Price Theory and Business Behavior by rdh18038

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									             Game Theory
                             Mike Shor
                             Lecture 8



   “The power to constrain
an adversary depends upon
 the power to bind oneself.”
        - Thomas Schelling
             Review

                 Credible commitments require
                       Severe enough punishment to change behavior
                       Irreversible and clear actions


                 Today:
                       Changing the game for strategic advantage
                       Overcoming the prisoner’s dilemma



Mike Shor
                                                                      2
Game Theory & Business Strategy
             Moving Beyond
             the Prisoner’s Dilemma
                 Why does the dilemma occur?
                       Interaction
                            No fear of punishment
                            Short term or myopic play
                       Firms:
                            Lack of monopoly power
                            Homogeneity in products and costs
                            Overcapacity
                            Incentives for profit or market share
                       Consumers                                    Today
                            Price sensitive
                            Price aware
                            Low switching costs


Mike Shor
                                                                             3
Game Theory & Business Strategy
             Altering Firm Behavior
                                                         Not-so-useful advice


                 Firms:
                     Lack        of monopoly power
                            Be   a monopolist


                     Homogeneity            in products and costs
                            Differentiate   product
                            Lower   costs

Mike Shor
                                                                                4
Game Theory & Business Strategy
             Altering Firm Behavior


                 Firms:
                     Overcapacity
                            Reduce  capacity
                            Eliminate the urge to lower prices



                     Incentives      for profit or market share
                            Cross-shareholding
                            Incentives   based on industry profits
Mike Shor
                                                                      5
Game Theory & Business Strategy
             The Prisoner’s Dilemma

              Equilibrium: $40 K
                                              Firm 2
                                           Low        High
                                  Low    40 , 40    65 , 35
                   Firm 1
                                  High   35 , 65    60 , 60


                                                   Cooperation: $60 K
Mike Shor
                                                                        6
Game Theory & Business Strategy
             Cross-Shareholding

                 If each firm acquires 20% of the other:
                                    Low
                 High             35 , 65




Mike Shor
                                                            7
Game Theory & Business Strategy
             Cross-Shareholding
                                                     Firm 2
                                                  Low      High
                                         Low    40 , 40   65 , 35
                                  Firm 1
                                         High   35 , 65   60 , 60

                                                     Firm 2
                                                  Low      High
                                         Low    40 , 40   59 , 41
                                  Firm 1
                                         High   41 , 59   60 , 60

Mike Shor
                                                                    8
Game Theory & Business Strategy
             Altering Consumer Incentives


                 Consumers
                     Price       sensitive
                            Use   customers as hostages
                     Price       aware
                            Less price information to customers
                            Increase search costs

                     Low         switching costs
                            Increase   lock-in
Mike Shor
                                                                   9
Game Theory & Business Strategy
             Hostages

                 Promises can sometimes be credible
                  through a contract with the party to
                  whom you are making the promise

                 Threats can never be credible through a
                  contract with the party to whom you are
                  making the threat

                 Must contract with third party
Mike Shor
                                                            10
Game Theory & Business Strategy
             The Bocchicchio Family


              “ Once a particularly ferocious branch
                of the Mafia in Sicily, it had become
                an instrument of peace in America. ”

                 How can Michael invite Don Tessio
                  for a meeting and guarantee that
                  Don Tessio will not be harmed?
Mike Shor
                                                        11
Game Theory & Business Strategy
             Customers as Hostages:
             Promises

                “I promise to keep prices high”

              Most Favored Customer clause
                       If I ever offer a lower price to any other customer,
                        I will offer it to you as well
                                      Firm 2
                                       High
                    Low              65 , 35 65 customers @ $1
             Firm 1
                    High             60 , 60 30 customers @ $2

Mike Shor
                                                                               12
Game Theory & Business Strategy
             Most Favored Customer Clause

                 Say, in period 1, both firms charge high
                 In period 2, pricing low requires a $1 refund
                  to 30 customers from last period
                                   High
             Low                  65 , 35


                           Firm 1:                     High
                         65 – 30 = 35       Low       35 , 35

Mike Shor
                                                                  13
Game Theory & Business Strategy
             Most Favored Customer Clause
                                                     Firm 2
                                                  Low      High
                                         Low    40 , 40   65 , 35
                                  Firm 1
                                         High   35 , 65   60 , 60

                                                     Firm 2
                                                  Low      High
                                         Low    10 , 10   35 , 35
                                  Firm 1
                                         High   35 , 35   60 , 60

Mike Shor
                                                                    14
Game Theory & Business Strategy
             NASDAQ Order Preferencing
                 You want to buy 100
                                              WXYZ      Ask Size
                  shares of WXYZ
                                              BEST      77   100
                 Your broker must
                  acquire shares at
                                              ABSB      77 ¼ 100
                  best available price        DEAN      77 ½ 100
                 What is MIKE’s incentive    CHAS      77 ¾ 100
                  to undercut BEST?           MIKE      78   100

                 But, your broker has an agreement with DEAN
                  to buy from him if he will match lowest price
                 What’s MIKE’s incentive to undercut BEST?
Mike Shor
                                                                   15
Game Theory & Business Strategy
             Customers as Hostages:
             Threats

             “I will punish you if you lower prices”


