@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

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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 competitor’s 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

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

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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

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

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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?

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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

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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

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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?

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

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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

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

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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

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

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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

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

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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

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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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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

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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 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

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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• Axelrod’s 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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Litho

LithoMake prints

Do not

consumer

Buy

Do not

Make more prints

Do not

• serial number• destroy the plate• other solution?

Strategic move: Lithographer

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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 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

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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

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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 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

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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

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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

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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

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Conditional strategic move: strike

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

baseball?

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Union

do not

reject union demand

Employer

accept

strike Lose current wageand possibly gain infuture wage

Maintain current wage

Conditional strategic move: Strike

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Conditional strategic move: Deposit insurance

depositor

maintains deposit

withdraws deposit

bank

run

remains solvent n.a.

?

bank

run

remains solvent n.a.

?

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Conditional strategic move: Hyperinflation

• How to use promise to guard against hyperinflation?