Economic Foundations of Strategy

1. Economic Foundations of Strategy Power Point Set #4

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

3. 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.

4. 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: • superior technology • reputation • broad distribution

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

6. Column Silence Fink -1 0 -1 Silence -10 Row -10 -8 Fink 0 -8 Game Theory and Strategy • Prisoners’ Dilemma Game

7. 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).

8. 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.

9. 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.

10. Column Cooperate Fink 1 4 Cooperate 5 4 Row -1 0 Fink 9 0 Game Theory and Strategy • Game with no dominant strategy equilibrium, but a Game with a Nash equilibrium.

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

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

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

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

15. 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?

16. 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

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

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

19. Cooperate L. Race 112 123 Cooperate 112 58 58 91 L. Race 123 91 Game Theory and Strategy • Joint Venture

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

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

22. Game Theory and Strategy • Lessons • 1. Commitment (sunk costs) can be used to achieve cooperation (e.g., Toyota and GM) • 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.

23. Game Theory and Strategy: • Lessons • 2. Commitment (sunk costs) can be used to achieve competitive advantage. • preemption strategy (e.g., Airbus vs. Boeing)

24. 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 businessand how “sunk” those investments are.