Republic of the Philippines

Laguna State Polytechnic University

ISO 9001:2015 Certified Level I Province of Laguna
Institutionally Accredited

Lesson Title: STRATEGIC DECISION MAKING AND UNCERTAINTY

Description of the Lesson

 This lesson will explain how strategic decision making is important for a business. Explain
the three basic strategies for slowing profit erosion: reducing costs, differentiating your
product, and reducing competitive intensity.
 This lesson will also discuss about the strategic and non-strategic view of bargaining.
 This lesson will also explain the uncertainty. Explain about making decisions with
uncertainty, the auction, and the common value of auction.
 This lesson will also discuss the problem of adverse selection and the problem of moral
hazard.

Intended Learning Outcomes

Students should be able to meet the following intended learning outcomes:
 Demonstrate understanding on how strategic games important for business decision
making.
 Identify the different strategic games.
 Explain the strategic and non-strategic view of bargaining.
 Demonstrate understanding on how to make decisions with uncertainty.
 Explain auctions and the common-value auctions.
 Identify the problem of adverse selection and moral hazard.

Lecture Guide

STRATEGIC DECISION MAKING

STRATEGIC GAMES

Game theory is the study of strategic decision-making. It talks about interactive

decision-making, where the outcome for each participant or "player" depends on the
actions of all. If you are a player in such a game, when choosing your course of action or
"strategy" you must take into account the choices of others. Studying game theory
doesn’t just help you figure out what’s likely to happen; it also gives you insight on how
you might be able to change the game to your advantage.

Sequential Move Game

 A sequential move game whereby the players observe their rival's utilizing decisions
before deciding on their own strategy. Players calculate the expected result by
thinking ahead and backwards and projecting how their actions will be interpreted in
the future. Wherein this enables them to predict the results of their own actions with
accuracy.

It is used in game theory to predict the outcome following a chain of events involving
at least two parties who make decisions that impact the satisfaction of the other
parties.

Sequential games are represented by using the extensive or tree form (decision tree)

Example:

To illustrate a sequential game, consider the small city of San Pablo, where there is
only one coffee shop, Shane’s Caffeine Corner. Shane currently makes PHP 50,000 a
year in profit. Let's say Jen has relocated to San Pablo City and is thinking of launching
Jen's Brewed Bliss, a coffee business. Since Shane owns the only restaurant in the
community, she currently has a monopoly and can set higher prices. However, she and
Jen would rule the San Pablo coffee shop market if Jen opened one. In addition to
losing revenue and market share, Shane would probably have to reduce her prices.
Shane has two choices: she can either start a price war by sharply cutting her pricing
and maintaining her market share by driving Jen's brewed bliss out of business, or she
can work with Jen, knowing that she will lose market share. The game is done, and
nothing changes if Jen chooses not to start a coffee shop.

Within game theory, a decision-making theorem identified as the Nash equilibrium

asserts that a player cannot attain the intended result by sticking to their original
plan. Wherein each player's strategy is optimal when considering the decisions of
other players.

In contrast to sequential games, another game theory which is simultaneous-move

games which occurs when players decide on a strategy and move without being aware
of the other players' actions.

PRISONERS’ DILEMMA

In the prisoners’ dilemma, conflict and cooperation are in tension, self-interest leads
the players to outcomes that no one likes, or it illustrates the difficulties that the
decision makers experience when they do not cooperate with each other. But the truth
behind this game is that they need to cooperate with their competitors because if they
don’t, it will cause much conflict on their side. Studying the games can help you find a
 way to avoid those bad outcomes.

The conflict of selfishness in prisoners’ dilemma happens due to the greediness of each
business to have greater profits and success towards their competitors in the business
world. They tend to make decisions that they think will be beneficial for them and at
the same time will be at the cost of the other player or competitors.

Example:

Imagine these prisoners A and B are two business competitors. A and B are arrested for
a crime, but the police do not have enough evidence to convict either of them, so they
offer them a deal

1. If both remain silent, they will go to jail for one year.

2. If one of them betrays and confesses. The confessor will go free and the other one
who did not confess will be jailed for 3 years.

