Managerial Managerial Economics:Economics Economics:Economics

of Strategyof Strategy

Managerial Managerial Economics:Economics Economics:Economics

of Strategyof StrategyGame Embedded StrategyGame Embedded Strategy

Patrick McNuttPatrick McNuttwww.patrickmcnutt.com

Abridged Abridged ©©

Workshop Lesson plan….

• Plan is to follow Besanko’s Economics of Strategy 5th Edition

• Day 1: Introduction and setting the scene using McNutt’s Game Embedded Strategy Chapters 1 and 2

• Day 1 : Revision of Chapters 3 and 5 (Used in Assignment No 1) 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 Chapters 8,9,10 and 11 and link into Units

3 and 4• Extra Chapters & Topics at the discretion of Workshop Director

Workshop Focus

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

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

• Market-as-a-game…market structure, oligopoly, and dynamic games of rivalry…Units 3 and 4. Besanko Ch 8,9,10 and 11 and McNutt Ch 6,7,8,9

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

Workshop Case Study

• Case assignment and group allocation• Objective is to define game dimension,

construct a CTL, define near-rival and find NE• Focus on geography and on a product [to

include an innovation, technology, service]• Research ‘sum of competitors’ in the market-

as-a-game• Apply the course materials as discussed in

class as ‘filters’ to narrow research.

Strategy architecture:

Observe patterns over time

time period t = NOWtime period t+ 1 = WAY

FORWARD

dT/dt = -1

Q: Why the game theoretic focus? A: At the frontier of

economic analysis…..• Management observed as ‘they are’ not ‘assumed to

be’• Management can be ranked (by type) and are faced

with trade-offs => something must come ‘top of the menu’

• 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 behavior)• Companies understand the competitive threat as

(recognised) interdependence (zero-sum and entropy)

Focus on signals and Focus on signals and type..Baumol type, Marris type..Baumol type, Marris type, CL type, Player typestype, CL type, Player types

Focus on signals and Focus on signals and type..Baumol type, Marris type..Baumol type, Marris type, CL type, Player typestype, CL type, Player types

Why? Key to understanding firm Why? Key to understanding firm behaviour & company strategy behaviour & company strategy

as observed in real timeas observed in real time

Costs of not being a Player in the market-as-a-

game• 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

The competitive threat!• Traditional Analysis can be 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?

Unit 1Management Models

• Understand Penrose effect and GHM Theory (Besanko pp158-161) and incomplete contracting

• Explain the rule MC = MR• 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

£

MMS-strategy

• Entropy when the industry elasticity ηp is less than the firm-specific elasticity: ηp < єp

• Player a’s market share equation: MSa = [ηp + σ.MSb]/єp

• Market Penetration: єp < σ.MSb and Market poaching σ < 1

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• Marris v = Tobin’s q ratio

Marris equations:dividends paradox & operating gearing

• Understand the α = operating gearing…..how much extra profit earned from every $1 of extra revenue

gd = gc = αp

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

opportunities (GO)…this is a Marris firm’s focus on gd.

• McNutt p50: Alternative to Calculating share price by DCF formula : share price pattern embedded in BGP equation as quadratic function of vertex form (h,k), where k is the share price turning point on the BGP and h is proxy for gd.

Marris v and Tobin q

• Allow q = v, and if (mean reversion) v < mean v then share prices should increase

• Marris v is a long term tool not a short term tool

• If v < 1 BUY ..if v > 1 SELL: Common denominator is the plough-back ratio (PBR) = 1 – divs/eps.

• But more R&D from G1 to G2 can accrue an agency cost as Bayesian shareholders SELL as value falls V1 to V2.

• More dividends could signal an absence of R&D growth

U1 U2 U3 U4Valuation ratio Shareholders perference

xBest to management

V2 Valuation curve

G1 G2 Growth rate

V1

V(min)

y

0

Focus on the cost Focus on the cost technology, vertical chains technology, vertical chains

and cost leadershipand cost leadership

Focus on the cost Focus on the cost technology, vertical chains technology, vertical chains

and cost leadershipand cost leadership

Why? Need to observe the Why? Need to observe the supply chain and a sustainable supply chain and a sustainable

competitive advantagecompetitive advantage

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 (McNutt Ch 5,

Besanko Ch 2 and link into Besanko Ch 13 on stategic cost advantage)

TCE & 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

Emphasis in Unit 2: Cost leadership

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 type 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

Capacity Constraints: Why ? Sustainable competitive

advantage• Case A: Unexhausted economies of scale due to

lag in product differentiation ..excess capacity?• Case B: Firm-as-a-player cannot produce sufficient

output to reach MES ..zero-sum?• Case C: Firm-as-a-player restraints production

(deliberate intent)..McNutt’s dilemma as production drives demand…(Veblen monopoly type)

• Speed of technology increases the firm-specific risk of Case A..CLASS QUESTION: adopt Case C to solve A?

