Managerial Economics: Applying the Tools Topic 5, Part 2

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Managerial Economics Applying the ToolsTopic
5, Part 2

• Added Value in a Monopoly
• Strategy and bargaining the bigger game
• Paul Kerin Sam WylieMBS Term 3, 2004

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Monopoly and Added Value

• Just use the Added Value rule You can never get
  more than your added value, or the group would do
  better by excluding you.
• Your Added Value roughly, the economic profit
  from you cooperating with the rest of the
  group
• maximise the pie, cooperate
• (Group
• you) a new option! Others
  cooperate, but
• you dont cooperate with rest of group

no cooperation
Now calculate Added Value for each player, in
turn!
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In-class exercise 1 Turbine generators

• Monopolist has a unit cost of production of 10k.
• Three buyers WTP 20k, WTP 19k, WTP 15k
• What is the possible range of prices, if the
  monopolist can produce 3 units?
• What is the possible range of prices, if the
  monopolist can only produce 2 units?
• If the price is in the middle of the possible
  range, what is the outcome?
• (Note Were going to look at the
  middle-of-the-range price, just to have an idea
  of what might happen.
• But you dont have to think this is
  reasonable!)

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Using Added Value

• In-class exercise Suppose it costs a monopolist
• 2k to produce his 1st unit
• 3k to produce the 2nd unit (so, 5k to produce 2
  units)
• 5k to produce the 3rd unit (so, 10k to produce
  3 units)
• There are 3 firms buying from the monopolist
• Alpha WTP 10k
• Beta WTP 9k
• Kappa WTP 7k
• What is the total surplus?
• What is the Added Value of each player?
• What is the possible range of prices they will
  pay?

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Margins and Added Value

• When we calculate the Added Value of Alpha, Beta
  and Kappa, we notice a strange outcome
• Each one is being treated as the 3rd customer
• ? Each one is being treated as the marginal
  customer!
• That is, when the others are deciding whether or
  not to throw that customer out of the
  negotiation, they consider that production costs
  will fall to 5k if hes thrown out
• But this thought process happens to each customer
  in turn!
• ? To build intuition, think about what would
  happen if a customer got more than his Added Value

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Strategy and Bargaining The bigger game

• 2-person games
• (briefly) multi-person games

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Bargaining Outcomes

• What factors determine what you get from
  bargaining?
• The total payoff to the group from cooperating
• Outside options
• the payoff each player would get from going off
  on her own (i.e. her BATNA)
• the payoff each group would get from going off on
  its own ( the determinant of Added Value)
• Main question
• Can you take action to affect these payoffs?

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Game leading up to Bargaining

• View the process of reaching agreement through
  bargaining as part of a bigger game
• Actions change surplus ultimate payoffs
• ? Need to use rollback to choose our
  pre-bargaining actions.

Player 2 makes investments
Payoffs
Bargaining
Bargaining
Payoffs
Player 1 enters the market
Bargaining
Payoffs
Other actions, payoffs
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2-person bargaining games

• Lets look at this issue using 2-person games,
  which are simpler.
• In 2-person games there are only 3 factors that
  determine the outcome of bargaining
• The total payoff to you and the other person from
  cooperating
• Your BATNA
• The other persons BATNA

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• Total surplus a brief reminder
• Total surplus the red circle minus
  those two slices.

• The red circle is the total payoff to both from
  cooperating
• The blue slice is the other persons BATNA
• The green slice is your BATNA

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BATNAs and splitting the surplus

• Your payoff from bargaining is
• Your BATNA a half share of the Total
  Surplus
• the green slice ½(the red area on this
  circle)

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• ? Your bargaining outcome improves when you

• Increase the total payoff to both from
  co-operating ( the whole circle)
• Decrease the payoff the other has without you
  (the blue slice) reduce
  their BATNA
• Increase the payoff you have without the others
  (the green slice)
• improve your BATNA

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Simple Example

• Your plant sells specialised rubber soles to Nike
• If you can interest Reebok in your product, your
  outside option is higher, even if Reeboks WTP is
  not as high as Nikes
• Your BATNA has improved
• Your bargained price with Nike will increase.
• You still sell to Nike
• ? no change in total payoff, except that
  possibly it was costly to interest Reebok in your
  product
• ? total payoff may actually be lower

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Inefficiency and Bargaining

• We have said that the bargaining process is
  generally efficient
• Negotiators agree on the surplus-maximising
  actions
• Then they negotiate over how to divide the
  surplus
• BUT
• Actions taken before negotiating are not
  efficient
• You take actions to affect your BATNA and the
  other persons BATNA, even though that doesnt
  create any more total payoff
• You are more concerned with improving your BATNA
  than with creating more total payoff!

