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Chapter 9: Economics of Strategy

Game theory

Brickley, Smith, and Zimmerman, Managerial Economics and

Organizational Architecture, 4th ed.

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Game theorylearning objectives

• Structure a simple game in both matrix and tree formats

• Specify a simple game• Identify Nash equilibria• Identify dominant strategies

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Game theory overview

• General analysis of strategic interaction

• Optimal decision making when– all decision agents are presumed

rational– each attempts to anticipate actions of

rivals

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Simultaneous-move,non-repeated interaction

• Simultaneous?– Rivals must make decisions with no

knowledge of each other’s decisions

• Nonrepeated?– The interaction occurs only once

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Example

• Boeing and Airbus individually choose and simultaneously submit a bid price (high or low) for 10 planes

• Each cell entry represents the payoffs• A dominant strategy is one the firm

chooses no matter what its rival does

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Strategic formdominant strategy

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Nash equilibriumrevisited

• In the absence of a dominant strategy, Nash equilibrium may predict outcome

• Nash equilibrium is set of strategies where firm does its best given rival’s actions

• Use arrow technique to identify Nash equilibrium

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Nash equilibrium

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Competition versus cooperation

• Boeing and Airbus make simultaneous choices of new communications systems– two technologies: Alpha & Beta– both benefit with same choice

• Results in two Nash equilibria– benefits from pre-commitment

communication

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Coordination gametwo Nash equilibria

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Coordination/competition game

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Mixed strategies

• Mixed strategy offers an element of surprise

• Boeing and Airbus must simultaneously commit to an advertising campaign– Boeing benefits most from same strategy– Airbus benefits most from differentiation

• Randomization with p=.5 is Nash equilibrium for both

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Mixed strategy

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Sequential interactions• Boeing & Airbus communications

technology choice– Boeing chooses first

• Analyze with backward induction– Boeing must take Airbus’s best

response into account in making its choice

– Boeing has first mover advantage• Credible commitment by second

mover can alter first mover choice

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Extensive formsequential game

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Repeated strategic interaction

• Boeing and Airbus compete often• Strategic choices can come to

incorporate more than short-term payoffs

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Strategic interaction and organizational architecture• Kiana manages Lenin• Len must choose between working

and shirking• Kiana must choose whether to

incur monitoring costs• No pure strategy equilibrium exists

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Interactive gameno pure strategy equilibrium

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Appendix Figures

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Payoffs to two memberssingle-period setting

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Generalized payoffs to two members

multiperiod setting

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Payoffs for two team members

low probability of future work together

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Payoffs for two team members

high probability of future work together