MBA299: Strategy

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MBA299 Strategy

• Game Theory and Strategy
• Take-aways
• April 20, 2006

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Why game theory?

• Game theory is an approach that can be used to
  predict what will happen in strategic situations
  
• Generates many powerful general insights, and
  powerful insights in some specific situations
  
• Strategic situations are ones in which players
  rewards (payoffs) are dependent on others
  actions
  
• launch of new Jennifer Lopez album probably not a
  strategic situation
  
• many other business decisions are made in
  strategic situations
  
• Ford decides to increase rebates on trucks
• JetBlue starts an Oakland-Boston route
• Microsoft bundles anti-popup software into new
  versions of Explorer
  
• Google launches desktop search software

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Game theory applied to business

• Pros
• A systematic way to analyze strategic situations
• Extremely useful when small numbers of players
  are involved
  
• Cons
• Involves a tradeoff between precision and
  robustness
  
• the more precisely you specify the rules of the
  game, the more precise the prediction becomes,
  but the less robust the prediction is
  
• rules drive the outcome of the game, and the more
  rules you write down, the more likely you are to
  get one wrong
  
• exception auctions, where the seller is setting
  the rules of the game
  
• Solving games becomes extremely difficult when
  there are many heterogeneous players
  
• Rely more on industry analysis in these situations

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Two types of game theory

• Non-cooperative Game Theory
• prisoners dilemma (a simultaneous move game)
• entry-response games (a sequential move game)
• many, many other extensions
• Uncertainty, asymmetric information, repeated
  interaction, signaling,
  
• Cooperative Game Theory
• examines how value is created by different
  configurations of players
  
• contains roots of a theory of competitive
  advantage
  

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A famous example of a simultaneous move game
The Prisoners Dilemma
Suspect B
1 year
No prison
Suspect A
1 year
10 years
10 years
9 years
No prison
9 years
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In the prisoners dilemma, each player has a
dominant strategy

• Suspect A is made strictly better off by
  Confessing, independent of what Suspect B does
  (check this!)
  
• Suspect B is made strictly better off by
  Confessing, independent of what Suspect A does
  (check this!)

Suspect B
1 year
No prison
Suspect A
1 year
10 years
10 years
9 years
No prison
9 years
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The prisoners dilemma has a number of common
analogs in business
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A solution concept the Nash Equilibrium

• Fundamental tool for examining non-cooperative
  games
  
• Idea Every player does the best that he/she
  can, given that the other players also do the
  best they can
  
• Outcomes (or payoffs) are inter-related, i.e.,
  player As payoff depends on As strategy and Bs
  strategy
  
• Definition
• a Nash equilibrium is a set of strategies for
  each player in which no player can improve
  his/her situation by choosing a different
  strategy, given the choices of the other players
• Testing for a Nash equilibrium
• Does any player have a profitable deviation,
  i.e., could any player improve his / her payoffs
  by choosing a different strategy?
  
• If there is a profitable deviation from a set of
  strategies, then this is not a Nash equilibrium

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The prisoners dilemma has a single Nash
equilibrium
Suspect B
1 year
No prison
Suspect A
1 year
10 years
10 years
9 years
No prison
9 years
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More simultaneous move games Coordination Game
Player B
10
0
Player A
10
0
0
5
0
5
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More simultaneous move games Coordination Game
with Different Payoffs (sometimes called Battle
of the Sexes)
Player B
1
0
Player A
2
0
0
2
0
1
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More simultaneous move games Baseball(also a
zero sum game)
Pitcher
Hit ball ()
Strike ()
Batter
Hit ball ()
Strike ()
Strike ()
Hit ball ()
Strike ()
Hit ball ()
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More simultaneous move games Chicken
Player B
Wuss
Bragging Rights
Player A
Wuss
Wuss
Wuss
Death
BraggingRights
Death
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Rules of the game who moves first?

• In a number of situations, it makes sense to
  analyze the game as if players were moving
  simultaneously
  
• Prisoners dilemma
• Baseball
• In other situations, it makes sense to specify
  the order of players moves (sequential moves)
  
• Entry games
• Entrant builds capacity (this takes longer,
  requires a commitment)
  
• Incumbent responds by changing price (this can be
  done rapidly, is not irreversible)
  

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Solving simultaneous move games

• Backward induction, Look forward, reason
  backward
  
• Solve the last stage of the game first, i.e.
  choose the strategy that maximizes the payoff for
  the player moving last
  
• Then solve the next to last stage in the game,
  assuming that the choice in the last stage has
  already been made
  
• Continue until the beginning of the game
• What does this process mean?
• Players see through others threats
• I may threaten to retaliate if you attack, but
  once it is my turn, I will do what is best for
  me. If it isnt best for me to retaliate once
  you have attacked, I wont do so

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Ryanair vs. Aer Lingus British Airways
Anticipating a pricing response

• In the A case, we asked the question, how will AL
  BA respond to Ryanairs entry on the Dublin
  London Route
  
• Two scenarios
• Untargeted retaliation cost to AL/BA I17-34M,
  Ryanair payoff negative
  
• Targeted retaliation cost to AL/BA I5-11M,
  Ryanair payoff negative
  
• Accommodation cost to AL/BA I 0 9M, Ryanair
  payoff I300,000

Untargeted retaliation
(Loss, - I25 M)
AL / BA
Targeted retaliation
(Loss, - I8 M)
Ryanair
Enter
(I 300K, -I 4 M)
Accom- modate
DontEnter
(0, 0)
Assumes Entry with 4 flights per day 44 seats
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Challenges for game theory in action

• Figuring out the payoffs and how they relate to
  strategies
  
• Often need to simplify strategies of all parties
  to isolate the impact of key choices
  
• Getting the structure of the game right
• Should other existing actors be considered?
• Do potential new entrants matter?
• Is the game being played once or multiple times?