More Frameworks

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More Frameworks Game Theory

• Rob Seamans Richard Wang
• MBA 299 Strategy
• April 25th, 2008

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This week

• Mid-term Recap
• Value Net
• Transaction Cost Economics
• More Simultaneous Move Games
• Oligopolies

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Mid-Term Recap

• Overall quality of the midterms was high
• Specific things to think about
• Penetration Is it realistic to assume that the
  low penetration rate means there is a huge
  opportunity if VMware can increase penetration to
  100?  The telephone penetration in US still is
  not at 100 current penetration probably
  represents low hanging fruit, it will be costly
  to increase penetration.
• Projections If you project that by 2019 Linux
  will overtake Windows, this implies that the
  server market will triple in ten years is this
  realistic?  Is this realistic given that one
  function of VMs is to reduce server sprawl?
• Competitor Reaction If you suggest that VMware
  partner with Red Hat, you need to explain what is
  in it for Red Hat (think about how Professor
  Leonard asks students to role play negotiations).
  Also, will this partnership change how Microsoft
  reacts? Might it lead to Microsoft speeding up
  delivery of its VM?

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Mid-Term Recap Moving Forward

• The following list should be helpful for future
  memos (and final!)
• Have an organized answer don't just start
  writing.  Use a framework to help organize your
  answer.  Describe your recommendation up front
  and then build support for the recommendation in
  the body of your paper.
• Don't recap what we already know from the case
  (waste of space)
• Don't spend too much time on industry analysis
  move quickly to strategic recommendations
• Don't make sweeping or categorical statements
  about what the strategy should be (e.g. "invest
  heavily in RD" or "optimize their strategy")
  instead, focus on how the strategy should be
  implemented
• Justify your recommendations
• Use quantitative analysis to support your
  argument
• . but don't insert tables from the case without
  using them in an analysis
• Make sure to support the assumptions you make
• Consider sensitivity analyses to see how your
  assumptions affect outcomes

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Dianne Greene
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This week

• Mid-term Recap
• Value Net
• Transaction Cost Economics
• More Simultaneous Move Games
• Oligopolies

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The value net

• The value net holds that the amount of value a
  company can capture is both defined and
  constrained by other players in the net

Customers
Company
Complementors
Competitors
Suppliers
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Complementor vs. Competitor axis looks at your
ability to sustain value capture

• A player is a complementor if customers value
  your product more when they have the other
  players product than when they have your product
  alone.
• Oscar Mayer and Colemans mustard
• A player is a competitor if customers value your
  product less when they have the other players
  product than when they have your product alone.
• Pepsi and Coke

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Who are the complementors?

• Cars Auto loans, insurance, roads
• Televisions VCRs, satellite TV
• TV shows TV guide
• Fax machines Phone lines
• Catalogs Delivery services
• Hardware Software
• GameCube Game titles
• Complementors are critical to business success!

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However, complementors can steal value!

• Computer industry example
• Microsoft and Intel are complementors of computer
  hardware companies, yet they constrain the value
  hardware players can capture
• How is Dell a complementor rather than a computer
  manufacturer?
• Value net is also complementary to core
  competencies you may figure out non-central
  activities allow most value capture
• These dynamics mean you may have uneasy
  relationships with complementors, even though
  they are necessary to increase total value of an
  industry

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Changing the players can increase your value
capture

• Bring in customers - Increase industry demand.
  This helps competitors, but may be worthwhile for
  you. To do this
• Educate consumers about your product (Diapers in
  Asia)
• Pay customers (esp. early adopters) to play
• Subsidize some customers, other full paying
  customers will follow (Initial discount to lower
  risk)
• Bring in suppliers
• Compaq / AMD / Intel
• Bring in complementors
• Do it yourself. Nintendo - both h/w s/w. Intel
• Pay complementors to play (at least initially)
• Bring in competitors does this ever make sense?
• Sometimes!

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This week

• Mid-term Recap
• Value Net
• Transaction Cost Economics
• More Simultaneous Move Games
• Oligopolies

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Two major rationales for vertical integration

• Rationale 1 Increase market power
• Ability to charge higher prices or price
  discriminate
• Foreclose competitors from suppliers or customers
• Rationale 2 Improve economic efficiency
• Improve technical or productive efficiency
• Lower costs by joining parts of value chain
• Improve transaction efficiency
• Reduce hold-up when suppliers have power
• Increase investments which may be risky due to
  hold-up
• Improve incentives (agency efficiency)
• Reduce incentive conflicts or allow better
  monitoring

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However, vertical integration has costs

• Costs of vertical integration
• Can add layers of bureaucracy or management
• Outside core competencies, can we get it cheaper
  from the market?
• Are market incentives better in motivating
  managers?
• Can raise intra-organization influence costs
  (lobbying, decisions that are inefficient but
  benefit one part of the firm)
• Can turn previous suppliers or customers into
  competitors, increasing costs or decreasing
  market size

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Transaction cost economics focuses on
relationship-specific investments

• A relationship-specific investment is one that
  isnt very valuable for another trading partner
  except the one who benefits from it
• Site specificity you locate your plant right
  next to a customers factory
• Technical specificity you build expensive metal
  molding equipment for a specific car
• Dedicated asset specificity you undertake a
  major specific investment with a specific
  customer in mind, and a very thin market
• Human capital specificity you train all of your
  employees on the specialized equipment of a
  certain supplier

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Why horizontally integrate?

