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@2008 Yi LU
Strategic Thinking
Dr. Yi LUMarch, 2008
@2008 Yi LU
• 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?
Introductory Story: Coke vs. Pepsi, 1999
@2008 Yi LU
Outline
• Nash equilibrium• randomized strategies• coordination / competition • sequencing• strategic move
@2008 Yi LU
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
@2008 Yi LU
Some concepts: Infinite regress
• Common problem in strategic situations:– My best move depends on competitor’s move– But her best move depends on my move
…..
• Nash equilibrium provides solution to infinite regress
@2008 Yi LU
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%
@2008 Yi LU
Nash equilibrium: Radio formats
Merkur
Lite AC no change
Jupiter
Hot AC J: 60,
M: 40
J: 60,
M: 40
no change J: 70,
M: 30
J: 50,
M: 50
@2008 Yi LU
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
@2008 Yi LU
Nash equilibrium: Dominated strategy
• generates worse consequences than another strategy, regardless of the choices of the other parties – should never use dominated strategy
@2008 Yi LU
Nash equilibrium: Solution
• Conventional method:– eliminate dominated strategies, then – check remaining cells
• “arrow” method
@2008 Yi LU
Nash equilibrium: Radio formats
Merkur
Lite AC no change
Jupiter
Hot AC J: 60,
M: 40
J: 60,
M: 40
no change J: 70,
M: 30
J: 50,
M: 50
@2008 Yi LU
Nash equilibrium: Competitive dilemma
Pepsi
Raise price Discount
Coke
Raise
price
C: 3,
P: 3
C: 0,
P: 5
Discount C: 5,
P: 0
C: 1,
P: 1
What should Coke do?
@2008 Yi LU
June 1998: Saudi Oil Minister Naimi, “I don’t 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”
Nash equilibrium: OPEC
@2008 Yi LU
Nash equilibrium: Non-equilibrium behavior
• What if another player doesn’t play Nash equilibrium strategy?
– don’t use dominated strategy – Nash equilibrium strategy may not be best
@2008 Yi LU
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.
@2008 Yi LU
Randomized Strategies: Where to advertise?
Competitor.com
NBA NHL
We.com
NBA W: 4,
C: 3
W: 3,
C: 4
NHL W: 3,
C: 4
W: 4,
C: 3
No Nash equilibrium in pure strategies
@2008 Yi LU
Randomized strategies
• Choose among pure strategies according to probabilities
• Must be unpredictable
@2008 Yi LU
Randomized strategies: Retail price competition
• Two competing retailers – Jaya and Ming
• Three segments– captive (loyal) to Ming– captive (loyal) to Jaya– switchers
@2008 Yi LU
Randomized strategies: Retail price competition
Ming
High price Low price
Jaya
High price
J: 60,
M: 40
J: 40,
M: 50
Low price
J: 50,
M: 40
J: 50,
M: 30
@2008 Yi LU
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
@2008 Yi LU
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
@2008 Yi LU
Coordination/competition: Choosing software
Bharat
MS-Word StarOffice
Toyo
MS-Word T: 1.5,
B: 1.5
T: 1,
B: 1
StarOffice T: 1,
B: 1
T: 1.5,
B: 1.5
@2008 Yi LU
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?
@2008 Yi LU
Coordination/competition: Evening news
TVB
7.30pm 8.00pm
ATV
7.30pm A: 1,
B: 1
A: 3,
B: 4
8.00pm A: 4,
B: 3
A: 2.5,
B: 2.5
@2008 Yi LU
Coordination/competition: 56kbps modems
End-users
k56flex X2
ISPs
k56flex I: 1,
U: 1
I: -1,
U: -1
X2 I: -1,
U: -1
I: 1,
U: 1
@2008 Yi LU
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
@2008 Yi LU
TVB
8:00
7:30ATV
1, 1
3, 4
7:30
8:00
ATV
4, 3
2.5, 2.5
7:30
8:00
TVB, ATV
Sequencing: TV news
@2008 Yi LU
Sequencing: Extensive form – equilibrium
• Backward induction– final nodes – intermediate nodes – initial node
@2008 Yi LU
Sequencing: First/second mover advantage
• Advantage doesn’t always go to first mover;– In war, better to see opponent’s move, and then take
action, eg, is enemy moving south or north?– New product category – let competitor test the market
and educate the customers
@2008 Yi LU
Sequencing: Repetition
• Expand strategies – condition actions on– external events– actions of other parties
• Tit-for-tat strategy
• other markets• other times
@2008 Yi LU
Sequencing: Cooperative pricing
• Tit-for-tat• Axelrod’s rules
– do not strike first– reciprocate both good and bad– act simply and clearly– do not be envious
@2008 Yi LU
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
@2008 Yi LU
Sequencing: Resolving competitive dilemma
• OPEC: – Saudi Arabia is low-cost producer – best
able to punish cheaters
@2008 Yi LU
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?
@2008 Yi LU
Strategic move
• Definition: Action to influence beliefs or actions of other parties in a favorable way
• Credibility– Irreversible commitment
@2008 Yi LU
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.
@2008 Yi LU
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.
@2008 Yi LU
Litho
LithoMake prints
Do not
consumer
Buy
Do not
Make more prints
Do not
• serial number• destroy the plate• other solution?
Strategic move: Lithographer
@2008 Yi LU
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
@2008 Yi LU
Strategic move: Counter lock-in
• Competitive upgrade– Boeing deal with Singapore Airlines: bought SIA’s old
Airbus planes– Mobile service provider: offer discount to users
switching from other providers
• Technological change– Sun’s Java Virtual Machine: technology to separate
applications from underlying operating system
@2008 Yi LU
Strategic move: Lock-out, Verizon Wireless
• Los Angeles wireless market– dominant – Verizon and Cingular– entrants – AT&T and Sprint
• Verizon America’s Choice: free minutes of calls to/from another Verizon customer
@2008 Yi LU
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%
@2008 Yi LU
Conditional strategic move
• Ideal: strategic move that doesn’t 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 needn’t 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 needn’t be carried out
@2008 Yi LU
Conditional strategic move: Morgan Stanley,“Shareholder rights plan”
• If any party acquires 15% or more of company’s 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
@2008 Yi LU
Morgan Stanley
does not
activates rights
Lucas
acquires 100,000shares
doesn’t bid
Lucas loses on initial stake + cost of takeover rises
Conditional strategic move: Poison pill
@2008 Yi LU
Sally
Does not
Accepts
Conditional strategic move: Two-tier takeover bid
Williams
First-tiercash offer
doesn’t bid
Williams
Williams gets control
Fails
$15
Holds share
Williams
Williams gets control $17.5
Fails Holds share
@2008 Yi LU
Conditional strategic move: strike
• American professional sports – Why are strikes less common in football than
baseball?
@2008 Yi LU
Union
do not
reject union demand
Employer
accept
strike Lose current wageand possibly gain infuture wage
Maintain current wage
Conditional strategic move: Strike
@2008 Yi LU
Conditional strategic move: Deposit insurance
depositor
maintains deposit
withdraws deposit
bank
run
remains solvent n.a.
?
bank
run
remains solvent n.a.
?
@2008 Yi LU
Conditional strategic move: Hyperinflation
• How to use promise to guard against hyperinflation?