              Price Matching Guarantee
                       If any competitor offers a lower price,
                        I will match it


                                   High                             Low
             Low                  65 , 35            Low          40 , 40

Mike Shor
                                                                            16
Game Theory & Business Strategy
             Price Matching Guarantee
                                                     Firm 2
                                                  Low      High
                                         Low    40 , 40   65 , 35
                                  Firm 1
                                         High   35 , 65   60 , 60

                                                     Firm 2
                                                  Low      High
                                         Low    40 , 40   40 , 40
                                  Firm 1
                                         High   40 , 40   60 , 60

Mike Shor
                                                                    17
Game Theory & Business Strategy
             Customers as Hostages

                 Price matching guarantees and most
                  favored customer clauses exploit:
                     customer price sensitivity
                     customer price awareness

                     low customer switching costs



                 Exactly the factors that make
                  price competition brutal!
Mike Shor
                                                       18
Game Theory & Business Strategy
             Increasing Search Costs:
             Theory

              It costs a consumer a transportation
               cost, t, to “visit” another firm
              If consumers expect prices of pe, how
               much should you charge?

              Can charge up to pe + t
              But, if you iterate this
                     If  you charge pe+t, competitor can charge
                        pe+t+t, but then you can charge pe+t+t+t
Mike Shor
                                                                   19
Game Theory & Business Strategy
             Increasing Search Costs:
             Implementation
                 Prevent price advertising
                            Government regulation             (liquor stores)
                            Industry agreement                (likely illegal)
                            Professional trade groups         (doctors)
                 Limit store hours
                                 Closing laws                 (florists)
                 Obfuscate price information (Dilbert “confusopolies”)
                            Provide “one at a time” pricing   (airlines)
                            Require visit                     (grocery stores)
                            Make comparison difficult         (mattresses, insurance)
                            Use multiple prices               (banking, auto dealers)

Mike Shor
                                                                                         20
Game Theory & Business Strategy
             Cooperation Summary

                 Question the assumptions
                     Firms:
                            Market power, differentiation
                            Capacity limits, firm incentives

                     Consumers
                            Pricesensitivity, price awareness
                            Costs of switching and search

                     Interaction
                            Fearof punishment
                            Long-term relationships, uncertain duration

Mike Shor
                                                                           21
Game Theory & Business Strategy
             Commitment Under Uncertainty

                 An offer you can’t refuse
                       After a seemingly successful interview,
                        the interviewer asks where the firm ranks
                        on your list of potential employees

                       Before answering, you are told:
                          The firm only hires applicants who rank it first
                          If the firm is in fact your first choice,
                           then you must accept a job offer in advance,
                           should one be made

Mike Shor
                                                                              22
Game Theory & Business Strategy
             Commitment Under Uncertainty

                 Why make such proposals?
                            Take advantage of your uncertainty
                            Take advantage of your risk-aversion
                            Make you commit before they do!




                 Binding early-decision college
                  applications


Mike Shor
                                                                    23
Game Theory & Business Strategy
             Flexibility vs. Commitment

                 Must balance:
                  Value of commitment
                     Change    in others’ behavior from your
                        committing to some course of action
                        generates value
                  Value of flexibility
                     Keeping     your options open and remaining
                        flexible allows you to react to changing
                        situations (option value)
Mike Shor
                                                                    24
Game Theory & Business Strategy
             Philips, N.V.
                 Commitment in CD introduction
                 Philips: innovator’s advantage
                            Initiate   construction of plant ahead of
                                  competitors
                 Decision problem of Philips in 1982:
                            Build  a disk-pressing plant in the U.S. and
                             invest in a substantial amount of capacity to
                             deter potentially entry (Sony, etc.)
                            Delay decision until commercial appeal of CDs
                             can be determined. Import CDs to the U.S. To
                             “test the waters.”
Mike Shor
                                                                             25
Game Theory & Business Strategy
             Calculating Option Value

                  The science
                 Option Value:
                       Added profit from flexibility (can’t lose)

                  The art
                 Countervailing forces:
                    By waiting, the firm risks:
                     Failing to capitalize fully on an opportunity.
                     Having the opportunity preempted by competitors.

                 What to do?
Mike Shor
                                                                         26
Game Theory & Business Strategy
             Philips, N.V. (continued)
             q  probability of mass acceptance of CDs

                 Pure option value
                                 In the absence of any competition
                                  Philips should wait if q < 0.380
                 Commitment value
                                 If Sony is as well informed about the market as Philips
                                  Philips should wait if q < 0.006
                 Informational advantage
                                 Because of proprietary market information obtained
                                  through its CD operations in Europe:
                                  Philips should wait if q < 0.130
Mike Shor
                                                                                            27
Game Theory & Business Strategy
             Resolution

                 Philips did not build a U.S. Plant in 1983
                            Its     assessment of the likelihood of general
                                  acceptance did not meet the threshold
                 Market realization (surprise!)
                 Sony constructed a U.S. Plant in 1984
                                 Terry Haute, Indiana
                 Philips attempted to compete
                                 Increased capacity in Hanover, Germany plant
                 Philips decided to invest in a U.S. Plant
                                 Only after the Sony plant was fully operational
Mike Shor
                                                                                    28
Game Theory & Business Strategy

								
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