MSU Weekend MBA Program – May 19, 2012

1. MSU Weekend MBA Program – May 19, 2012 Game Theory and Strategic Interaction Among Firms Ch. 10 : Ch. 6, pgs. 206-210 : Ch.11, pgs 419-423

2. Oligopoly • Definition- A market structure in which there are only a few firms each of which is large relative to the total industry (results in strategic interaction)

3. Warning • Due to the complexity involved in analyzing oligopolies and the differences across industries/markets, there is no single model that is relevant to all oligopolies. Use Game Theory to analyze.

4. One Example: Cournot Oligopoly • Few firms in market serving many customers. • Firms produce either differentiated or homogeneous products. • Each firm believes rivals will hold their output constant if it changes its output. • Barriers to entry exist.

5. Numerical Example of Cournot Oligopoly • Two Firms: Firm 1 and Firm 2 • Firms produce a homogenous product • Market Demand is P=100-Q • Q=Q1+Q2 where Q1 is Firm 1’s output and Q2 is Firm 2’s output • Each firm has constant marginal cost of 20 and zero fixed costs.

6. What if the firms perfectly collude? What total output should they produce? Q=40. Can’t have more profits than what a monopolist would. MR

7. Suppose firms collude where both firms produce an output of 20 (i.e., Q1=Q2=20) Firm 1’s Profits = 60*20-20*20=800 Firm 2’s Profits = 60*20-20*20=800 =AVC=ATC

8. Why might you expect that the firms will not be able to collude in this manner? If Firm 1 thinks Firm 2 will produce 20, then Firm 1 can increase his profits to 900 if produce 30. Firm 1’s Profits = 50*30-20*30=900 Firm 2’s Profits = 50*20-20*20=600 =AVC=ATC

9. Cournot Equilibrium • A situation in which neither firm has an incentive to change its output given the other firm’s output. (In terms of game theory, this is called the Nash Equilibrium)

10. Profits from Cournot Equilibrium: Q1=26.67 and Q2=26.67 so Q=Q1+Q2=53.3 Firm 1 Profits=46.66*26.67-20*26.67= 713 Firm 2 Profits=46.66*26.67-20*26.67= 713 46.66 =AVC=ATC 53.33

11. Cournot Equilibrium compared to Perfect Collusion • Cournot Equilibrium Q1=26.67 , Firm 1 Profits = 713 Q2=26.67 , Firm 2 Profits = 713 • Perfect Collusion Q1=20 , Firm 1 Profits = 800 Q2=20 , Firm 2 Profits = 800

12. Industry Characteristics that Facilitate Collusion • Repeated Interaction Suppose Firm 1 thinks Firm 2 won’t deviate from Q2=20 if Firm 1 doesn’t deviate from collusive agreement of Q1=20 and Q2=20. In addition, Firm 1 thinks Firm 2 will produce at an output of 80 in all future periods if Firm 1 deviates from collusive agreement of Q1=20 and Q2=20. Firm 1’s profits from not cheating Firm 1’s profits from cheating(by producing Q1=30 Today) … …

13. Industry Characteristics that Facilitate Collusion • Stable Industry • Few Number of Firms • If a firm cheats on a collusive agreement, the probability the firm is “caught” is high. • Ability to Credibly Punish in a Severe Manner. • Industry demand is growing. • Expectation of firms’ behavior is clear.

14. My All Time Favorite example of how expectations are formed Coca-Cola, PepsiCo Set To Call Off Bitter Soft-Drink Price War Staff Reporter of The Wall Street Journal ATLANTA -- A brief but bitter pricing war within the soft-drink industry might be drawing to a close -- all because no one wants to be blamed for having fired the first shot. Coca-Cola Enterprises Inc., Coca-Cola Co.'s biggest bottler, said in a recent memorandum to executives that it will "attempt to increase prices" after July 4 amid concern that heavy price discounting in most of the industry is squeezing profit margins. The memo is a response to statements made to analysts last week by top PepsiCo Inc. executives. Pepsi, of Purchase, N.Y., said "irrational" pricing in much of the soft-drink industry might temporarily squeeze domestic profits, and it laid the blame for the price cuts at Coke's door.

