Managerial Economics Economics of Strategy Game Embedded Strategy

Managerial Economics: Economics of Strategy Game Embedded Strategy Patrick Mc. Nutt www. patrickmcnutt. com Abridged ©

Workshop Lesson plan…. • • Plan is to follow Besanko’s Economics of Strategy 5 th Edition Day 1: Introduction and setting the scene using Mc. Nutt’s Game Embedded Strategy Chapters 1 and 2 Day 1 : Revision of Chapters 3 and 5 (Used in Assignment No 1) and Introduce Chapter 2 (Economies of Scale and Scope) Day 1 Workshop Study Groups & Case Analysis Break-out Sessions at 330 -530 pm Day 1 and Day 2 with group Presentation Day 3 at 2 pm start Day 2 & 3: Focus on Chapters 8, 9, 10 and 11 and link into Units 3 and 4 Extra Chapters & Topics at the discretion of Workshop Director

Workshop Focus • Signals, Management type and relevance of TCE. . Unit 1. Besanko Ch 3 and 5, Mc. Nutt Ch 1 • Cost leadership and economics of capacity. . commitment Unit 2. Besanko Ch 2 and Mc. Nutt Ch 5 • Market-as-a-game…market structure, oligopoly, and dynamic games of rivalry…Units 3 and 4. Besanko Ch 8, 9, 10 and 11 and Mc. Nutt Ch 6, 7, 8, 9 • Real Time case Analysis…go to Page 45 of colourcoded Storybook

Workshop Case Study • Case assignment and group allocation • Objective is to define game dimension, construct a CTL, define near-rival and find NE • Focus on geography and on a product [to include an innovation, technology, service] • Research ‘sum of competitors’ in the market-as-agame • Apply the course materials as discussed in class as ‘filters’ to narrow research.

Strategy architecture: Observe patterns over time period t = NOW time period t+ 1 = WAY FORWARD d. T/dt = -1

Q: Why the game theoretic focus? A: At the frontier of economic analysis…. . • Management observed as ‘they are’ not ‘assumed to be’ • Management can be ranked (by type) and are faced with trade-offs => something must come ‘top of the menu’ • Firms are conduits of information flows (vertical chain) • Supply chain capacity constraints and technology-lag • Reducing price does not necessarily lead to an increase in revenues (elasticity) • Prices are primarily signals (observed behavior) • Companies understand the competitive threat as (recognised) interdependence (zero-sum and entropy)

Focus on signals and type. . Baumol type, Marris type, CL type, Player types Why? Key to understanding firm behaviour & company strategy as observed in real time

Costs of not being a Player in the market-as-a-game • Agency costs can accrue. . across the shareholders (esp institutional). . changing CEOs • Bounded rationality and opportunity costs with trade-offs • Make or Buy dilemma • First Mover Advantage (FMA) v Second Mover Advantage (SMA) • Play to win v Play not to lose! • Follower status ‘behind the curve’ • Technology lag and failure to differentiate ‘fast enough’ to sustain a competitive advantage

The competitive threat! • Traditional Analysis can be biased towards answering this question for Company X: what market are we in and how can we do better? • Economics of strategy (GEMS) asks: what market should we be in?

Unit 1 Management Models • Understand Penrose effect and GHM Theory (Besanko pp 158 -161) and incomplete contracting • Explain the rule MC = MR • Understand Bounded Rationality • Go to Table 1. 2 pp 14 Mc. Nutt Game Embedded Strategy Compare with Next Slide where you add in Williamson/TCE

Behavioural Baumol Marris Williamson Objective Multiple goals TR: Sales Growth: gd Managerial Utility or Value Approach Satisficing – subject to Profit Constraint Maximisation - subject to Security Constraint Maximisation - subject to Profit Constraint Principal Agent Issue Yes Yes Short v Long Term Varies Short and also dynamic Long Short Reaction & Interaction Yes Partial Decision Making Coalitions Yes Management and zero-sum Relevance of shareholders Yes, . . TCE

Baumol strategy or Maximising Market Share: MMS • Recognise zero sum constaint and entropy (redistribution within market shares) • Market Shares (before): 40+30+20+10 • Zero-sum (after): 30+40+20+10 • Entropy (after): 30+35+25+10 • Iff {∆qi/∆Q} > 0 market exhibits nonprice competition: • Check {∆q. NOKIA/∆QSmartphones} < 0

Total Cost £ Total Revenue Min Profit Constraint Output Sales driven beyond the point of max profit but within the minimum profit constraint Profit/Loss

MMS-strategy • Entropy when the industry elasticity ηp is less than the firm-specific elasticity: ηp < єp • Player a’s market share equation: MSa = [ηp + σ. MSb]/єp • Market Penetration: єp < σ. MSb and Market poaching σ < 1

Precis on a Marris model… • Mc. Nutt Ch 4: Understand balanced equation gc = gd to identify parameters of profitability • Supply of capital: debt v equity • Demand for capital: R&D exp v dividends • Instrumental variables influencing growth – visit Diageo case in Kaelo v 2. 0 • KFIs: profits/output and output/capital • Marris v = Tobin’s q ratio

Marris equations: dividends paradox & operating gearing • Understand the α = operating gearing…. . how much extra profit earned from every $1 of extra revenue gd = gc = αp • P = eps/r : Static firm no growth opportunities • P = eps/r + PV(GO): Dynamic firm with growth opportunities (GO)…this is a Marris firm’s focus on gd. • Mc. Nutt p 50: Alternative to Calculating share price by DCF formula : share price pattern embedded in BGP equation as quadratic function of vertex form (h, k), where k is the share price turning point on the BGP and h is proxy for gd.