Focus on player Focus on player strategy set in a strategy set in a game dimensiongame dimension

Focus on player Focus on player strategy set in a strategy set in a game dimensiongame dimension

So: dark strategySo: dark strategy

S1: limit pricing strategyS1: limit pricing strategy

S2: credible threat strategyS2: credible threat strategy

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. (Management).• 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.

Unit 3: Game type and signalling

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

Nissan CTL pp20 or Apple CTL p94 in McNutt• Recognition of market interdependence (zero-

sum)• Price as a signal v Baumol model of TR max• Scale, size and capacity: cost leadership

signals• Dividends as signals in Marris model

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

What determines the intensity of rival competition?

• Price Bertrand games [strategic complements + elasticity] and non-price Cournot games [strategic substitutes + zero sum].

• Reaction, signalling and ‘best you can do, given reaction of competitor’

• Moonshots, noise and cheap talk in a signalling game (on rival costs, rival capacity)

• Patterns of observed behaviour & likely reaction• Leader-follower as ‘knowledge’ and trust• Accommodation v entry deterrence• ’

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

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

the market• Potential entrant type and the threat of

entry• Newborn players and extant

(incumbent) type

Limit Pricing Model in Besanko pp310-318 and McNutt

pp71-76• Outline the game dimension:

dominant incumbents v camuflaged entrant type

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

v accomodation [next slide]

1

2

Enter

0,10

-7,2

5,8

Do Not Enter

Agressive

Accommodating

Entry Deterrent Strategy• Reputation of the incumbents• 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)

Describe (prices as signals) game

dimension• Focus on the Sony v Microsoft game in

McNutt Fig 9.3 and Fig 9.4 pp 115• Players and type of players• Speed and frequency of reaction in the CTL• Observe the pattern of observed behaviour• Identify a Nash equilibrium…sequence of price

reactions towards NE….sequence of non-price signals on output towards NE.

• Identify intersection of reaction functions

Continuing with Unit 4: Define a price war

• Determine the Bertrand reaction function

• 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

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

• Altruism, fairness, selfish gene, dominant strategy, minimax

• Understand NE: if neither player would gain by unilaterally changing strategy

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

(B,Y) > (A, X)• Commitment and chat• Punishment 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: Elasticity and Threat of Entry

Player 2

Strategy A Strategy B

Player 1 Strategy A 2 2 0 3

Strategy B 3 0 1 1

Firm 2 profit payoffs

High Price $6

Low Price $4

Firm 1 payoffs High Price $6 10 10 x 13

Low Price $4 13 y 2 2

•Would outcome change if the game is repeated? The Folk Theorem

10,10

13,02,2

0,13

Low Prices

High Prices

Low Prices High Prices

Player 1

Player 2

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: Play not

to lose v play to win (FMA)• Strategic ToolBox in terms of identifying

the competitive threat v cartel coordination on (High. High)..Cheating

Class Exercise: Find Nash Equilibrium?

• Two players must simultaneously decide which strategy to adopt.

• Does this example illustrate the concept of first mover advantage v second mover advantage

• Should the players chat to avoid (1,1)?.

Strategy A Strategy B

Strategy A 3,3 2,4

Strategy B 4,2 1,1

Absence of price wars?Link into the HBR

articles• Hypothesis: Price Wars occur due

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

volumes ∆qi/∆Q < 0; (ii) uncompetitive cost structure (productivity); (iii) technology & time; (iv) management type.

GEMS and Strategic Analysis

•Knowledge of the identity of near rival:

Actionyou -> Reactionrival

-> NashReplyyou

Fig 9.4 p115 McNutt

& Fig 8.3 p231 Besanko

Game Embedded Strategy: GEMS:

Complete the Diagram

What Market should Your Company be in?

Games & Feedback

Industry Analysis

Play-out Game Scenario B

e.g. change the gamenew

product development

Strategic Options (Identify the Games)

Play-out Game Scenario A e.g. market

entrycompetitors reactions

Play-out Game Scenario C

e.g. change the game

Consolidation

Strategic Decisions

Porter’s 5 Forces BCG Value Net

S.W.O.T. P.A.R.T.S. McKinsey

Game theory

Organizational Goals

Game theory Insights

Final Scenarios for YOUR Company……

• The RationaleMarkets evolve

• The RationaleType, Technology

and Time• The RationaleKnow your market

• The StrategyNon-binary

• The StrategyGame metrics and

analytics• The Strategy

GEMS

Thank you for participating………

Sapere aude

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