15. My All Time Favorite example of how expectations are formed In the June 5 memo, Summerfield K. Johnston Jr. and Henry A. Schimberg, the chief executive and the president of Coca-Cola Enterprises, respectively, said the bottler's plan is to "succeed based on superior marketing programs and execution rather than the short-term approach of buying share through price discounting." "This is a first step to disengagement," said Andrew Conway, an analyst in New York for Morgan Stanley & Co. "Coke and Pepsi are out to improve profitability for the category, not destroy it, so this would bode for a stabilization." For all the signals of a truce, though, Coca-Cola Enterprises' memo could just as easily be seen as throwing down the gauntlet. Messrs. Johnston and Schimberg said in the memo that should "the competition" view the attempt to raise prices "as an opportunity to gain share through predatory pricing, we will, as we have in the past, respond immediately."

16. Other Applications of Game Theory • National Defense – Terrorism and Cold War • Movie Release Dates and Program Scheduling • Auctions http://en.wikipedia.org/wiki/Spectrum_auction http://en.wikipedia.org/wiki/United_States_2008_wireless_spectrum_auction https://www.msu.edu/~conlinmi/teaching/PIM821/internetauctions.pdf • Sports – Cards, Cycling, and race car driving • Politics – positions taken and $$/time spent on campaigning • Nanny Monitoring • Group of Birds Feeding • Mating Habits

17. Game Theory and Terrorism Game theory helps insurers to judge the risks of terror Financial Times Jenny Wiggins September 8, 2004 Shortly after September 11 2001, a small group of companies that specialise in assessing risk for the insurance industry launched US terrorism risk models. These combine technology and data to predict likely terrorist targets and methods of attack, and possible losses to life and property. They are aimed at the insurance and reinsurance industry, which already uses similar models to assess potential losses from natural catastrophes such as hurricanes and earthquakes. "Most major commercial insurers and reinsurers are using terrorism modelling today," says Robert Hartwig, chief economist at the Insurance Information Institute.

18. Game Theory and Terrorism (cont.) Andrew Coburn, director of terrorism research at RMS, says the company can pinpoint possible targets because it believes terrorists make rational decisions. "Their methods and targeting are very systematic," he says. RMS uses game theory - analytical tools designed to observe interactions among people - in its models. It argues that, as security increases around prime targets, rational terrorists will seek out softer targets. Industry participants, however, say the predictive abilities of the models are limited, given the difficulty of foreshadowing human behaviour. The development of the models has attracted the interest of the US government…

19. Game Theory and Randomization Random Checks Newsweek October 22, 2007 Security officials at Los Angeles International Airport now have a new weapon in their fight against terrorism: randomness. Anxious to thwart future terror attacks in the early stages while plotters are casing the airport, security patrols have begun using a computer program called ARMOR (Assistant for Randomized Monitoring of Routes) to make the placement of security checkpoints completely unpredictable.

20. Game Theory and Randomization (cont.) Randomness isn't easy. Even when they want to be unpredictable, people follow patterns. That's why the folks at LAX turned to the computer scientists at USC. The idea began as an academic question in game theory: how do you find a way for one "agent" (or robot or company) to react to an adversary who has perfect information about the agent's decisions? Using artificial intelligence and game theory, researchers wrote a set of algorithms to randomize the actions of the first agent. Academic colleagues couldn't appreciate how the technology could be useful. "It was very disappointing," says Milind Tambe, the USC engineering professor who led the ARMOR team.

21. Applications of Game Theory • National Defense – Terrorism and Cold War • Movie Release Dates and Program Scheduling • Auctions http://en.wikipedia.org/wiki/Spectrum_auction http://en.wikipedia.org/wiki/United_States_2008_wireless_spectrum_auction https://www.msu.edu/~conlinmi/teaching/PIM821/internetauctions.pdf • Sports – Cards, Cycling, and race car driving • Politics – positions taken and $$/time spent on campaigning • Nanny Monitoring • Group of Birds Feeding • Mating Habits

22. Grey’s Anatomy vs. The Donald NBC delays 'Apprentice' premiere By Nellie Andreeva Dec 20, 2007 NBC is taking the premiere of "Celebrity Apprentice" out of the cross-hairs of the last original episode of ABC's "Grey's Anatomy"... or so it seems.NBC on Wednesday said that it will push the launch of "Apprentice" from Jan. 3 to Jan. 10, expanding "Deal or No Deal" to two hours on Thursday, Jan. 3.The move follows ABC's midseason schedule announcement Friday that included the last original episode of "Grey's" airing Jan. 3,…

23. Grey’s Anatomy vs. The Donald 'Grey' move has NBC red Peacock shifts 'Apprentice' back By Nellie Andreeva Dec 21, 2007 The Thursday night scheduling tango between NBC and ABC continued Thursday morning when ABC officially announced that it will move the last original episode of "Grey's Anatomy" from Jan. 3 to Jan. 10.That led to a reversal in NBC's Wednesday decision to push the premiere of "Celebrity Apprentice" from Jan. 3 toJan. 10 to avoid the first-run "Grey's."NBC said Thursday afternoon that "Apprentice," hosted by Donald Trump, will now launch Jan. 3 as originally planned.

