Strategic Thinking

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Strategic Thinking

• Dr. Yi LU
• March, 2008

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Introductory Story Coke vs. Pepsi, 1999

• 1995-99 intense price war
• November 1999
• Nov. 16 Coca-Cola raised price 7
• Nov. 22 Pepsi raised price 6.9
• Coke and Pepsi will move now from price-based
  competition to marketing-based competition
  (Andrew Conway, Morgan Stanley)
• How did they get out of price war?

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Outline

• Nash equilibrium
• randomized strategies
• coordination / competition
• sequencing
• strategic move

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Some concepts Strategic situations

• Strategy is a plan for action in a situation
  where parties actively consider the interactions
  with one another in making decisions.
• Game theory set of ideas and principles to
  guide strategic thinking
• simultaneous actions strategic form
• sequential actions extensive form

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Some concepts Infinite regress

• Common problem in strategic situations
• My best move depends on competitors move
• But her best move depends on my move
• ..
• Nash equilibrium provides solution to infinite
  regress

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Nash equilibrium Radio formats

• Jupiter has two plans change to Hot AC or no
  change.
• Merker also has two plans change to Lite AC or
  no change
• If he changes to Hot AC while his opponent does
  not change, he will take 60 of the market share
• If he does not change while his opponent changes,
  he will take 70 of the market share
• If both change, Jupiter will take 60
• If both remain unchanged, Jupiter will take 50

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Nash equilibrium Radio formats
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Nash equilibrium

• Given that the other players choose their Nash
  equilibrium strategies, each party prefers its
  own Nash equilibrium strategy
• No one is willing to deviate unilaterally from a
  Nash equilibrium

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Nash equilibrium Dominated strategy

• generates worse consequences than another
  strategy, regardless of the choices of the other
  parties
• should never use dominated strategy

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Nash equilibrium Solution

• Conventional method
• eliminate dominated strategies, then
• check remaining cells
• arrow method

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Nash equilibrium Radio formats
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Nash equilibrium Competitive dilemma
What should Coke do?
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Nash equilibrium OPEC

• June 1998 Saudi Oil Minister Naimi, I dont
  think anybody expects 100 compliance Once the
  price goes up, there will be cheating
• March 1999 Algerian Oil Minister Youcef Yousfi,
  OPEC is still able to act collectively and
  restore market stability

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Nash equilibrium Non-equilibrium behavior

• What if another player doesnt play Nash
  equilibrium strategy?
• dont use dominated strategy
• Nash equilibrium strategy may not be best

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Randomized Strategies Where to advertise?

• Two on-line e-commerce providers planning
  advertising strategy advertise in NBA
  (basketball) or NHL (hockey) series?
• We.com plan to use comparative advertising more
  effective when viewers see advertisements of both
  competitors
• Competitor.com using unique advertising more
  effective on separate channel.

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Randomized Strategies Where to advertise?
No Nash equilibrium in pure strategies
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Randomized strategies

• Choose among pure strategies according to
  probabilities
• Must be unpredictable

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Randomized strategies Retail price competition

• Two competing retailers Jaya and Ming
• Three segments
• captive (loyal) to Ming
• captive (loyal) to Jaya
• switchers

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Randomized strategies Retail price competition
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Randomized strategies Retail price competition

• Challenge is how to attract price-sensitive
  customers without sacrificing profit from the
  less price-sensitive ones.
• Pricing trade-off
• high price to extract buyer surplus of loyal
  customers
• low price to get store switchers
• Solution random discounts

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Coordination/competition Zero/positive sum

• zero-sum games (pure competition) one party
  better off only if other is worse off
• positive-sum games (coordination) both can be
  better off or both worse off
• co-opetition competition and coordination

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Coordination/competition Choosing software
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Coordination/competition Focal point

• Single Nash equilibrium clear focal point
• Multiple Nash equilibria must look for focal
  point
• Example Boyfriend and you are separated in
  shopping mall. Where to search for him?

