Economic Foundations Economic Foundations of Strategyof Strategy

Power Point Set #4

Game Theory and Strategy

Key Concept: Preemption of Strategically Valuable Assets

Access to raw materials (e.g. Alcoa)

Wal-mart’s rural strategy

Game Theory and Strategy

Creating Customer Switching Costs

Establishing standards for a computer operating systemMatsushita’s VHS format becoming dominant over Sony’s BetaNote: Given that a second mover’s product development costs can be much lower than the first mover’s product development costs, first-mover advantages must be substantial to justify first moving as a strategy.

Game Theory and StrategyTechnological Leadership

In the 1970s, DuPont built a dominant position in the titanium dioxide market by exploiting:• superior technology• scale economies• accumulated experience for low costs

Gillette competes with a differentiation strategy in disposable razors by exploiting:• superior technology• reputation• broad distribution

Analyzing Competitive Dynamics -Commitment Vs. Flexibility

CommitmentGame Theoretic preemption strategy

FlexibilityReal (Strategic) Options Analysis

Game Theory and Strategy

Prisoners’ Dilemma GameR

ow

Silen

ce

Fin

k

Silence FinkColumn

-1

0-1

0

-10 -8

-8

-10

Game Theory and Strategy

Prisoners’ Dilemma Game

Row Player: Dominant Strategy: FinkColumn Player: Dominant Strategy: Fink

Dominant Strategy (Nash) Equilibrium: (-8, -8)

Note: It is a dilemma since if they both cooperated by remaining silent: (-1, -1).

Game Theory and Strategy

The prisoners’ dilemma game can occur in many contexts:

What is best for an individual may not be best for a division.What is best for a division may not be best for a firm.What is best for a firm many not be best for an industry.What is best for an industry may not be best for a nation.What is best for a nation may not be best for the world.

Game Theory and Strategy

Now that we have learned the concept of dominant strategy equilibrium, there is a second important equilibrium concept called a Nash equilibrium.

Note: All dominant strategy equilibrium are Nash equilibrium, but not all Nash equilibrium are dominant strategy equilibrium.

Game Theory and StrategyGame with no dominant strategy equilibrium, but a Game with a Nash equilibrium.

Row

Coop

era

teFin

kCooperate Fink

Column

5

4 1

9

-1 0

0

4

Game Theory and Strategy

A cooperative game with conflictGame with 2 Nash equilibria.

Man

Pri

ze F

igh

tB

allet

Prize Fight BalletWoman

2

-1 1

-5

-5 2

1

-1

Game Theory and StrategySuppose this game were played sequentially?Would it be better to go first or second?

Man

Pri

ze F

igh

tB

allet

Prize Fight BalletWoman

2

-1 1

-5

-5 2

1

-1

Game Theory and StrategyGame Theory and Strategy

New game: Joe’s sad undergraduate days

Man

Pri

ze F

igh

tB

allet

Prize Fight BalletWoman

10

100 20

4

90 30

8

6

Game Theory and StrategyGame Theory and Strategy

Would you want to move first or second?

Man

Pri

ze F

igh

tB

allet

Prize Fight BalletWoman

10

100 20

4

90 30

8

6

Sources of First Mover Advantages

Economies of ScaleExperience or Learning Curve EffectsBrand Equity“Network Externalities”

- How are you going to use these effects to get a first mover advantage? - How does this lead to a sustainable advantage?

First Mover Disadvantages May Lead To Second Mover Advantages

The Costs of Early Adoption - The “Bleeding Edge” of Technology

Changing Product and/or Process Technology

Changing Consumer Tastes Product TechnologyProcess Technology

Game Theory and Strategy

Initial Game (played simultaneously)

Air

bu

s

No L

au

nch

Lau

nch

No Launch LaunchBoeing

400

400300

300

200 -100

-200

200

How Can “Commitment” Affect A Competitor’s Response?How Can “Commitment” Affect A Competitor’s Response?

Commitment = An Irreversible Action (Sunk Costs)Competition In The Commercial Aircraft Industry

Air

bu

s

No L

au

nch

Lau

nch

No Launch LaunchBoeing

400

400300

300

200 -100

-200

200

Game Theory and StrategyGame Theory and Strategy

Joint Venture

Coop

era

teL.

Race

Cooperate L. Race

112

123112

123

58 91

91

58

How Can “Commitment” Affect A Competitor’s Response?How Can “Commitment” Affect A Competitor’s Response?

Commitment = An Irreversible Action (Sunk Costs)

GM Coop

era

teL.

Race

Cooperate L. RaceToyota

112

123112

-28

58 91

-51

58

How Can “Commitment” Affect A Competitor’s Response?How Can “Commitment” Affect A Competitor’s Response?

Mutual sunk cost commitments

GM Coopera

teL.

Race

Cooperate L. RaceToyota

112

-28112

-28

58 -51

-51

58

Game Theory and StrategyLessons

1. Commitment (sunk costs) can be used to achieve cooperation (e.g., Toyota and GM)

The importance of mutualmutual economic hostages: The wise manager should think beyond Machiavelli’s myopic approach to contracting and should seek both to give and receive credible (sunk cost) commitments that facilitate ongoing relationships and adaptation.

Game Theory and Strategy:Lessons

2. Commitment (sunk costs) can be used to achieve competitive advantage.

•preemption strategy (e.g., Airbus vs. Boeing)

Game Theory and StrategySome key points on strategic commitment:

Always give attention to how your competitors’ returns vary under different strategic scenarios;

It is important to communicate the commitment to the other firms (for both competition and cooperation);

“Sunk cost” investments can be used to pre-commit to a certain strategy and, thus, influence competitor response; and

Understand what strategic investments are important in your business and how “sunk” those investments are.