24. Game Theory and Movie Release Dates The Imperfect Science of Release Dates New York Times November 9, 2003 On Dec. 25, which this year happens to be a Thursday, five new movies will be released in theaters -- six, if you count a new Disney IMAX film called ''Young Black Stallion.'' As with the Fourth of July and Thanksgiving, there is a special cachet to opening a film on Christmas Day…. The casual moviegoer rarely ponders why a particular bubbly romantic comedy, serial-killer thriller, literary costume drama or animated talking-farm-animals movie opens on the day it does. Movies come; movies go; movies wind up on video. To those responsible for putting those films on the screen, however, nothing about the timing of their releases is arbitrary.

25. Game Theory and Movie Release Dates (cont.) Last December featured one of the most dramatic games of chicken in recent memory, when two films starring Leonardo DiCaprio were both slated to open on Christmas weekend. Ultimately, Miramax blinked first, moving the release of Martin Scorsese's ''Gangs of New York'' five days earlier and ceding the holiday to the other DiCaprio film, DreamWorks' ''Catch Me if You Can.'' ''We didn't think about moving,'' says Terry Press, the head of marketing for DreamWorks. ''We had been there first, and 'Catch Me if You Can' was perfect for that date.'' This year, DreamWorks chose to schedule a somber psychological drama, ''House of Sand and Fog,'' for the day after Christmas, deferring a bit to Miramax. ''I don't want our reviews to run on the same day as 'Cold Mountain,''' Press says. Ever wonder why a movie theater shows a preview of an upcoming movie that is to be released in 2 years?

26. Applications of Game Theory • National Defense – Terrorism and Cold War • Movie Release Dates and Program Scheduling • Auctionshttp://en.wikipedia.org/wiki/Spectrum_auction http://en.wikipedia.org/wiki/United_States_2008_wireless_spectrum_auction https://www.msu.edu/~conlinmi/teaching/PIM821/internetauctions.pdf • Sports – Cards, Cycling, and race car driving • Politics – positions taken and $$/time spent on campaigning • Nanny Monitoring • Group of Birds Feeding • Mating Habits

27. Google - Auctions Secrets of Googlenomics Wired Magazine: May 22, 2009 AdWords, Google's unique method for selling online advertising. AdWords analyzes every Google search to determine which advertisers get each of up to 11 "sponsored links" on every results page. It's the world's biggest, fastest auction, and it takes place, Varian says, "every time you search.“ At first, Google's ads at the top of the page were sold the old-fashioned way, by a crew of human beings headquartered largely in New York City. Down the right side were other ads that smaller businesses could buy directly online. /

28. Google – Auctions (cont.) Over time, Google decided to price the slots on the side of the page by means of an auction. Not an eBay-style auction that unfolds over days or minutes as bids are raised or abandoned, but a huge marketplace of virtual auctions in which sealed bids are submitted in advance and winners are determined algorithmically in fractions of a second…. Google decided that the winner of each auction would pay the amount (plus a penny) of the bid from the advertiser with the next-highest offer. This is a second price sealed bid auction. /

29. Second price sealed bid auction Suppose Larry Page is willing to pay $2 million for a yacht and is bidding on the yacht against Sergey Brin in a second price sealed bid auction. Larry Page has some idea but is not certain how much Sergey is willing to pay. What should Larry Page bid? What should Larry Page bid if it is a first price sealed bid auction? /

30. Applications of Game Theory • National Defense – Terrorism and Cold War • Movie Release Dates and Program Scheduling • Auctionshttp://en.wikipedia.org/wiki/Spectrum_auction http://en.wikipedia.org/wiki/United_States_2008_wireless_spectrum_auction • Sports – Cards, Cycling, and race car driving • Politics – positions taken and $$/time spent on campaigning • Nanny Monitoring • Group of Birds Feeding • Mating Habits

31. Game Theory Terminology • Simultaneous Move Game – Game in which each player makes decisions without knowledge of the other players’ decisions (ex. Cournot or Bertrand Oligopoly). • Sequential Move Game – Game in which one player makes a move after observing the other player’s move (ex. Stackelberg Oligopoly).

32. Game Theory Terminology • Strategy – In game theory, a decision rule that describes the actions a player will take at each decision point. • Normal Form Game – A representation of a game indicating the players, their possible strategies, and the payoffs resulting from alternative strategies.

