bargaining Power Credibility Reducing flexibility
P&G
R&D No R&D
R&D
No R&D
Kimberly-Clark
40, 20 80, -20
60, 40-20, 60
Chapter 13 105©2005 Pearson Education, Inc.
Auctions
Markets in which products are bought and sold through formal bidding processes Encourages competition that increases
seller’s revenue Low cost of transactions Useful for unique items or those with
fluctuating valueTokyo fish market
Chapter 13 106©2005 Pearson Education, Inc.
Auction Formats
1. Traditional English (oral) Seller actively solicits progressively higher
bids from a group of potential buyers Buyers are always aware of highest bid Stops when no one passes highest bid
Chapter 13 107©2005 Pearson Education, Inc.
Auction Formats
2. Dutch auction Seller begins by offering item at relatively
high price, then reduces it by fixed amounts until item is sold
First buyer accepting offered price can buy item at that price
Chapter 13 108©2005 Pearson Education, Inc.
Auction Formats
3. Sealed-bid All bids are made simultaneously in sealed
envelopes, where winning bid is the one who submitted highest bid
A. First price Sales price equals highest bid
B. Second price Sales price equals second highest bid
Chapter 13 109©2005 Pearson Education, Inc.
Valuation and Information
How to choose an auction format1. Private-value auction – bidder knows
individual valuations of object, but valuations differ from bidder to bidder Signed baseball
2. Common-value auction: bidders uncertain what the value is Offshore oil reserve
Chapter 13 110©2005 Pearson Education, Inc.
Price-Value Auctions
Each bidder must choose bidding strategy
Payoff for winning is reservation price minus price paid
Payoff for losing is zero
Chapter 13 111©2005 Pearson Education, Inc.
Private Value Auction
English oral auction and second–price sealed bid auctions Bidding truthfully is dominant strategy Pay based on value of second highest bidder
so no incentive not to bid reservation price Risk to bidding higher than reservation price
Chapter 13 112©2005 Pearson Education, Inc.
Private Value Auctions
English auction Continue bidding until second person is
unwilling to make bid
Sealed-bid auction Winning bid approximately equal to the
second highest bidder’s reservation price
Both yield the same revenue
Chapter 13 113©2005 Pearson Education, Inc.
Common Value Auctions
Winner’s Curse The winner is worse off because they
overestimated the value of the item and thereby overbid
Must reduce bid by amount equal to the expected error of the winning bidder
If a lot of variation in other bidders, then estimates are fairly imprecise
Chapter 13 114©2005 Pearson Education, Inc.
Maximizing Auction Revenue
1. Private Value Auction Encourages many bidders to increase
expected bid of winner
2. Common Value Auction Uses open rather than sealed bid
Generates greater revenue Reveals information about true value,
reducing concern of winner’s curse
Chapter 13 115©2005 Pearson Education, Inc.
Maximizing Auction Revenue
3. Private value auction Sets min bid equal to or higher than value
to you of keeping good for future sale Protects against loss if bidders are unaware
of value Increases size of bids by letting bidders
think item is valuable No sale could make bidders think item is
low quality
Chapter 13 116©2005 Pearson Education, Inc.
Bidding and Collusion
Buyers can allow benefit from collusion Can be done legally through buying groups Can be done illegally through collusive
agreements that violate antitrust laws Collusion is not easy because of large
incentive to cheat Repeated auctions allow for penalizing
participants that break agreement
Chapter 13 117©2005 Pearson Education, Inc.
Bidding and Collusion
Examples
1. Collusion among baseball owners to limit their bidding for free agent players in the 1980’s
2. Two of the world’s most successful auction houses were found guilty of agreeing to fix prices of commissions
Sotheby’s and Christie’s
Chapter 13 118©2005 Pearson Education, Inc.
Internet Auctions
Popularity of auctions has skyrocketed with growth of internet
Most popular site is eBay Dominates online person-person auction
industry
Subject to large network externalities Choose auction site with largest number of
potential bidders
Chapter 13 119©2005 Pearson Education, Inc.
Internet Auctions
eBay auctions are somewhat different from types discussed
A few caveats: No quality control function Poor seller feedback Bid manipulation may occur