ManagerialManagerial Economics Economics Economics Economics

of Strategy and of Strategy and GamesGames

ManagerialManagerial Economics Economics Economics Economics

of Strategy and of Strategy and GamesGamesDecoding StrategyDecoding Strategy

Patrick McNuttPatrick McNuttFollow @tuncnuncFollow @tuncnunc

www.patrickmcnutt.comAbridged Abridged ©©

What is game theory?• Observed behaviour in a game dimension.

G• Identify the players in the game and the

players type• Finding the patterns in rival behaviour• Updating belief systems.• Independent decision making v

interdependence; one-shot v repeated play

Decoding Strategy and Strategic Analysis

•Knowledge of the identity of near rival:

Actionyou -> Reactionrival

-> NashReplyyou

Why the focus?At the frontier of economic

analysis…..• Understand management as ‘they are’ not as theory

hitherto ‘assumed them’ to be• Management can be ranked (by type) and are faced

with indifference trade-offs => something must come ‘top of the menu’: the 3rd variable or z. Trade off (x, y) to max z.

• Firms are conduits of information flows (vertical chain)• Supply chain capacity constraints and technology-lag• Reducing price does not necessarily lead to an increase

in revenues (elasticity)• Prices are primarily signals (observed behaviour)• Companies understand the competitive threat as

(recognised) interdependence (zero-sum and entropy)

Workshop Lesson plan….

• Learning Plan is to follow Besanko’s Economics of Strategy 6th Edition ..selected Chapters and cases/examples.

• Day 1 : Synopsis of E-Tutorials and Revision of Chapters 3 and 4 (Vertical Boundaries of the Firm, Agency and Co-ordination) and Introduce Chapter 2 (Economies of Scale and Scope)

• Day 1: Game Dimension and Introduce Workshop Case Analysis

• Day 1: Introduction and setting the scene using McNutt’s Decoding Strategy 2nd Edition Chapters 1 to 9 as required

• Day 2 & 3: Focus on Besanko Part II: Chapters 5,6,7 and 8 and link into Units 3 and 4

Workshop Focus

• Management type and relevance of TCE: Unit 1. Besanko Ch 3 & 4 and 5, McNutt Ch 1

• Cost leadership and economics of capacity: Unit 2. Besanko Ch 2 and McNutt Ch 5

• Market-as-a-game…market structure, oligopoly, and dynamic games…Units 3 and 4. Besanko Ch 5,6,7 and 8 and McNutt Ch 6,7,8 and 9

• Real Time case Analysis…go to Page 45 of colour-coded Storybook

Example A: What is type?

If you believe it to be true that Leo the Liar will never tell the truth, how do you respond to his helping hand as you cling for your life over the precipice of a cliff? Do you ignore his helping? Do you rely instead on the many apps on your smartphone, so tightly grasped in your other hand, trying to make contact with your best friend to come and rescue you?

Define Strategy

Cooperation arises in this instance if you and Leo as players in a game can infer from past behaviour that both of you are likely to be trustworthy. Leo may forgo the short term gain of keeping to type for the long term benefit of your friendship. He rescues you from the cliff. You, however, will use the experience in order to determine whether or not to believe Leo in the future.

Example B:

Player’s belief system

Your company’s strategy is s1: delayed launch of a new innovative product for 2 years. Rumors do appear of an impending launch date. You do not deny such rumors. In the interim, an article appears a reputable trade journal reporting that a not dissimilar product is about to be launched by your competitor in the next few weeks.

Define Strategy

Do you stop and think about s1? Do you reshape your strategy to s2: launch the product as soon as possible?

Minimax criteria.

If you look at examples in the book Decoding Strategy pp148-151 we discuss this for Samsung v Apple but it can be applied here also in any market-as-a-game

Strategy

Simply, identify the near rival [reacting first] and set up the game tree assuming that near-rival plays minimax, that is, confining you to the least of the greatest market shares in the game - so then you play maximin, to maximise the least loss.

The competitive threat!• Traditional Analysis is biased

towards answering this question for Company X: what market are we in and how can

we do better?• Economics of strategy (GEMS) asks:

what market should we be in?