33. Example 1: Prisoner’s Dilemma(Normal Form of Simultaneous Move Game) Confess (1<2) What is Peter’s best option if Martha doesn’t confess? Confess (6<10) What is Peter’s best option if Martha confess?

34. Example 1: Prisoner’s Dilemma Confess (1<2) What is Martha’s best option if Peter doesn’t confess? Confess (6<10) What is Martha’s best option if Peter Confesses?

35. Example 1: Prisoner’s Dilemma First Payoff in each “Box” is Row Player’s Payoff . Dominant Strategy – A strategy that results in the highest payoff to a player regardless of the opponent’s action.

36. Game Theory and Altruism Mathematics and faith explain altruism The Boston Globe, September 27, 2008 Saturday If evolution is all about survival of the fittest, then why have humans evolved a sense of altruism and cooperation? The seeming contradiction has engaged theologians, scientists, and even comic book writers (think the Incredible Hulk) who've probed human duality and how its good half sometimes empowers selflessness to override self-interest The British biologist and atheist Richard Dawkins believes that altruism in modern humans is essentially an evolutionary oops, albeit a beneficial one. It paid off in prehistory, when people lived in clans and protecting others meant the survival of their own gene pools; now that we've expanded into large cities, our instinct to help others still kicks in, even though those we aid may have no relation to us.

37. Game Theory and Altruism On the other hand, Francis Collins, former director of the National Human Genome Research Institute and a Christian, sees in our willingness to work with others the handprint of God. Then there is Harvard's Martin Nowak. A mathematician and biologist, he agrees with Dawkins's explanation of how we evolved to be good Samaritans. Yet as a Catholic, he rejects Dawkins's notion that believing in evolution precludes belief in a God who included altruism in evolution's bequest to us. Needless to say, he also rejects Dawkins's disdain for believers as scientifically illiterate yahoos. This Vienna-born mathematician says that if you do the math, you'll find that cooperation is more than just a nice leftover from humanity's infancy; it's a winning strategy for living, a way to thrive.

38. Game Theory and Altruism For the past three years, with Sarah Coakley, formerly of Harvard Divinity School and now at Cambridge University in England, Nowak pursued a study project, the title of which - "The Evolution and Theology of Cooperation"- gives a clue to its partnership between science and religion. Nowak said his work demonstrated the mathematical probability that being cooperative, generous, and forgiving produces better results for people than looking out for Number One. As part of his demonstration, Nowak devised repeated rounds of an exercise from game theory called the prisoner's dilemma. The math is complex to laypeople, but the basic premise of the game is straightforward: Two prisoners held separately are given their options: If both stay silent, each gets six months in jail. If both implicate the other, they each get five years. If one turns traitor and the other stays mum, the gabby prisoner goes free, but the other gets 10 years. Neither knows what the other will do. In isolation, each thinks: Finking on the other guy could bring me freedom, but it could also bring us both five years. Cooperating with each other, by both of us clamming up, guarantees a short, six-month sentence. Mathematically speaking, Nowak said, cooperation is the best bet.

39. Example 2: Price Setting Game Is there a dominant strategy for Firm B? Low Price Is there a dominant strategy for Firm A? Low Price

40. Nash Equilibrium • A condition describing a set of strategies in which no player can improve her payoff by unilaterally changing her own strategy, given the other player’s strategy. (Every player is doing the best they possibly can given the other player’s strategy.)

41. Example 1: Nash? Nash Equilibrium: (Confess, Confess)

42. Example 2: Nash? Nash Equilibrium: (Low Price, Low Price)

43. Traffic and Nash Equilibrium Queuing conundrums; Traffic jams The Economist, September 13, 2008 Strange as it might seem, closing roads can cut delays DRIVERS are becoming better informed, thanks to more accurate and timely advice on traffic conditions. Some services now use sophisticated computer-modelling which is fed with real-time data from road sensors, satellite-navigation systems and the analysis of how quickly anonymous mobile phones pass from one phone mast to another. Providing motorists with such information is supposed to help them pick faster routes. But the latest research shows that in some cases it may slow everybody down. Hyejin Youn and Hawoong Jeong, of the Korea Advanced Institute of Science and Technology, and Michael Gastner, of the Santa Fe Institute, analysed the effects of drivers taking different routes on journeys in Boston, New York and London. Their study, to be published in a forthcoming edition of Physical Review Letters, found that when individual drivers each try to choose the quickest route it can cause delays for others and even increase hold-ups in the entire road network.