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Inefficiency and bargaining

• Your payoff from bargaining is
• Your BATNA a half share of the Total
  Surplus
• the green slice ½(the red slice of the
  circle)
• Before bargaining
• If you invest to increase the total payoff (size
  of the circle), you get 50 of the increase
• Insufficient incentive to increase total payoff
• If you invest to increase your BATNA, without
  changing to total payoff, you get 100 of that
  increase, as opposed to 50 before
• If you invest to decrease the other persons
  BATNA, you get 50 of that decrease!
• Excessive incentive to affect BATNAs

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More Subtle ExampleToo smart for your own good?

• A software company is developing a game for the
  Sony Playstation
• After developing the game, he will sell it to
  Sony, to be packaged with the Playstation
• Designing the game costs 300,000 in wages. The
  game will earn 500,000 in revenues (and there
  are no other costs to marketing it). Sony
  designed their platform so that the game cannot
  be adapted to another gaming machine (such as the
  X-cube) ? The designer has low outside options
• Is total surplus maximised by developing the
  game?
• What is the negotiated price, if the developer
  designs the game?
• Would he agree to design?

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Too smart for your own good?

• Sony has too good a bargaining position

(-50,000 250,000)
Split the range
Sony
design
be fair
(100,000 100,000)
Software Firm
Dont design
(0, 0)
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Bargaining and Sunk Costs

• Why is the software design firm in such a bad
  bargaining position? SUNK COSTS
• Software firm has already incurred the costs of
  designing the game.
• ? These costs are sunk
• The software firms outside option is zero (not
  counting sunk design costs) low outside options

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Specialised versus General Investments

• There are many investments that can be made to
  increase value between supplier and firm
• locating near each other
• systems to coordinate product, reduce stocks
• adapting suppliers product to work well in the
  customer firms product. Example software
  bundled with Windows
• adapting product characteristics to improve WTP
  for the overall product. Example
  extra-high-performance brakes for Mercedes
• But if the specialised investment is not as
  valuable to other trade partners, the suppliers
  outside options are low
• the supplier is at risk of hold-up

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Contracts and hold-up

• If the Software firm agrees to work, it will be
  held up gain Negative Surplus from its
  investment
• A strategically-thinking firm does not agree to
  design the game, and therefore both receive a
  payoff of 0
• This is the ultimate inefficiency no production
  takes place at all!
• The hold-up problem would be resolved if they
  could negotiate and sign a contract before the
  designer starts working but to do so, they need
  to be able to write a credible contract
• they need a credible commitment

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Solution Negotiate before design

• Sony and the software firm add a new option to
  the tree

(100,000 100,000)
Bargain before design
(-50,000 250,000)
Sony
Split the range
Be fair
Software Firm
(100,000 100,000)
Dont agree to design
(0, 0)
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The timing of bargaining

• In the software designers case, the contract
  needs to be written before investment to avoid
  inefficiency
• Remember, bargaining is efficient
• If they can bargain before investing, the
  investments they make will maximise total payoff
• The sooner we can bargain and write a contract,
  the more total payoff is saved
• What prevents us from writing contracts early?
• you may not know who to negotiate with, yet
  Laundry business built up in a neighborhood, then
  a factory moves in afterward
• In RD you might want to sell your idea, but
  explaining your idea gives it away. ? Cant
  bargain until you patent

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Enforceable contracts

• Even if we bargain and write a contract, the
  contract may not be enforceable
• its difficult/expensive to verify and enforce
  injured firms wont go to court after a breach of
  contract if doing so costs more than the award
• ? in that case, its not an enforceable contract
• uncertainty about the future ?hard to write
  long-term contracts
• business is complex ? hard to spell out all the
  details
• If a contract cant be enforced, theres no point
  in writing it
• ? then we bargain later in the game

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Other solutions to the hold-up problem

• Making contracts more enforceable
• Reducing the legal cost of enforcing a contract
  
• ex arbitration is usually quicker and less
  expensive
• Raising penalties for breach of contract
• ex blackballing from the business community
• Building a reputation ( committing not to breach
  a contract)
• If we still cant write an enforceable contract,
  we have to find another way to commit not to hold
  up our trading partner
• Paying in installments
• Taking hostages (the Ugly Princess problem)

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Connection to multi-person games

• A monopoly has an incentive to commit to restrict
  supply
• Why? given that it reduces the total payoff
• But it limits the Added Value of each buyer
• Actions taken before bargaining can affect the
  bargaining outcomes
• Once again, you can be too smart for your own
  good
• If buyers have to make sunk investments to be in
  the market, the monopolist has to commit not to
  hold up buyers
• Otherwise, there will be no buyers in the market

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From Co-opetition

• Pay to Play
• Coke/Pepsi vs Nutrasweet