Marris v and Tobin q • Allow q = v, and if (mean reversion) v < mean v then share prices should increase • Marris v is a long term tool not a short term tool • If v < 1 BUY. . if v > 1 SELL: Common denominator is the plough-back ratio (PBR) = 1 – divs/eps. • But more R&D from G 1 to G 2 can accrue an agency cost as Bayesian shareholders SELL as value falls V 1 to V 2. • More dividends could signal an absence of R&D growth

Focus on the cost technology, vertical chains and cost leadership Why? Need to observe the supply chain and a sustainable competitive advantage

Bridge Unit 1 and Unit 2 • • Shareholder as principals expect max value Management to minimise the agency costs Positive Learning Transfer, PLT Nomenclature on type: Baumol type (signal = price), Marris type (signal = dividends). • Cost leadership type (Mc. Nutt Ch 5, Besanko Ch 2 and link into Besanko Ch 13 on stategic cost advantage)

TCE & Co-ordination • Coase asked in ‘ The Nature of Firms’ in 1937: Why are not all economic transactions coordinated by markets? • • • When transaction costs are too high, exchange to be coordinated by organisations Transaction costs: costs of negotiating, monitoring and enforcing contracts. Behavioural assumptions: bounded rationality & opportunism. The relative cost of organising transaction through different forms of governance determined by: • Extent to which complete contracts are possible. Where contract refers to agreement between two parties which could be explicit or not. • Extent to which there is a threat of opportunism by parties in the transaction. • Degree of asset specificity in the transaction. • Frequency with which the transaction is repeated. Storybook p. 12

Emphasis in Unit 2: Cost leadership as a type (of player) • Profitabiltiy v scale and (size and scope) • Production as a Cost-volume constraint • Understanding the economcis of productivity as exemplar for incentives • Normalisation equation • Sources of Cost Efficiency [next slide] • Cost leadership type checklist. . Mc. Nutt p 61

Sources of cost efficiency • Measure of the level of resources needed to create given level of value Capacity utilisation How much to produce given capital size? Other Economies of scale X-inefficiencies, location, timing, external environment, organisation discretionary policies How big should the scale of the operation be? Transaction costs Production-cost relationship Which are the vertical boundaries of the firm? Economies of scope What product varieties to produce? Learning and experience factors How long to produce for?

MES Point: Production - demand - production to attain cost leadership £ SAC 1 SAC 2 Lower per unit cost for more units sold SAC 3 LAC Av. Cost = marginal cost 0, 0 q 1 qt Current plan of plant closures to lower cost base not completed q 2 Q

Capacity Constraints: Why ? Sustainable competitive advantage • Case A: Unexhausted economies of scale due to lag in product differentiation. . excess capacity? • Case B: Firm-as-a-player cannot produce sufficient output to reach MES. . zero-sum? • Case C: Firm-as-a-player restraints production (deliberate intent). . Mc. Nutt’s dilemma as production drives demand…(Veblen monopoly type) • Speed of technology increases the firm-specific risk of Case A. . CLASS QUESTION: adopt Case C to solve A?

Focus on player strategy set in a game dimension So: dark strategy S 1: limit pricing strategy S 2: credible threat strategy

Oligopoly and Game Theory T 3 + GEMS • • Study of strategic interactions: how firms adopt alternative strategies by taking into account rival behaviour Structured and logical method of considering strategic situations. It makes possible breaking down a competitive situation into its key elements and analysing the dynamics between the players. • Key elements: • Players. (Management). • Strategies. • Payoffs • Equilibrium. Every player plays her best strategy given the strategies of the other players. Objective. To explore oligopolistic industries from a game embedded strategy (GEMS) perspective. The use of T 3 framework, which considers 3 key dimensions (Type, Technology & Time), will allow oligopolists to better predict the likely strategic response of competitors when analysing competition from game embedded strategy perspective. • •

Unit 3: Game type and signalling • Decisions are interpreted as signals • Observed patterns and Critical Time Line. Nissan CTL pp 20 or Apple CTL p 94 in Mc. Nutt • Recognition of market interdependence (zerosum) • Price as a signal v Baumol model of TR max • Scale, size and capacity: cost leadership signals • Dividends as signals in Marris model

Bridging Unit 1 and Unit 3: Game analysis • Binary reaction; Will Player B react? Yes or No? • If YES, decision may be parked • If NO, decision proceeds on error • Surprise • Non-binary reaction: Player B will react. Probability = x% • Decision taking on conjecture of likely reaction • No Surprise