Management Models• Understand Penrose effect• Understand Bounded Rationality• Go to Table 1.2 pp21 McNutt

DecodingStrategy Compare with Next Slide where

you add in Williamson/TCE

Behavioural Baumol Marris Williamson

Objective Multiple goals TR:Sales Growth:gd Managerial Utility or Value

Approach Satisficing – subject to Profit

Constraint

Maximisation– subject to

Profit Constraint

Maximisation - subject to

Security Constraint

Maximisation - subject to Profit Constraint

Principal Agent Issue

Yes Yes Yes Yes

Short v Long Term

Varies Short and also dynamic

Long Short

Reaction & Interaction

Yes Partial Partial Partial

Decision Making Coalitions

Yes Management and zero-sum

Relevance of shareholders

Yes,..TCE

Lets’ begin! Unit 1: Why the emphasis on behaviour (of

players)?• The Firm as a ‘nexus of contracts’• Vertical chains and agency costs• Shareholders and management-as-agent• Make-buy dilemma and incomplete

contracting• Type of management and Bounded

rationality

Co-ordination• Coase asked in ‘ The Nature of Firms’ in 1937:

• Transaction costs: costs of negotiating, monitoring and enforcing contracts.• Behavioural assumptions: bounded rationality & opportunism.• The relative cost of organising transaction through different forms of

governance determined by:• Extent to which complete contracts are possible. Where contract refers to

agreement between two parties which could be explicit or not.• Extent to which there is a threat of opportunism by parties in the

transaction.• Degree of asset specificity in the transaction.• Frequency with which the transaction is repeated.

Storybook p.12

Why are not all economic transactions coordinated by markets?

When transaction costs are too high, exchange to be coordinated by organisations

Companies as Players in a Market-as-a-game?

• Principal-agent relationship• Shareholders as principals and

management as agents• Who are decision makers?Management ≈ firms ≈ companies

=PLAYERS (key decision makers)

Costs of not being a Player

• Agency costs can accrue..across the shareholders (esp institutional)..changing CEOs

• Bounded rationality and opportunity costs with trade-offs

• Make or Buy dilemma• First Mover Advantage (FMA) v Second Mover

Advantage (SMA)• Play to win v Play not to lose!• Follower status ‘behind the curve’• Technology lag and failure to differentiate ‘fast enough’

to sustain a competitive advantage

Maximising Market Share: Table 1.1 p9 McNutt

• Recognise zero sum constaint and entropy (redistribution within market shares)

• Market Shares (before): 40+30+20+10• Zero-sum (after): 30+40+20+10• Entropy (after): 30+35+25+10• Iff {∆qi/∆Q} > 0 market exhibits non-

price competition:• Check {∆qNOKIA/∆QSmartphones} < 0

Total Revenue

Total Cost

Profit/LossSales driven beyond the point of max profit but within the minimum profit constraint

Min Profit Constraint

Output

£

Precis on a Marris model…

• McNutt Ch 4: Understand balanced equation gc = gd to identify parameters of profitability

• Supply of capital: debt v equity• Demand for capital: R&D exp v dividends• Instrumental variables influencing growth

– visit Diageo case in Kaelo v2.0• KFIs: profits/output and output/capital• Tobins q and Marris v ratio

U1 U2 U3 U4Valuation ratio Shareholders perference

xBest to management

V2 Valuation curve

G1 G2 Growth rate

V1

V(min)

y

0

Marris equations/dividends paradox

• Calculating share price by DCF formula

• P = eps/r : Static firm no growth opportunities• P = eps/r + PV(GO): Dynamic firm with growth

opportunities…this is a Marris firm

• Common denominator is the plough-back ratio (PBR) = 1 – divs/eps…This is a Marris equation

• More dividends can signal an absence of R&D growth• But more R&D from G1 to G2 can accrue an agency

cost as Bayesian shareholders SELL as value falls V1 to V2.

