Chapter 12

Game Theory and

Business Strategy
 Introduction

❑ In this chapter we will focus on game theory, a set of tools used to analyze strategic
decision-making.

Methods
❑ Oligopoly firms interact within a game as players that follow the rules of the game.
Games can be static or dynamic.
❑ Players decide their strategies based on payoffs, level of information and their
rationality.
❑ The game optimal solution is a Nash Equilibrium and depends on information &
rationality.
❑ Players determine transaction prices in bargaining and auction mechanisms.

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 12.1 Oligopoly Games

American and United again:

❑ Players and Rules
✓ Two players, American and United, play a static game (only once) to
decide how many passengers per quarter to fly. Their objective is to
maximize profit.

❑ Strategies
✓ Each firm’s strategy is to take one of the two actions, choosing either
a low output (48 k passengers per quarter) or a high output (64 k).

❑ Payoff Matrix or Profit Matrix

✓ Table 12.1 summarizes this information. For instance, if American
chooses high output (qA=64) and United low output (qU=48),
American’s profit is $5.1 million and United’s $3.8 million.

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 12.1 Oligopoly Games

Table 12.1 Dominant Strategies in a Quantity Setting, Prisoners’

Dilemma Game

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 12.1 Oligopoly Games

Dominant Strategies
❑ If one is available, a rational player always uses a dominant strategy: a
strategy that produces a higher profit than any other strategy the player
can use no matter what its rivals do.
❑ The dominant strategy solution of this game is qA = qU = 64.

Prisoner’s Dilemma game

✓ Prisoners’ dilemma game: all players have dominant strategies that
lead to a profit that is inferior to what they could achieve if they
cooperated.

Note: A dominant strategy might lead to maximized profit or not as in the

case above

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 12.1 Oligopoly Games

Best Responses
❑ Many games do not have a dominant strategy solution. So, we use the
approach of best response: the strategy that maximizes a player’s profit
given its beliefs about its rivals’ strategies.
❑ Best response is the basis for a Nash equilibrium: A set of strategies if,
when all other players use these strategies, no player can obtain a higher
profit by choosing a different strategy.
❑ A Nash equilibrium is self-enforcing.

Example: Assume both American and United can choose from 3 strategies:
96, 64, or 48 passengers.

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 12.1 Oligopoly Games

Table 12.2 Best Responses in a Quantity Setting, Prisoners’ Dilemma

Game

Nash Equilibrium: Only one cell possible (both parts green): qA = qU = 64.

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 Table 12.3 Advertising Games: Prisoners’
Dilemma or Joint-Profit Maximizing
Outcome?

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 12.2 Types of Nash Equilibria

❑ There are three types of Nash equilibrium:

❑ Unique Nash equilibrium (our focus)
✓ Only one combination of strategies is each firm’s strategy a best
response to its rival’s strategy.
✓ Examples are the Bertrand and Cournot models, and all games played
so far.
❑ Multiple Nash equilibria
✓ Many oligopoly games have more than one Nash equilibrium.
✓ To predict the likely outcome of multiple equilibria we may use
additional criteria.
❑ Mixed strategy Nash equilibria
✓ In the games we played so far, players were certain about what
action to take at each rival’s decision (pure strategy).
✓ When players are not certain they use a mixed strategy: a rule telling
the player how to randomly choose among possible pure strategies.

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 12.3 Information & Rationality

The Logic of Incomplete Information & Rationality

❑ We have assumed so far firms have complete information: know all
strategies and profits.
❑ However, in more complex games firms have incomplete information.

❑ We have assumed so far players act rationally: they use all their available
information to determine their best strategies (maximizing profit
strategies).
❑ However, players may have limited powers of calculation, or be unable to
determine their best strategies (bounded rationality).
❑ When firms have incomplete information or bounded rationality, the Nash
equilibria is different from games with full information and rationality.

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 12.3 Information & Rationality

Incomplete Information
❑ Investment game: Google and Samsung must decide ‘to invest’ or ‘do not invest’ in
complementary products that “go together.” (Chrome OS and Chromebook,
respectively)
❑ Profit asymmetry: A Chromebook with no Chrome OS has no value at all, but
Chrome OS with no Chromebook still has value.
❑ Assume complete information:
✓ If each firm has full information, Google’s dominant strategy is ‘to invest’ and
Samsung’s best response to it is ‘to invest.’

❑ Assume incomplete information

✓ With private information, Samsung does not know Google’s dominant strategy is
always ‘to invest.’
✓ Given its limited information, Samsung weights a modest gain versus a big loss.
If it thinks it is likely Google will not invest (big loss), then Samsung does not
invest.
✓ Samsung and Google fail to coordinate their strategies

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 12.3 Information & Rationality

Table 12.8 Complementary Investment

Game

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 12.3 Information & Rationality

Maximin Strategies
❑ In very complex games, a manager with bounded rationality may use a
rule of thumb approach, perhaps using a rule that has worked in the past.