3. If both confess, they will serve each sentence for 2 years.

One’s selfish optimal strategy: To confess to be free from punishment.

Worse outcome of selfishness: Both of them will confess.

Actual Optimal Strategy: Cooperate with other parties and choose to remain silent
since it will be beneficial to both.

This can be modeled as game theory since A and B are the players and their choices are
whether to confess or remain silent, the outcome of the game are the sentences they
will receive.

In this scenario, each player must consider the potential actions and strategies of other
players when making their own decisions.

 If A believes that B will confess, then his optimal strategy is to confess as well so
he will not be sentenced.
 However, if each player acts with their own interest to be free then both of them
confess, they will receive a sentence of two years.
 Therefore, the optimal strategy must remain silent since they will be sentenced
shorter or only 1 year.

This example illustrates the essence of game theory which is to analyze strategic
interactions between decision- makers to identify the optimal outcomes. And
Prisoners’ Dilemma which is to consider or cooperate with your co-decision makers.

The message of PD is that when each of two (or more) parties acts selfishly and does
not cooperate with the other, they do worse than when they act unselfishly and
cooperate together.

Prisoners’ Dilemma can be observed also in real-life business situations. For example,
two brands engaged in a price war may well be caught up in a Prisoners’ Dilemma.
Each brand knows that if he has lower prices than his rival, he will attract his rival’s
customers and thereby increase his own profits. It is based on the Law of Demand, that
if the price goes down, the demand goes up. But if both of them decide to lower their
prices, it will result in both gaining customers but earning smaller profits.

Prisoners’ Dilemma could be resolved if the game were played repeatedly. Players
would learn that they do best when both act unselfishly and cooperate. Because if one
player failed to cooperate in one game, the other player could strike back by not
cooperating in the next game, and both would lose until they began to “see the light”
and cooperated again.

To see this, suppose two skincare lines set up their booths in a 10-day bazaar. And
there is a price war between them.

If one of the brands made the first strike, there is a tendency that she would be affected
at the end if he became selfish and uncooperative. When the game is played repeatedly,
and neither player knows when the sequence will end, that the cooperative strategy
can succeed.

This game theory reminds us that in business it is not always being selfish, you need to
consider others, even your competitors, in your decisions. We need to be sure and
careful in business decisions, such looking to other relevant outcomes of those. In
repeated games, it is much easier to get out of bad situations. Here are some general
rules of thumb:

• Be nice. No first strikes.

• Be easily provoked: Respond immediately to rivals.

• Be forgiving: Don’t try to punish other players too much.

• Don’t be envious: Focus on your own slice of the profit pie, not on your competitor’s.

• Be clear: Make sure your competitor’s can easily interpret your actions.

PRISONERS DILEMMA

Prisoner's Dilemma describes a situation wherein, according to game theory, two

players acting selfishly will ultimately result in a suboptimal choice for both. It was
conceptualized by Merrill Flood and Melvin Dresher at the Rand Corporation in 1950.
Later on, it was formalized and named by Canadian Mathematician Albert William
Tucker. The typical prisoner's dilemma is set up in such a way that both parties choose
to protect themselves at the expense of the other participant. As a result, both
participants find themselves in a worse state than if they had cooperated with each
other in the decision-making process.The prisoner’s dilemma presents a situation
where two parties, separated and unable to communicate, must each choose between
cooperating with the other or not. The highest reward for each party occurs when both
parties choose to cooperate. To easily understand the prisoner's dilemma here is an
example: there are 2 robbers A and B. They have been arrested and are being
interrogated in separate rooms. Authorities do not have any witnesses and can only
prove the case against them if they can convince at least one robber to betray his
accomplice and testify to the crime. The robbers have the choice to cooperate or defect
and testify to the investigators.