Bridge Unit 1 and Unit 2

• Shareholder as principals expect max value• Management to minimise the agency costs• Positive Learning Transfer, PLT• Nomenclature on type: Baumol type (signal =

price), Marris type (signal = dividends).• Cost leadership type (link into Besanko Ch 11

& 13 on strategic cost advantage)

Unit 2: Cost leadership [CL]as a type (of player)

• Profitabiltiy v scale and (size and scope)• Production as a Cost-volume constraint

• Understanding the economcis of productivity as exemplar for incentives

• Normalisation equation• Sources of Cost Efficiency [next slide]

• Cost leadership checklist..McNutt p78

Sources of cost efficiency• Measure of the level of resources needed to

create given level of value

Production-cost relationship

Production-cost relationship

Capacity utilisation

How much to produce given capital size?

Capacity utilisation

How much to produce given capital size?

Economies of scale

How big should the scale of the operation be?

Economies of scale

How big should the scale of the operation be?

Other

X-inefficiencies, location, timing, external environment, organisation discretionary policies

Other

X-inefficiencies, location, timing, external environment, organisation discretionary policies

Transaction costs

Which are the vertical boundaries of the firm?

Transaction costs

Which are the vertical boundaries of the firm?

Economies of scope

What product varieties to produce?

Economies of scope

What product varieties to produce?

Learning and experience factors

How long to produce for?

Learning and experience factors

How long to produce for?

£

Q0,0

SAC1SAC2

SAC3 LAC

q1q2

Lower per unit cost for more units sold

qt

Current plan of plant closures to lower cost base not completed

Av.Cost = marginal cost

MES Point: Production - demand - productionto attain cost leadership

Why? Capacity Constraints:

• Case A: Unexhausted economies of scale due to product differentiation

• Case B: Firm-as-a-player does not produce large enough output to reach MES

• Case C: Firm-as-a-player restraints production (deliberate intent)..McNutt’s dilemma as production drives demand…(Veblen monopoly type)

• Convergence of technology increases the firm-specific risk of Case C:

• Strategic Choice A or B or C?

Unit 3: Game type and signalling

• Decisions are interpreted as signals• Observed patterns and Critical Time

Line (CTLs). Go to Appendix in McNutt• Recognition of market interdependence

(zero-sum and entropy)• Price as a signal v Baumol model of TR

max• Scale and size: cost leadership• Dividends as signals in a Marris model

Oligopoly and Game TheoryT3 + GEMS

• Study of strategic interactions: how firms adopt alternative strategies by taking into account rival behaviour

• Structured and logical method of considering strategic situations. It makes possible breaking down a competitive situation into its key elements and analysing the dynamics between the players.

• Key elements:• Players. Company or manager.• Strategies.• Payoffs

• Equilibrium. Every player plays her best strategy given the strategies of the other players.

• Objective. To explore oligopolistic industries from a game embedded strategy (GEMS) perspective.

• The use of T3 framework, which considers 3 key dimensions (Type, Technology & Time), will allow oligopolists to better predict the likely strategic response of competitors when analysing competition from game embedded strategy perspective.

Bridging Unit 1 and Unit 3: Game analysis

• Binary reaction; Will Player B react? Yes or No?

• If YES, decision may be parked

• If NO, decision proceeds on error

• Surprise

• Non-binary reaction: Player B will react. Probability = x%

• Decision taking on conjecture of likely reaction

• No Surprise

Describe (prices as signals) game

dimension• Players and type of players• Prices interpreted as signals• Understand (price) elasticity of demand and

cross-price elasticity• Patterns of observed behaviour• Leader-follower as knowledge• Accommodation v entry deterrence• Reaction, signalling and Nash equilibrium: ‘best

you can do, given reaction of competitor’

Type of Players• Incumbent type v entrant type• Dominant type v predatory incumbent • De novo entrant type and geography of

the market• Potential entrant type and the threat of

entry as a credible threat• Contestable markets, newborn players

and extant (incumbent) type

Entry Deterrent Strategy & Barriers to entry

• Reputation of the incumbents• Capacity building• Entry function of the entrant• De novo and entry at time period t• Potential entrant - forces reaction at

time period t from incumbent• Coogan’s bluff strategy (classic poker

strategy) and enter the game.