• Scale
• Market power, exploit economies of scale,
  increase power with suppliers
• Leverage know-how across new customers, channels,
  products and/or technologies
• Access a growing market

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This week

• Mid-term Recap
• Value Net
• Transaction Cost Economics
• More Simultaneous Move Games
• Oligopolies

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Coordination Games Divide the Market
B
Segment A Segment B
-1,-1
1,3
Segment A Segment B
A
-1,-1
3,1
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Zero-Sum Games Matching Pennies
B
Heads Tails
1,-1
-1,1
Heads Tails
A
1,-1
-1,1
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Some examples of the coordination games
prisoners dilemmas

• Prisoner's dilemma
• Pricing decisions when there are only a few firms
• Coordination games
• Timing of advertisements on TV/radio
• Entry into (CSG) markets
• These games differ in the amount of commitment
  required and what communication can get you in
  terms of outcomes

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This week

• Mid-term Recap
• Value Net
• Transaction Cost Economics
• More Simultaneous Move Games
• Oligopolies

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COURNOT DUOPOLY WITH IDENTICAL FIRMSSet-up

• Two identical firms (firm 1 and firm 2) produce
  widgets
• Firms choose their quantities (q) simultaneously
• Profit for each firm (i) is given by the standard
  function
• p i Pqi Ci(qi)
• For simplicity assume no fixed costs Ci(qi)
  cqi
• p i Pqi ciqi
• Note that total supply is Q q1 q2
• Assume demand is linear Qa-P
• P(Q) a Q (inverse demand)
• Assume c lt a

P
c
Q
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COURNOT DUOPOLY WITH IDENTICAL FIRMSSolution

• p i(q1,q2)P(Q)qi - cqi
• qiP(qiqj)-c
• qia-(qiqj)-c
• Recall Nash EQM gt max p i given js best play
  (and vice versa)
• How do we find the maximum of a function? Take
  derivatives!
• F.O.C. with respect qi for firm i (assuming
  qjlta-c) is . . .
• a 2qi qj c 0
• qi ½(a qj- c)
• Solving the pair of equations by substitution
• q1 ½ (a q2 c) ½ (a ½(a q1 c) c)
• (3/2)q1 ½ (a c)
• q1(a-c)/3 q2

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COURNOT DUOPOLY WITH IDENTICAL FIRMSIntuition

• Remember that the monopoly outcome is
• qm(a-c)/2
• pm (a-c)2/4
• The optimal outcome for the two firms would be to
  divide the market at the monopoly output level
• For example qiqj ½ qm
• But each firm has a strong incentive to deviate
  at this qm
• Check ½ qm is not firm 2s best response to ½
  qm by firm 1

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COURNOT EQUILIBRIUM WITH Ngt2Homogeneous
Consumers and Firms
Solution pi (q1,q2 . . . qn) qiP(Q)-c
qia-bQ-c Recall Nash EQM gt max profit for i
given all other players best play So F.O.C. for
qi, assuming qjlta-c qi1/2(a-c)/b
?qj Solving the n equations q1q2 . .
.qn(a-c)/(n1)b
j?i
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COURNOT DUOPOLY (N2)Homogeneous Consumers,
Firms Have Different Costs
Solution pi (q1,q2) qiP(qiqj)-ci
qia-(qiqj)-ci So F.O.C. for qi, assuming
qjlta-c qi1/2(a-qj-ci) Solving the pair of
equations qi2/3a - 2/3ci 1/3cj qj2/3a - 2/3cj
1/3ci
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STACKELBERG DUOPOLOYGame Set-up

• Firm 1 moves first and chooses q10
• Firm 2 observes q1 and chooses q20
• Payoffs are ?(qi,qj)qiP(Q)-c
• P(Q) a - Q
• Q q1 q2
• Solve by backwards induction

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STACKELBERG DUOPOLOYEquilibrium Outcomes

• Firm 2
• max ?2(q1,q2) max q2a-q1-q2-c
• q20 q20
• q2R2(q1) a - q1 - c/2 (assuming q1 lt a -c)
• Firm 1
• anticipates Firm 2s move
• max ?1(q1,R2(q1)) max q1a-q1-R2(q1)-c
• q10 max q1a-q1-c/2
• q1 a-c/2 and R2(q1) q2 a-c/4

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STACKELBERG DUOPOLOYAnalysis (I)

• Recall the Cornout duopoly outcome was a-c/3
  for both firms so total output is higher in the
  Stackelberg game . . . and therefore prices are
  lower
• Cornout total output 2a-c/3
• Stackelberg total output 3a-c/4
• Firm 1 is better off in the Stackelberg game but
  Firm 2 is worse off
• Firm 1 could have chosen the Cornout output level
  but did not therefore Firm 1 must be better off
• Firm 2 produces less at lower prices so must be
  worse off

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STACKELBERG DUOPOLOYAnalysis (II)

• Observe the role of information
• Firm 1 knows that Firm 2 will optimize its
  output based on what Firm 1 does
• Firm 2 knows that Firm 1 knows that Firm 2 will
  optimize its output based on what Firm 1 does
• Order matters too
• If Firm 1 went after Firm 2 and Firm 2 chose
  a-c/4, Firm 1s optimal output would be
  3a-c/8 . . . so Firm 2s choice would not be an
  equilibrium outcome . . . and we would end up
  back at the Cournot output level

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STACKELBERG DUOPOLOYIntuition

• Firm 1 is the dominant firm, in fact it acts like
  a monopolist, while Firm 2 takes the scraps off
  the table (acting as a monopolist in the
  remaining market)
• Firm 1 is the first mover in a market while Firm
  2 is the late-comer
• Note the difference in equilibrium in a
  sequential move game versus a simultaneous move
  game
• Do you observe this effect in the CSG game when
  you are entering a market already held by an
  incumbent?

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Next week

• Preparation for Final Exam