OUTCOME B B
COOPERATES DEFECTS
A (1,1) (5,0)
COOPERATE
A DEFECTS (0,5) (3,3)

An example of prisoner's dilemma in the economy is oligopoly pricing. An oligopoly

market is a market structure wherein a small number of producers work to restrict
output and/or fix prices so they can achieve above-normal market returns. A company
can choose to “cooperate” by keeping the price high, or they can "betray" by reducing
their price and stealing the whole market. Coca-cola and Pepsi each have similar
market share for a price-sensitive commodity. If one of them lowers prices to gain
customers, the other is likely to do the same. As a result, neither of them gains
momentum but ends up with lower prices. This is analogous to the prisoners
confessing when they should remain silent. The best option for both Coke and Pepsi is
to keep prices as-is but the reality of perpetual promotions shows they both fall prey to
the prisoner’s dilemma.

ADVERTISING DILEMMA

Advertising dilemma has the same structure as the prisoners’ dilemma. Provides a
framework for understanding how to strike a balance between cooperation and
competition and is a useful tool for strategic decision-making.

Advertisements are useful because they shape clients’ brand perception and influence
their preference for one brand over another. Hence, we tend to think that removing
advertisements could result in a decrease in their profit as the company will have less
brand exposure to the public.

Example:

Before 1970, two big cigarette manufacturers, RJR and Phillip Morris were placing a
huge amount of budget on advertisement. However, in 1970, advertisement on
cigarettes was banned due to the Public Health Cigarette Smoking Act. However, after
the advertisement ban in 1970, the two major tobacco companies increased their
profit. Although advertisement is useful to increase their brand presence, it does not
have much significance in distinguishing one particular brand from others when all of
them have advertisements.

• When both companies do advertise, both companies will make $20m.

• If one chooses to advertise and the other doesn’t, the one that advertises will make
$50m, while the company that didn’t advertise will only make $10m.

• Considering the idea of dominant strategy and Nash equilibrium, we can analyze this
chart by saying that both companies’ dominant strategy is to advertise, and the Nash
equilibrium exists when both companies advertise.

Both RJR and Phillip Morris could make more money by not advertising. Cigarette
advertising is predatory; that is, it serves mainly to steal market share from rivals
without increasing market size.

OUTCOME OF A PRISONER’S DILEMMA

The likely outcome for a prisoner's dilemma is that both players defect (i.e., behave
selfishly), leading to suboptimal outcomes for both. This is also the Nash Equilibrium, a
decision-making theorem within game theory that states a player can achieve the
desired outcome by not deviating from their initial strategy. The Nash equilibrium in
this example is for both players to betray one another, even though mutual cooperation
leads to a better outcome for both players; however, if one prisoner chooses mutual
cooperation and the other does not, one prisoner's outcome is worse.

BOTTOMLINE

The prisoner's dilemma is a well-known parable for the difficulty of solving collective
action problems. By acting in their own self-interests, the metaphorical prisoners find
themselves with a greater penalty than they would face if they had worked together.
However, when the experiment is repeated over the long term, it is possible for the
players to devise incentives for cooperation.

GAME OF CHICKEN

It’s a classic game in game theory that serves as a model of conflict for two
players and is often used to describe the situation where two parties are on a path of
direct conflict or competition. In this situation, there are two young boys who are
driving to each other at full speed. If the players continue on the same path, they will
bump into each other, and both of them will die. If one swerves out of the way and the
other doesn't, the one who swerves "loses" and is labeled the chicken or coward, while
the second, implicitly braver player, wins and will be called the king. This game can be
used to model competition in business where firms face a choice between cooperation
and competition.

This game theory is also called the “Hawk-Dove Game” since it is used by the
biologists to observe the behavior of various animals and how it evolves in different
times. This theory can also be associated with people, wherein there are individuals
who are a bit aggressive or what we called aggressor and can be considered as the
hawk, while there are persons who can be considered as the doves or the ones who are
timid or hesitant.

Example:

 Players: Player 1 and Player 2

 Strategy: Continue Straight or Swerve
 Payoffs:
 If one of them swerved, that person would be called a chicken or a
coward. The one who chose to continue straight will be labeled as the king
or the braver one.
 If both of them choose to continue straight or neither of them chooses to
swerve, they will crash into each other, and both of them might die.
 If both of the players choose to swerve, the two of them will regret missing
out on the opportunity to be the king.

