Game Theory and Competitive Strategy

1. Game Theory and Competitive Strategy Selecting a course of action in a situation in which rival players are selecting strategies that suit their interests is the basic problem of game theory.

2. 1. Players and their actions A situation of competitive rivalry must involve two or more players whose choice of actions affect each other. • A “player” can be a firm, an interest group or coalition, a military leader, government official. • Games generally consider only one kind of action—e.g., number of daily departures, fares, in-flight services, schedules, advertising, choice of hubs, ordering planes, expanding terminals, use of computerized reservations systems, mergers and acquisitions, and human resource decisions.

3. 2. Outcomes and Payoffs The firm’s action, together with the actions of its rivals, determine its payoff • In the standard “business” game, the payoff can be in the form of profit, market share, ratings points, • In war games, the payoff might be measured in enemy killed or territory seized. • In political games, payoffs may be measured in votes or campaign contributions.

4. 3. Underlying “rules” The rules of the game define the range of possible outcomes and payoffs • For example, collusion to fix prices or a merger among direct rivals in a concentrated market structure may be against the rules. • Another set a rules specifies whether players move sequentially or simultaneously, who moves first, and what does each player know about the other players’ preference and prior to actions?

5. The TV Ratings Game • CBS and NBC must make the following decision about their weeknight primetime (8:00 – 10:00 p.m.) program line-up: • Should CBS put its ratings “hit” in the 8 p.m. slot and follow with a “run of the mill” show at 9 p.m.? • Should NBC put its ratings “hit” in the 8 p.m. slot and follow with a “run of the mill” show at 9 p.m.?

6. We would like to avoid head to head competition with “Friends.” The 8 p.m. slot does have more potential viewers Meanwhile, at CBS

7. The TV Ratings Game ABC CBS Note: The

8. Notes on the payoff matrix • By convention, the “row” players payoff (in this case NBC) is listed first. • If each network leads with its “hit” show at 8:00 p.m., NBC’s audience (8 to 10 p.m.) will be 36 million viewers and CBS’s will be 33 million). • The total number of viewers in each time slot is show underneath the payoff. For example, if both lead with the hit show, then NBC will have 21 million viewers in the 8:00 p.m. slot and 15 in the 9:00 p.m. slot.

9. Looks like leading with our hit is a dominant strategy Meanwhile, at CBS

10. Market Entry in the Bookselling Industry • Bordersand Barnes and Noble are considering the location of a book superstore in a midsize city. • The market is currently underserved by incumbent booksellers; however, the market is not large enough to support 2 superstores.

11. The payoff matrix. Borders Barnes andNoble • Notice there is no dominant strategy here. • Were this a sequential game, there would be a first mover advantage. • Either player can claim a fist mover advantage by being the first to make a credible commitment to enter, which normally entails incurring non-recoverable costs.

12. Entry deterrence • Here we model the problem of entry in the case where there is an incumbent monopolist. • A second firm (the potential entrant) must decide: To enter, or not to enter? • If the second firm enters, the incumbent must decide whether to maintain price or cut price. • If the incumbent maintains price, then entry is profitable. If the incumbent decides to cut price, the entry in unprofitable.

13. If the potential entrant has the first move, then entry makes sense. After entry, the incumbent’s best move is to maintain price—and this is known to the potential entrant. So how can the incumbent’s threat to cut price be taken seriously?

14. Deterring EntryIn this case the incumbentdoes not deterred becauseof the incumbent’s threatto cut price is not credible M a i n t a i n p r i c e 4, 6 E n t e r I C u t p r i c e - 4 , 4 E D o n o t e n t e r 0 , 1 2

15. An effective strategy for deterring entry would be to establish the pre-entry price at a level would would make entry unprofitable. We call this “limit pricing.” This principle may explain why some dominant firms charge prices less than those which maximize short-run profits.

16. Deterring Entry with Limit Pricing The incumbent (I) deters entry by making a credible threat to cut price. E n t e r 4 , 6 M a i n t a i n p r i c e E D o n o t e n t e r 0 , 1 2 I E n t e r - 4 , 4 C u t p r i c e E D o n o t e n t e r 0 , 9

17. Definition and Scope of Collusive Practices People of the same trade seldom meet together, even for merriment or diversion, but the conversation ends in conspiracy against the public, or in some contrivance to raise prices. Adam Smith, The Wealth of Nations

18. What is collusion? • Collusion means an arrangement (formal or informal) “among, or on behalf of, enterprises in the same line of business which is designed to limit competition among them” (Douglas Greer, 1992). • Successful collusion occurs when “firms in an industry behave in such a way that, given the relevant supply and demand functions (including those of rivals), the combined profits of the entire set of firms is maximized (George Stigler, 1961).

19. A cartel is a formal system of coordination among rival sellers. For example , a cartel might establish (based on negotiation among members) prices, output quotas, or restricted selling territories.

20. Incentive to engage in coordinated action among sellers • Failure among firms in tightly concentrated market structures could mean mutually destructive price wars. • Seller coordination can be very profitable. Note that our duopolists, by action as joint monopolists, could have increased their payoff by $50 each.

21. Factors affecting the feasibility of (sustained) coordinated action among rival sellers • Number of sellers • Number of buyers • Similarity of costs • Product differentiation (or lack thereof). Collusion tends to be ineffective against large buyers

22. Problem of Unequal Costs in a Duopoly $ MC of Seller 2 P1 is the preferred price of seller 1; P2 is the preferred price of seller 2 P2 MC of Seller 1 P1 Market Demand MR 0 Q

23. Modus operandi of seller coordination • Price LeadershipExamples: Northwest Airlines was price leader on the LA-Minneapolis route—it disclosed periodic adjustments in fares to its rival (US West) via a jointly used computerized reservation system. GE set turbine generator prices by applying a “multiplier” to number published in a pricing book. Westinghouse could then predict GE’s bids by advance knowledge of the multiplier. • Use of a Joint Sales AgencyExamples: DeBeersis a joint sales for diamond mining units worldwide. Also, the Southeastern Conference and the National Football League.

24. Modus operandi of seller coordination, continued • Bid riggingExample: The Tennessee paving conspiracy • Geographic Market DivisionExample: Basing point pricing in the steel industry • Customer Allocation • Focal Point Pricing: This is a system of “tacit” coordination . A set of retail prices(such as $9.95 or $3.95—as opposed to, say, $9.99 or $3.99) are established as “focal points”—that is, a method of silently communicating to rivals that you wish to avoid price competition where these items are concerned.