Limit Pricing Model in Besanko pp207-211 and McNutt

pp85-88• Outline the game dimension:

dominant incumbents v camouflaged entrant type

• Define strategy set for incumbents• Allow entry and define the equilibrium• Preference - entry deterrent strategy

v accommodation [next slide]

1

2

Enter

0,10

-7,2

5,8

Do Not Enter

Agressive

Accommodating

Game Strategy• When in a game? – recognise

interdependence?• Nash premise: Action, Reaction and CV matrix• Non-cooperative sequential (dynamic) games• TR Test McNutt pp48..one-shot move• Limit price [to avoid entry] and predatory

pricing to force exit.• Near rival plays Minimax, so I play Maximin

[focus on my worst minimum payoff and try to maximise].

 n          

  Player BS4

 S5

 S6

 S7

Row MinimumMaximin strategy by A

Player A: S1

 95

 5

 50

 40

 5

S2 60 70 55 90 55S3 30 35 30 10 10

Column maximumMinimax strategy by B

 95

 70

 55

 90

 

Continuing with Unit 4: Define a price war

• Determine the Bertrand reaction function:• Besanko Fig 5.3 pp190 and McNutt Fig 9.4

p143• Compute a Critical Time Line (CTL)from

observed signals..Examples of CTL in McNutt in the Appendix

• Find a price point of intersection• Case Analysis of Sony v Microsoft at

McNutt pp 141-144 and also in Kaelo v2.0

Nash Equilibria• Define the Nash equilibria [next slide]• Analyse the Payoff matrix

(B,Y) > (A, X)• Commitment and chat: one-shot and

repeated play• Punishment ‘grim’ strategy• Strategy Set in terms of credible

mechanisms

10,10

8,-50,0

-5,8

Strategy A

Strategy B

Strategy X Strategy Y

Player 1

Player 2

Prisoners’ Dilemma

•Apply Prisoners’ Dilemma to Pricing Policy: Independent v Interdependent

Player 2

Confess Don’t Confess

Player 1 Confess 8 8 0 20

Don’t confess 20 0 3 3

Firm 2

High Price

Low Price

Firm 1 High Price 8 8 0 20

Low Price 20 0 3 3

•Would outcome change if the game is repeated?

Visit Kaelo v2.0 and Games/Signalling

• Examples: Critical Time Line the Appendix of McNutt’s text Decoding Strategy.

• Play a PD game and investment game in Kaelo v2.0

• Selfish gene [one-shot], dominant strategy to cheat.

• Altruism, fairness – repeated play/learning.• Understand the ‘no signalling’ payoff

matrices [next slide]

The ‘no signalling’

payoffs• Simultaneous game between A & B who must decide on how to spend the evening.

• Problem of coordination where players have different preferences but common interest in coordinating strategies.

• One key application includes the battles for standards: • VHS by JVC vs Betamax by Sony in the 1980s• BlueRay DVD by Sony vs HD DVD by Toshiba in 2008

• Effect of sequentialisation? Solution. Commitment? Signalling?

B

in out

A

in 10,5 2,4

out 0,1 4,8

Application of ‘no signalling’ game

• Two pharmaceutical companies must simultaneously decide which products to research.

• Does this example illustrate the concept of ‘first mover advantage[FMA]?

• How could companies signal? Signing contracts with leading universities, hiring expert.

A O

A -2,-2 20,10

O 10,20 -1,-1

Games as Strategy: Strategic ToolBox

• Segmentation strategy to obtain FMA• Relevance of chain-store paradox• Dark Strategy and 3 Mistakes in McNutt

pp117-118• Second Mover Advantage, SMA v FMA• Fig 9.7 pp161 McNutt Strategic ToolBox

in terms of identifying the competitive threat v cartel coordination on (High. High)..Cheating

10,10

13,02,2

0,13

Low Prices

High Prices

Low Prices High Prices

Player 1

Player 2

Absence of price wars?Link into the HBR

articles• Hypothesis: Bertrand Price Wars occur

due to a mis-match in price signals.• Mismatch can occur due to (i) declining

volumes ∆qi/∆Q < 0; (ii) uncompetitive cost structure; (iii) decreasing productivity; (iv) management type (predator); (v) calling-my-bluff

Final Scenarios for YOUR Company……

• The RationaleMarkets evolve

• The RationaleType, Technology

and Time• The RationaleKnow your near-rival

• The StrategyNon-binary

• The StrategyGame metrics,

feedback & analytics

• The StrategyGEMS

Thank you for participating………

Sapere aude

‘That which one can know, one should dare to know’