Managerial Economics Managerial Economics Economics of Strategy Economics of Strategy

and Gamesand Games

Managerial Economics Managerial Economics Economics of Strategy Economics of Strategy

and Gamesand GamesEconomics of StrategyEconomics of Strategy

Patrick McNuttPatrick McNuttwww.patrickmcnutt.com

Abridged 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

Game Embedded 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….

• Plan is to follow Besanko’s Economics of Strategy 6th Edition

• Day 1 : Revision of Chapters 3 and 4 (Agency and Co-ordination) and Introduce Chapter 2 (Economies of Scale and Scope)

• Day 1 Workshop Study Groups & Case Analysis• Break-out Sessions at 330-530pm Day 1 and Day 2 with

group Presentation Day 3 at 2pm start• Day 2 & 3: Focus on Besanko Part II: Chapters 5,6,7 and 8 and

link into Units 3 and 4• Day 1: Introduction and setting the scene using McNutt’s

Game Embedded Strategy Chapters 1 and 2

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

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?

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

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

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

Management Models• Understand Penrose effect• Understand Bounded Rationality• Go to Table 1.2 pp14 McNutt

Game Embedded Strategy 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

Baumol strategy or Maximising Market

Share: MMS• 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.

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 p61

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?

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 3: Game type and signalling

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

Line.see Nissan example pp20 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.

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 ‘best you can do,

given reaction of competitor’

Link Units 3 and 4: Game Dimension

• What is a game – loss of independence?• Nash premise: Action, Reaction and Reply• Non-cooperative sequential (dynamic) games• Introduce oligopoly and players (companies) n < 5• TR Test and Elasticity McNutt pp36• Single shot price reduction: (i) fail TR test and

revenues fall; (ii) near rival misreads the price as a signal.

• Limit price [to avoid entry] and predatory pricing to force exit.

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• Coogans bluff strategy (classic poker

strategy) and enter the game.

Limit Pricing Model in Besanko pp207-211 and McNutt

pp71-76• 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

Continuing with Unit 4: Define a price war

• Determine the Bertrand reaction function:• Besanko Fig 5.3 pp190• Compute a Critical Time Line (CTL)from

observed signals..Examples of CTL in McNutt pp 20 Figure 2.1 and pp94 Fig 7.4

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

McNutt pp 114-116 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• Strategic ToolBox 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

• Example: Critical Time Line in Sony v Microsoft in Kaelo v2.0, Apple v Nokia game dimension McNutt pp92

• 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

pp95-97• Second Mover Advantage, SMA v FMA• 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

Locate Your Company’S game dimension

Scenario A?Scenario B?Scenario C?

GEMS & T3 Framework pp130-132 in McNutt

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’