44. Traffic and Nash Equilibrium (cont.) The physicists give a simplified example of how this can happen: trying to reach a destination either by using a short but narrow bridge or a longer but wide motorway. In their hypothetical case, the combined travel time of all the drivers is minimised if half use the bridge and half the motorway. But that is not what happens. Some drivers will switch to the bridge to shorten their commute, but as the traffic builds up there the motorway starts to look like a better bet, so some switch back. Eventually the traffic flow on the two routes settles into what game theory calls a Nash equilibrium, named after John Nash, the mathematician who described it. This is the point where no individual driver could arrive any faster by switching routes.

45. Traffic and Nash Equilibrium (cont.) The researchers looked at how this equilibrium could arise if travelling across Boston from Harvard Square to Boston Common. They analysed 246 different links in the road network that could be used for the journey and calculated traffic flows at different volumes to produce what they call a "price of anarchy" (POA). This is the ratio of the total cost of the Nash equilibrium to the total cost of an optimal traffic flow directed by an omniscient traffic controller. In Boston they found that at high traffic levels drivers face a POA which results in journey times 30% longer than if motorists were co-ordinated into an optimal traffic flow. Much the same thing was found in London (a POA of up to 24% for journeys between Borough and Farringdon Underground stations) and New York (a POA of up to 28% from Washington Market Park to Queens Midtown Tunnel). Modifying the road network could reduce delays. And contrary to popular belief, a simple way to do that might be to close certain roads. This is known as Braess’s paradox, after another mathematician, Dietrich Braess, who found that adding extra capacity to a network can sometimes reduce its overall efficiency.

46. Game Theory and Politics Game Theory for Swingers: What states should the candidates visit before Election Day? Oct. 25, 2004 Some campaign decisions are easy, even near the finish of a deadlocked race. Bush won't be making campaign stops in Maryland, and Kerry won't be running ads in Montana. The hot venues are Florida, Ohio, and Pennsylvania, which have in common rich caches of electoral votes and a coquettish reluctance to settle on one of their increasingly fervent suitors. Unsurprisingly, these states have been the three most frequent stops for both candidates. Conventional wisdom says Kerry can't win without Pennsylvania, which suggests he should concentrate all his energy there. But doing that would leave Florida and Ohio undefended and make it easier for Bush to win both. Maybe Kerry should foray into Ohio too, which might lead Bush to try to pick off Pennsylvania, which might divert his campaign's energy from Florida just enough for Kerry to snatch it away. ... You see the difficulty: As in any tactical problem, the best thing for Kerry to do depends on what Bush does, and the best thing for Bush to do depends on what Kerry does. At times like this, the division of mathematics that comes to our aid is game theory.

47. Game Theory and Politics (cont.) To simplify our problem, let's suppose it's the weekend before Election Day and each candidate can only schedule one more visit. We'll concede Pennsylvania to Kerry; then for Bush to win the election, he must win both Florida and Ohio. Let's say that Bush has a 30 percent chance of winning Ohio and a 70 percent chance at Florida. Furthermore, we'll assume that Bush can increase his chances by 10 percent in either state by making a last-minute visit there, and that Kerry can do the same. If Bush and Kerry both visit the same state, then Bush's chances remain 30 percent in Ohio and 70 percent in Florida, and his chance of winning the election is 0.3 x 0.7, or 21 percent. If Bush visits Ohio and Kerry goes to Florida, Bush has a 40 percent chance in Ohio and a 60 percent chance in Florida, giving him a 0.4 x 0.6, or 24 percent chance of an overall win. Finally, if Bush visits Florida and Kerry visits Ohio, Bush's chances are 20 percent and 80 percent, and his chance of winning drops to 16 percent.

48. Example 3: Bush and Kerry Bush’s dominant strategy is to visit Ohio. .3*.7 .4*.6 .2*.8 .3*.7 Nash Equilibrium: (Ohio, Ohio)

49. EXAMPLE 4: Entry into a fast food market: Is there a Nash Equilibrium(ia)? Yes, there are 2 – (Enter, Don’t Enter) and (Don’tEnter, Enter).Implies, no need for a dominant strategy to have NE. NO Is there a dominant strategy for BK? NO Is there a dominant strategy for McD?

50. EXAMPLE 5: Monitoring Workers Is there a Nash Equilibrium(ia)? Not a pure strategy Nash Equilibrium– player chooses to take one action with probability 1 Randomize the actions yields a Nash = mixed strategy John Nash proved an equilibrium always exists NO Is there a dominant strategy for the worker? NO Is there a dominant strategy for the manager?