What determines the intensity of rival competition? • Price Bertrand games [strategic complements + elasticity] and non-price Cournot games [strategic substitutes + zero sum]. • Reaction, signalling and ‘best you can do, given reaction of competitor’ • Moonshots, noise and cheap talk in a signalling game (on rival costs, rival capacity) • Patterns of observed behaviour & likely reaction • Leader-follower as ‘knowledge’ and trust • Accommodation v entry deterrence • ’

Link Units 3 and 4: Game Dimension • • • What is a game – loss of independence? Nash premise: Action, Reaction and Reply Non-cooperative sequential (dynamic) games Introduce oligopoly and players (companies) n < 5 TR Test and Elasticity Mc. Nutt pp 36 Single shot price reduction: (i) fail TR test and revenues fall; (ii) near rival misreads the price as a signal

Type of Players • Incumbent type v entrant type • Dominant type v monopoly incumbent • De novo entrant type and geography of the market • Potential entrant type and the threat of entry • Newborn players and extant (incumbent) type

Limit Pricing Model in Besanko pp 310 -318 and Mc. Nutt pp 71 -76 • Outline the game dimension: dominant incumbents v camuflaged entrant type • Define strategy set for incumbents • Allow entry and define the equilbrium • Preference - entry deterrent strategy v accomodation [next slide]

Entry Deterrent Strategy • • Reputation of the incumbents Entry function of the entrant De novo and entry at time period t Potential entrant - forces reaction at time period t from incumbent • Coogans bluff strategy (classic poker strategy)

Describe (prices as signals) game dimension • Focus on the Sony v Microsoft game in Mc. Nutt Fig 9. 3 and Fig 9. 4 pp 115 • Players and type of players • Speed and frequency of reaction in the CTL • Observe the pattern of observed behaviour • Identify a Nash equilibrium…sequence of price reactions towards NE…. sequence of non-price signals on output towards NE. • Identify intersection of reaction functions

Continuing with Unit 4: Define a price war • Determine the Bertrand reaction function • Compute a Critical Time Line (CTL)from observed signals. . Examples of CTL in Mc. Nutt pp 20 Figure 2. 1 and pp 94 Fig 7. 4 • Find a price point of intersection • Case Analysis of Sony v Microsoft at Mc. Nutt pp 114 -116 and also in Kaelo v 2. 0

Visit Kaelo v 2. 0 and Games/Signalling • Example: Critical Time Line in Sony v Microsoft in Kaelo v 2. 0, Apple v Nokia game dimension Mc. Nutt pp 92 • Play a PD game and investment game in Kaelo v 2. 0 • Altruism, fairness, selfish gene, dominant strategy, minimax • Understand NE: if neither player would gain by unilaterally changing strategy

Nash Equilibria • Define the Nash equilibria [next slide] • Analyse the Payoff matrix (B, Y) > (A, X) • Commitment and chat • Punishment strategy • Strategic Tool. Box in terms of credible mechanisms

Prisoners’ Dilemma Player 2 Strategy A Player 1 Strategy B Strategy A 2 2 0 3 Strategy B 3 0 1 1 • Would outcome change if the game is repeated? The Folk Theorem • Apply Prisoners’ Dilemma to Pricing Policy: Elasticity and Threat of Entry Firm 2 profit payoffs Firm 1 payoffs High Price $6 Low Price $4 High Price $6 10 x 13 Low Price $4 13 2 2 10 y

Games as Strategy: Strategic Tool. Box • Segmentation strategy to obtain FMA • Relevance of chain-store paradox • Dark Strategy and 3 Mistakes in Mc. Nutt pp 95 -97 • Second Mover Advantage, SMA: Play not to lose v play to win (FMA) • Strategic Tool. Box in terms of identifying the competitive threat v cartel coordination on (High). . Cheating

Class Exercise: Find Nash Equilibrium? • Two players must simultaneously decide which strategy to adopt. Strategy A Strategy B Strategy A 3, 3 2, 4 Strategy B 4, 2 1, 1 • Does this example illustrate the concept of first mover advantage v second mover advantage • Should the players chat to avoid (1, 1)? .

Absence of price wars? Link into the HBR articles • Hypothesis: Price Wars occur due to a mis-match in price signals. • Mismatch can occur (i) declining volumes ∆qi/∆Q < 0; (ii) uncompetitive cost structure (productivity); (iii) technology & time; (iv) management type.

GEMS and Strategic Analysis • Knowledge of the identity of near rival: Actionyou -> Reactionrival -> Nash. Replyyou Fig 9. 4 p 115 Mc. Nutt & Fig 8. 3 p 231 Besanko

Game Embedded Strategy: GEMS: Complete the Diagram What Market should Your Company be in? Games & Feedback

Final Scenarios for YOUR Company…… • The Rationale • The Strategy Markets evolve Non-binary • The Rationale • The Strategy Type, Technology and Game metrics and Time analytics • The Rationale • The Strategy Know your market GEMS

Thank you for participating……… Sapere aude ‘That which one can know, one should dare to know’