In this case, there are two Nash equilibrium wherein both of the players prefer a
different Nash which essentially means that there is a loser and a winner. In being able
to specify that this theory is considered a game of chicken, one “off equilibrium” is
worse for both of the parties. (Both of them chose to continue straight and crashed
with one another.) Aside from that, the other “off equilibrium” is better for the loser.

DATING GAME

It shares the tension between group interest (cooperation) and self-interest

(conflict) inherent in a prisoner’s dilemma. The dating game also gives you a way to
analyze the tension between divisions within a corporation.

Example:

There’s a guy and a girl who hang out for a while and decide to watch a movie together.
There’s a tension between them, and they’re both wondering if there’s romantic
feelings there or if they are just friends.

 Players: Guy (Player 1) and Girl (Player 2)

 Strategy: Act like it’s a date or act like just friends

If both of the players act like it’s a date, they will get a payoff of 8. But if player 1
acts like it’s a date, while player 2 acts like just friends, P1 will get a payoff of 0 due to
embarrassment, and vice versa. If both of the players acted like just friends, the two of
them got a payoff of 4. Both of the players have their own dominant strategy. But
overall, in this situation, the Nash equilibrium is that both of the players are acting like
friends. But they are better off if both of them act like it’s a date.

SHIRKING OR MONITORING GAME

Through this game theory, a firm can consider the problem of how to manage
workers efficiently as a game between an employer and an employee. It helps us
understand how best to manage self-interested employees.

Example:

If the manager monitors and the worker is working, the manager incurs a cost
but the worker enjoys a positive payoff (he was checked and was not caught shirking).
If the worker shirks and the manager monitors, the manager gets a positive payoff (he
caught a shirking worker), but the worker incurs a loss. If the manager doesn’t monitor
and the worker works, the manager is happy (positive payoff), the worker is unhappy
(he regrets not shirking). Finally, if the manager doesn’t monitor and the worker
shirks, the manager’s payoff is negative and the worker’s payoff is positive. In this
game, there is no pure strategy Nash Equilibrium, however there is (or are) mixed
strategy Nash Equilibrium (or Equilibria). Mixed strategy equilibria in particular would
imply that the manager does random monitoring.

Price Discrimination Dilemma

In a competitive market, using price discrimination as a strategy can backfire. If you

start charging different prices for the same product, your competitors might do the
same in response. This can lead to a situation where everyone's profits decrease, and
you end up worse off than if no one had practiced price discrimination.

For example:

Imagine you run a coffee shop in a neighborhood with several competitors. You decide
to use price discrimination by offering discounted coffee to students on weekdays. This
strategy attracts more student customers and boosts your sales.

However, your competitors notice this and start offering even bigger discounts to
students. This leads to a price war, where all the coffee shops are constantly lowering
their prices to attract students. As a result, everyone's profits decline, and you all end
up worse off than if none of you had started price discrimination.

Price Discrimination

•is a selling strategy that charges customers different prices for the same product or
service based on what the seller thinks they can get the customer to agree to.

•is practiced based on the seller's belief that customers in certain groups can be asked
to pay more or less based on certain demographics or on how they value the product or
service in question.

NOTE: Price discrimination charges customers different prices for the same products
based on a bias toward groups of people with certain characteristics.

Types of Price Discrimination

1.First-degree, or perfect price discrimination (Personalized Pricing )- a seller charges a

different price to each individual customer based on their willingness to pay.

Example: An airline uses dynamic pricing to sell tickets. They analyze a customer's
browsing and purchase history, and if they detect that a customer has a higher
willingness to pay for a flight, they offer a higher price for that specific ticket. On the
other hand, if a customer typically searches for budget options, they receive a lower
price.

2. Second-degree price discrimination, or nonlinear pricing (Product Versioning)- a seller

offers multiple versions of a product or service at different price points. Customers
self-select into the version that aligns with their preferences and price sensitivity.
Quantity discounts or premia are the obvious examples.

