Any Questions from Last Class?

Chapter 13Strategic Games

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Chapter 12 – Take Aways

When a seller cannot identify low- and high-value consumers or cannot prevent arbitrage between two groups, it can still discriminate, but only indirectly, by designing products or services that appeal to groups with different price elasticities of demand, who identify themselves based on their purchase patterns.

If you offer a low-value product that is attractive to high-value consumers, you may cannibalize sales of your high-price product.

When bargaining with a customer, do not bargain over unit price; instead, bargain over the price of a bundle.

Bundled pricing can allow a seller to extract more consumer surplus if willingness to pay for the bundle is more homogeneous than willingness to pay for the separate items in the bundle.

Review of Chapter 12

Conditions associated with indirect price discrimination You cannot identify low- and high-value consumers or You cannot prevent arbitrage between two groups

You can still discriminate, but only indirectly, by designing products or services that appeal to different groups

If you offer a low-value product that is attractive to high-value consumers, you may “cannibalize” sales of your high-price product.

Bundling products “flattens out” the demand curve, and makes it possible to capture more of the consumer surplus.

When bargaining with a customer, do not bargain over unit price; instead bargain over the price of a bundle.

Introductory Anecdote

China 1995 Rural Credit Union raised rates from 9.2% to

10.8% on one-year savings Hunan Development bank matched Capital costs increased at both banks, without

a corresponding increase in deposits, and profit at both banks declined.

1996, Central Bank ended “ruinous competition”

Game Theory

Games Players, strategies, payoffs For analyzing interdependence One firm’s profits depend on rival actions

If each player acts optimally, rationally, and selfishly, we can compute the likely outcome or “equilibrium” of the game

Why use game theory? Helps implement the third “generic strategy” of controlling

competition Study outcome or equilibrium of game and perhaps figure

out how to change the game to your advantage

Sequential Move Games

Players take turns moving, and each player observes what its rival did before it has to move.

To compute the equilibrium of a sequential game, it is important to look ahead and reason back.

Example: simple two-move game First player anticipates how the second will react to various

moves and the payoffs associated with outcomes Each player chooses her best move knowing how the other

will react. Analyze using tree form

Nash Equilibria Named for John Nash

The "father" of non-cooperative game theory Proved the existence of the Nash equilibrium in his doctoral

dissertation at Princeton University Definition

A set of strategies, one for each player, such that no player has incentive to unilaterally change her action

Players are in equilibrium if a change in strategies by any one of them would lead that player to earn less than if she remained with her current strategy

Practice http://mba.vanderbilt.edu/Mike.Shor/courses/game-theory/docs/lectures0123/Equilibria.html

Entry Game (Sequential Move) Entry Accommodation

But, remember, one of the points of studying game theory is to figure out how to gain an advantage

Entrant

Incumbent

enter stay out

price lowprice high

60 , 70 -40 , 0

0 , 100

Entry Game (Sequential Move) Entry Deterrence A credible threat to price low if entry occurs

will deter entry Difficult to make this threat credible

Entrant

Incumbent

enter stay out

price low

-40 , 0

0 , 100

Simultaneous Move Games

Players move simultaneously Does not require players moving “at same time” Requires that each player makes move without

knowing other player’s move in advance Analyze using matrix or reduced form

Prisoners’ Dilemma

Prisoners’ dilemma Two suspected criminals being interrogated If only one confesses, the one who confesses goes free,

while the other one receives ten years in jail. If they both confess, each receives five years in jail. If neither confesses, they both serve two years.

Why the PD is interesting

Equilibrium is for both to confess But, they BOTH would be better off if neither

confessed By following self interest, the players make

the group worse off Tension between conflict (self interest) and

cooperation (group interest) inherent in the game

Need to devise ways to escape the dilemma

Prisoners’ Dilemma in Business Pricing dilemma

Both would be better off if they could Price High But, that outcome is not an equilibrium Need to find a way to “coordinate” actions BUT, beware violating the law

More Dilemmas

Price discrimination dilemma

Even More Dilemmas

Advertising dilemma

Even More Dilemmas

Free riding dilemma

Lessons of Prisoners’ Dilemma

Don’t get caught in one Change payoff structure of game so your profits are not

dependent on others’ actions Differentiate product Lower costs

How to get out of one (Axelrod’s Tournament) Be nice: no first strikes Be forgiving Be easily provoked Don’t be envious Be clear

Control competition LEGALLY!!

Game of Chicken

Two equilibria Try to manipulate game to get the one you want Coordination or communication is important

Game of Chicken (Market Entry) Exploit first-mover advantage

Firm A

Firm B

S. Africa Italy

S. AfricaItaly

50 , 100 -50 , -50 100 , 50

S. AfricaItaly

0 , 0

Dating Game

Dating Game

Cooperation between divisions

Shirking/Monitoring Game

No equilibrium in pure strategies So “mix” to avoid being taken advantage of

Alternate Intro Anecdote In 1992, America Airlines (AA) announced a new pricing strategy -

Value Pricing. American narrowed the number of fares possible from 500,000 to 70,000 by

classifying each into one of four classes (first class, coach, discounted 7 and 21 day purchase) and began pricing based on flight length.

Changes resulted in lower list prices for both business and leisure travelers. According to AA, Value Pricing was to create “simplicity, equity, and

value” in their prices Company expectations

Demand would be stimulated Volume on AA planes would increase Overall growth in market share and profitability would follow

What really happened?? Competitors responded aggressively by cutting prices Industry profits plummeted Value Pricing initiative abandoned within months of its launch