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Game Theory: The Competitive Dynamics of Strategy

Game Theory: The Competitive Dynamics of Strategy. MANEC 387 Economics of Strategy. David J. Bryce. The Structure of Industries. Threat of new Entrants. Competitive Rivalry. Bargaining Power of Suppliers. Bargaining Power of Customers. Threat of Substitutes.

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Game Theory: The Competitive Dynamics of Strategy

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  1. Game Theory: The Competitive Dynamics of Strategy MANEC 387 Economics of Strategy David J. Bryce

  2. The Structure of Industries Threat of new Entrants Competitive Rivalry Bargaining Power of Suppliers Bargaining Power of Customers Threat of Substitutes From M. Porter, 1979, “How Competitive Forces Shape Strategy”

  3. Competitor ResponseConcepts from Game Theory • Sequential move games in normal form • Simultaneous vs. sequential move games –hypothetical Boeing v. McDonnell-Douglas game (bullying brothers) • Sequential move games in extensive form • Backward induction • Subgame-perfect equilibria

  4. Fundamentals of Game Theory • Identify the players • Identify their possible actions • Identify their conditional payoffs from their actions • Determine the players’ strategies – My strategy is my set of best responses to all possible rival actions • Determine the equilibrium outcome(s) – equilibrium exists when all players are playing their best response to all other players

  5. Simultaneous-Move Bargaining • Management and a union are negotiating a wage increase • Strategies are wage offers & wage demands • Successful negotiations lead to $600 million in surplus, which must be split among the parties • Failure to reach an agreement results in a loss to the firm of $100 million and a union loss of $3 million • Simultaneous moves, and time permits only one-shot at making a deal.

  6. The Bargaining Game in Normal Form Union W=$10 W=$5 W=$1 * W=$10 Management * W=$5 * W=$1

  7. “Fairness” – the Natural Focal Point Union W=$10 W=$5 W=$1 * W=$10 * Management W=$5 * W=$1

  8. Lessons in Simultaneous-Move Bargaining • Simultaneous-move bargaining results in a coordination problem • Experiments suggests that, in the absence of any “history,” real players typically coordinate on the “fair outcome” • When there is a “bargaining history,” other outcomes may prevail

  9. A Sequential Game - Single Offer Bargaining • Now suppose the game is sequential in nature, and management gets to make the union a “take-it-or-leave-it” offer • Write the game in extensive form • Summarize the players • Their potential actions • Their information at each decision point • The sequence of moves and • Each player’s payoff

  10. Step 1: Management’s Move 10 5 M 1

  11. Step 2: Append the Union’s Move Accept U Reject 10 Accept 5 M U Reject 1 Accept U Reject

  12. Step 3: Append the Payoffs Accept 100, 500 U -100, -3 Reject 10 Accept 300, 300 5 M U -100, -3 Reject 1 Accept 500, 100 U -100, -3 Reject

  13. Multiple Nash Equilibria * Accept 100, 500 U -100, -3 Reject 10 * Accept 300, 300 5 M U -100, -3 Reject 1 * Accept 500, 100 U -100, -3 Reject

  14. Step 7: Find the Subgame Perfect Nash Equilibrium Outcomes • Outcomes where no player has an incentive to change its strategy at any stage of the game, given the strategy of the rival, and • The outcomes are based on “credible actions;” that is, they are not the result of “empty threats” by the rival.

  15. Sequential Strategies in the Game Tree • Final player chooses the option that maximizes her payoff • The previous player chooses the option that maximizes his payoff conditional on the expected choice of the final player, and so on • This is backward induction – work backward from the end “sub-game,” each player makes optimal choices assuming that each subsequent rival chooses rationally • The equilibrium is called sub-game perfect

  16. Only One Subgame-Perfect Nash Equilibrium Outcome Accept 100, 500 U -100, -3 Reject 10 Accept 300, 300 5 M U -100, -3 Reject 1 * Accept 500, 100 U -100, -3 Reject

  17. Re-Cap • In take-it-or-leave-it bargaining, there is a first-mover advantage. • Management can gain by making a take-it or leave-it offer to the union. • Management should be careful, however; real world evidence suggests that people sometimes reject offers on the the basis of “principle” instead of cash considerations.

  18. Moroni, Zarahemna and Credible Threats (or Bush, Saddam and those pesky WMDs) Payoffs 0 100 Spare * M Attack Deliver/Oath -200 -100 Z Don’t Deliver 200 -200 Spare M Attack -150 -50 See Alma 44, Book of Mormon

  19. Moroni – Zarahemna and Credible Threats Payoffs 0 100 Spare M Take Oath Attack -200 -100 Z Deliver Don’t Take 100 ? * Spare Z M Attack -175 -100 Don’t Deliver 200 -200 Spare M Attack See Alma 44, Book of Mormon -150 -50

  20. Summary and Takeaways • The reasoning of game theory supplies a useful way to predict the outcome of competitive interactions • By diagramming a game, players can identify their best potential strategies • Threats of retaliation must be credible • Incumbents may be able to deter entrants by making major strategic commitments (credible threats)

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