Example: A software company offers a free basic version of its productivity software, a
standard version with more features for a monthly fee, and a premium version with
advanced tools for a higher monthly fee. Customers can choose the version that best
suits their needs and budget.

3. Third-degree price discrimination (Market Segmentation) - charging different prices

to different groups of customers based on their characteristics, such as age, location,
income, or student status. examples are student and senior discounts or charging
different prices on different days of the week.

Example: A movie theater offers different ticket prices for various customer segments.
They charge one price for adults, a lower price for seniors, and a reduced price for
children. Each group pays a different price based on their demographics, but they all
enjoy the same movie.

In summary, price discrimination can take several forms, including adjusting prices to
individual customers (first-degree), offering multiple product versions at varying costs
(second-degree), and charging different client groups differently (third-degree). When
businesses utilize these techniques, competitors may imitate them, resulting in price
wars and lower profits for everyone. As a result, businesses must exercise caution in
their use of price discrimination.

STRATEGIC VIEW OF BARGAINING

 The strategic view of bargaining envisions bargaining as a game of chicken where

the ability to commit to a position allows a player to capture the lion’s share of
the gains from trade.
 In the strategic view of bargaining credible commitments are difficult to make
because they require players to commit to a course of action against their self-
interest.
 In a game of chicken both parties will try to steer the game to their preferred
equilibrium by committing to a position. If you can convince your rival that
you’re going to bargain hard, regardless of what your rival does, he will do better
by accommodating, and you will get a bigger share of the gains from trade.
 To see the value of commitment, we examine the game as a sequential-move
game where the party able to make a commitment gets to move first.

Example:

 Imagine that a company’s managers are bargaining with a labor union over a
fixed sum and that each player has just two possible strategies: bargain hard or
accommodate. If both bargain hard, they’ll fail to reach a deal, and therefore each
 will earn nothing; if both accommodate, they split the gains from trade. If one
player bargains hard and the other accommodates, the player who bargains hard
takes 75% of the gains from agreement.

In this case, imagine that the union makes either a generous offer or a low offer;
and then management must either accept or reject the offer. If management
accepts the offer, it earns what the union offered; if not, management locks out the
union, and each party earns nothing.

NONSTRATEGIC VIEW OF BARGAINING

Nonstrategic View of Bargaining

 The non-strategic view of bargaining focuses on the gains and alternatives to

agreement to determine the outcome of bargaining.
 Under the non-strategic view of bargaining, the terms of agreement are
determined by your opponent’s outside options, the outside options, and the
opponents.
 It does not focus on the explicit rules of the game to understand the likely
outcome of the bargaining.
 It is the alternatives to agreement that determine the terms of any agreement.

Anything you can do to increase your opponent’s gains from reaching agreement or to
decrease your own will improve your bargaining position.

Example:

 The best time to ask for a raise is when you already have an attractive offer from
another company. Because you have a good alternative, your gain to reaching
agreement is small, which makes you less eager to reach agreement.

Note: The similarity of the disagreement value to the idea of opportunity cost. The cost of
staying in your current job is the offer you give up if you stay. If you have a good
alternative offer, the opportunity cost of staying in your job is high, putting you in a
stronger bargaining position.
Sources:

https://www.britannica.com/science/game-theory/The-prisoners-dilemma

https://www.youtube.com/watch?v=DlY4sP6YUts&t=195s
https://www.coursehero.com/file/p6o486/shirking-worker-but-the-worker-incurs-a-
loss-If-the-manager-doesnt-monitor-and/

https://www.youtube.com/watch?v=Q1DVAFRuAtI

https://www.youtube.com/watch?
v=LfNP5SKAbpw&pp=ygUSUHJpc29uZXIncyBEaWxlbW1h

Group Members

 Bautista, Karylle
 Belano, Rommelyn
 Besa, Kathlyn
 Binay, Cyrus Annilov
 Bio, Rizalynn
 Bisbe, Giselle
 Bitare, Meryl Angel
 Briñ osa, Maria Jeanelle