❑ A maximin strategy maximizes the minimum profit. This approach

ensures the best possible profit if your rival takes the action that is worst
for you.

❑ The maximin solution for the game in Table 12.8 is for Google to invest
and for Samsung not to invest.

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 12.5 Auctions

❑ An auction is a sale in which a good or service is sold to the highest

bidder. In auction games, players called bidders devise bidding strategies
without knowing other players’ payoff functions.

Real Scenarios for Auction Games

✓ Government related games: Government procurement auctions;
auctions for electricity and transport markets; auctions to concede
portions of the airwaves for radio stations, mobile phones, and
wireless internet access.
✓ Market transaction games: goods commonly sold at auction are
natural resources such as timber and drilling rights for oil, as well as
houses, cars, agricultural produce, horses, antiques, and art. And of
course, goods online in sites like eBay.

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 12.5 Auctions

❑ Format of bidding
✓ English auction: Ascending-bid auction process where the good is sold to the
last bidder for the highest bid. Common to sell antiques.
✓ Dutch auction: Descending-bid auction process where the seller reduces the
price until someone accepts it and buys at that price.
✓ Sealed-bid auction: Bidders submit a bid simultaneously without seeing
anyone else’s bid and the highest bidder wins. In a 1st-price auction, the winner
pays its own, highest bid. In a 2nd-price auction, the winner pays the amount
bid by the 2nd-highest bidder.
❑ Value
✓ Private value: Individual bidders know how much the good is worth to them but
not how much other bidders value it.
✓ Common value: The good has the same value to everyone, but no bidder knows
exactly what that value is. In a timber land auction, bidders know the price of
lumber but not how much lumber is in the trees.

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 12.5 Auctions

Bidding Strategies in Private-Value Auctions:

Second-Price Auction Strategies
❑ Second-Price Auction Game Rules: traditional sealed-bid, second-price
auction.
✓ The amount that you bid affects whether you win, but it does not
affect how much you pay if you win, which equals the second-highest
bid.
❑ Bidding your highest value is your best strategy
✓ Suppose that you value a folk art carving at $100. If you bid $100
and win, your CS = 100 - 2nd price. If you bid less than $100, you risk
not winning. If you bid more than $100, you risk ending up with a
negative CS.
✓ So, bidding $100 leaves you as well off as, or better off than, bidding
any other value.
Note: The winner will pay the value of the second-highest bidder.

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 12.5 Auctions

English Auction Strategy

❑ English Auction Game Rules: The good is sold to the last bidder for the
highest bid. Each bidder has a private value for a single, indivisible good.
✓ The amount that you bid affects whether you win and pay.
❑ Your best strategy is to raise the current highest bid as long as your bid is
less than the value you place on the good.
✓ Suppose that you value a folk art carving at $100. If you bid an
amount b and win, your surplus is $100 – b. Your surplus is positive
or zero for b ≤ 100. But, negative if b > 100. So, it is best to raise
bids up to $100 and stop there.

Note: If all participants bid up to their value, the winner will pay slightly
more than the value of the second-highest bidder. Thus, the outcome is
essentially the same as in the sealed-bid, second-price auction.

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 12.5 Auctions

Equivalence of outcomes
❑ Dutch auction rules: Descending-bid auction process where the seller reduces the
price until someone accepts the offered price and buys at that price.
❑ Sealed-bid rules: Bidders submit a bid simultaneously without seeing anyone else’s
bid, the highest bidder wins and pays its own bid.
✓ In both games, each bidder has a private value for a single, indivisible good.
✓ The amount that you bid affects whether you win and pay.
❑ The best strategy for both games is to bid an amount that is equal to or slightly
greater than what you expect will be the second-highest bid, given that your value is
the highest.
✓ Bidders shave their bids to less than their value to balance the effect of
decreasing the probability of winning and increasing CS. The bid depends on the
beliefs about the strategies of rivals.
✓ Thus, the expected outcome is the same under each format for private-value
auctions: The winner is the person with the highest value, and the winner pays
roughly the second-highest value.

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 12.5 Auctions

The Winner’s Curse

❑ The winner’s curse occurs in common-value auctions: the winner’s bid
exceeds the common-value item’s value. So, the winner ends up paying
too much.
✓ The overbidding occurs when there is uncertainty about the true value
of the good, as is in timber land auctions.

❑ Bounded rationality and the winner’s Curse

✓ Although rational managers should avoid the winner’s curve, there is
strong empirical evidence for the winner’s curse (corporate acquisition
market).
✓ One explanation is bounded rationality.

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