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Coordination/competition Evening news
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Coordination/competition 56kbps modems
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Sequencing

• Game in extensive form sequence of moves
• nodes a point at which a party must choose a
  move
• branches a line leading from nodes
• outcomes

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Sequencing TV news
TVB, ATV

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Sequencing Extensive form equilibrium

• Backward induction
• final nodes
• intermediate nodes
• initial node

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Sequencing First/second mover advantage

• Advantage doesnt always go to first mover
• In war, better to see opponents move, and then
  take action, eg, is enemy moving south or north?
• New product category let competitor test the
  market and educate the customers

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Sequencing Repetition

• Expand strategies condition actions on
• external events
• actions of other parties
• Tit-for-tat strategy
• other markets
• other times

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Sequencing Cooperative pricing

• Tit-for-tat
• Axelrods rules
• do not strike first
• reciprocate both good and bad
• act simply and clearly
• do not be envious

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Sequencing Resolving competitive dilemma

• Repetition use punishment strategy
• I will follow quota, but if you cheat, then in
  next period, I will also cheat
• Can achieve cooperation (avoid price competition)
  depending on
• time horizon
• discounting of future profit relative to current
  profit

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Sequencing Resolving competitive dilemma

• OPEC
• Saudi Arabia is low-cost producer best able to
  punish cheaters

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Strategic move Two-tier takeover

• In December 1994, Williams Companies, a natural
  gas producer and pipeline operator, announced a
  two-tier bid for Transco Energy Co.
• First tier buy up to 60 for 17.50 each share
  in cash
• Second tier conditional on Williams securing at
  least 51 and would convert all remaining Transco
  shares into 5/8ths of a Williams common share,
  which is estimated at 15 each share.
• How does this two-tier structure force
  shareholders to accept?

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Strategic move

• Definition Action to influence beliefs or
  actions of other parties in a favorable way
• Credibility
• Irreversible commitment

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Strategic move Lithography

• Lithography is a process by which an artist
  creates a stone or metal plate, then treats the
  plate with ink, and prints pictures.
• Most lithographers specify the number of copies
  that they will print from each plate.
• Lithography is a business with significant
  economies of scale
• After preparing the initial plate, the
  lithographer can generate more prints with low
  marginal costs.

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Strategic move Lithography

• In the eyes of consumers, the value of a
  lithograph, like any other work of art, depends
  on the supply
• Two much copies destroy the value.
• Thus the lithographer needs some way to convince
  potential buyers that he will not keep producing
  more prints.

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Strategic move Lithographer

Make more prints
Litho
Make prints
Do not
Litho

• serial number
• destroy the plate
• other solution?

Do not
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Strategic move Lock-in

• sunk costs become switching costs
• learning
• complementary hardware
• lock-in strategy
• initially, price low/free to lock in buyer
• exploit later

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Strategic move Counter lock-in

• Competitive upgrade
• Boeing deal with Singapore Airlines bought SIAs
  old Airbus planes
• Mobile service provider offer discount to users
  switching from other providers
• Technological change
• Suns Java Virtual Machine technology to
  separate applications from underlying operating
  system

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Strategic move Lock-out, Verizon Wireless

• Los Angeles wireless market
• dominant Verizon and Cingular
• entrants ATT and Sprint
• Verizon Americas Choice free minutes of calls
  to/from another Verizon customer

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Strategic move Pepsi Cola, 1999

• March Pepsi spun off Pepsi Bottling Group (PBG)
• November
• Nov. 16 Coca-Cola raised price 7
• Nov. 22 Pepsi raised concentrate by 6.9
• PBG raised retail price by 5

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Conditional strategic move

• Ideal strategic move that doesnt impose costs
• Threat
• A strategic move that imposes costs under
  specified conditions to change the beliefs or
  actions of other parties
• if it succeeds, then neednt be carried out
• Promise
• A strategic move that conveys benefits under
  specified conditions to change the beliefs or
  actions of other parties
• if it succeeds, then neednt be carried out

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Conditional strategic move Morgan
Stanley,Shareholder rights plan

• If any party acquires 15 or more of companys
  shares, other shareholders get right to buy
  additional shares at 50 discount.
• Impact on hostile bidder?
• This shareholder rights plan is a threat to
  potential bidders

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Conditional strategic move Poison pill
Lucas loses on initial stake cost of takeover
rises

activates rights
Morgan Stanley
does not
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Conditional strategic move Two-tier takeover bid

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Conditional strategic move strike

• American professional sports
• Why are strikes less common in football than
  baseball?

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Conditional strategic move Strike

Lose current wage and possibly gain in future wage
strike
Union
do not
Maintain current wage
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Conditional strategic move Deposit insurance

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Conditional strategic move Hyperinflation

• How to use promise to guard against
  hyperinflation?