CHAPTER 2

GAME THEORY AND COMPETITIVE

STRATEGY

Yitbarek Takele (PhD, MBA & MA Econ)

Associate Professor of Business Administration
Addis Ababa University

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“Only the paranoid survive.”

Andy Grove, Co-founder of Intel

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 Topics to be Discussed

▪ Introduction
▪ Gaming and Strategic Decisions
▪ Dominant Strategies
▪ The Nash Equilibrium
▪ Repeated Games
▪ Sequential Games
▪ Threats, Commitments, and Credibility
▪ Entry Deterrence
▪ Bargaining Strategy
▪ Auctions

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 2.1 Introduction
What is Game Theory?

“No man is an island”

▪ Study of rational behavior in interactive or interdependent

situations
▪ Bad news:
Knowing game theory does not guarantee winning
▪ Good news:
Framework for thinking about strategic interaction

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 Games we play in life & business
▪ Group projects Free-riding, reputation
▪ Flat tire Coordination
▪ Mean professors Commitment
▪ Grade curves Prisoner’s dilemma
▪ Tennis / Baseball Mixed strategies
▪ Traffic Congestion
▪ Dating Information manipulation

▪ Market entry Commitment

▪ Drug testing Mixed strategies
▪ Supply chains Auctions
▪ Corporate takeovers Winner’s curse
▪ Fishing Congestion
▪ Patent races Game of chicken
▪ Stock options Compensation schemes
▪ OPEC output Collusion & enforcement

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 Interactive Decision Theory

▪ Decision Theory
 You are self-interested and selfish
▪ Game Theory
 So is everyone else

“ If it’s true that we are here to help others, then what exactly are
the others here for? ”
- George Carlin

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 Game Theory: The Golden Rule

COMMANDMENT
Never assume that your opponents’ behavior is fixed.
Predict their reaction to your behavior!

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 Decision Theory vs. Game Theory

▪ Ten of you go to a restaurant

▪ If each of you pays for your own meal… This is a decision problem
▪ If you all agree to split the bill... Now, this is a gam

May I recommend the Bleu Cheese for ten dollars?

Restaurant Decision-Making

Sure!

It is only
a dollar
more
for me!

Check splitting policy changes incentives.

 Understanding Incentives

▪ Do bicycle helmets cause less injuries?

▪ Should airplanes require children to be in their own seats?
▪ Why shut down a plant operating at capacity?
▪ Why cannibalize your own sales?
▪ Why offer price guarantees to consumers?

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 A Simple Game
▪ Game theory: analysis of optimal decision making in competitive
situations.
▪ Players: parties that work to maximize their interest in games
▪ Strategy: a plan for the action that a player in a game will take under.
▪ Payoff: outcome of strategies used by players

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 Prisoners’ Dilemma and Game Theory

Prisoner B
Confess Don’t Confess

Confess -5, -5 -1, -10

Prisoner A

Don’t Confess -2, -2

-10, -1

• Question
 Dominant strategy?
 Nash equilibrium?
 Maximin solution?

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 2.2 Gaming and Strategic Decisions

Strategic view:
“If I believe that my competitors are rational and act to maximize their
own profits, how should I take their behavior into account when making
my own profit-maximizing decisions?”

“The strategy design is based on understanding your opponent’s point of

view, and (assuming your opponent is rational) deducing how he or she
is likely to respond to your actions”

Strategic question:
Shall we cooperate or compete?

What are the strategic conditions?

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 Gaming and Strategic Decisions

▪ Cooperative Game
o Players negotiate binding contracts that allow them to plan
joint strategies
o Example: Buyer and seller negotiating the price of a good or
service or a joint venture by two firms (e.g., Microsoft and Apple)
o OPEC, Oligopoly firms

▪ Competitive/Non-cooperative Game
o Negotiation and enforcement of a binding contract are not
possible
o Example: Two competing firms assuming the others behavior
irrelevant and independently determine the pricing and advertising
strategy to gain market share (e.g., OPEC & Russia).

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 Applying Game Theory in Acquisition

▪ Scenario
▪ Company A: The Acquirer
▪ Company T: The Target
▪ A will offer cash for all of T’s shares
▪ The value of T depends on the outcome of a current oil exploration
project.
o Failure: T’s value = $40
o Success: T’s value = $100/share
o All outcomes are equally likely
▪ T’s value will be 50% greater with A’s management.
▪ A, must submit the proposal before the exploration outcome is
known.
▪ T will not choose to accept or reject until the outcome is known
only to T.
▪ Question
▪ What price A shall offer? Why?

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 2.3 Dominant Strategies

 Criteria and Meaning

▪ “I’m doing the best I can no matter what you do.”
▪ “You’re doing the best you can no matter what I do.”
▪ One that is optimal no matter what an opponent does.

 Example
• A & B sell competing products
• They are deciding whether to undertake advertising campaigns

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 Payoff Matrix for Advertising Game

Firm B
Advertise Don’t Advertise

Advertise 10, 5 15, 0

Firm A

Don’t Advertise 6, 8 10, 2

▪ Observations (1)
 A: regardless of B, advertising is the best
 B: regardless of A, advertising is the best

▪ Observations (2)
 Dominant strategy for A & B is to advertise
 Do not worry about the other player
 Equilibrium in dominant strategy

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 Dominated Strategies

• Dominated Strategies:
a strategy such that the player has another strategy that gives a
higher payoff no matter what the other player does.
• The opposite of a dominant strategy.

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 Example

Toyota

Build Build Do Not

Large Small Build
Build 0, 0 12, 8 18, 9
Large
Honda Build 8, 12 16, 16 20, 15
Small
Do Not 9, 18 15, 20 18, 18
Build

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 Case: Find Nash Equilibrium

Coke

$ 10.50 $ 11.50 $ 12.50 $ 13.50

Pepsi $ 6.25 66, 190 68, 199 70, 198 73, 191

$ 7.25 79, 201 82, 211 85, 214 89, 208

$ 8.25 82, 212 86, 224 90, 229 95, 225

$ 9.25 75, 223 80, 237 85, 244 91, 245

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 2.4 The Nash Equilibrium

▪ Criteria and Meaning

▪ “I’m doing the best I can given what you are doing”
▪ “You’re doing the best you can given what I am doing.”
▪ The optimal decision of a player without a dominant strategy which
depend on what the opponent does.

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 Modified Advertising Game

Firm B
Advertise Don’t Advertise

Advertise 10, 5 15, 0

Firm A

Don’t Advertise 6, 8 20, 2

▪ Observations (1)
 A: No dominant strategy; depends on B’s actions
 B: Advertise

▪ Observations (2)
 What should A do? (Hint: consider B’s decision)

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Example (1): Product choice problem for Nash equilibrium
▪ Scenario:
▪ Two cereal companies
▪ Market for one producer of crispy cereal
▪ Market for one producer of sweet cereal
▪ Each firm only has the resources to introduce one cereal
▪ Noncooperative
Firm 2
Crispy Sweet

Crispy -5, -5 10, 10

Firm 1
Sweet 10, 10 -5, -5

▪ Question
▪ Is there a Nash equilibrium? If not, why? If so, how can it be reached

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Example (2): Beach Location Game for Nash equilibrium

▪ Scenario
 Two competitors, X and Y, selling soft drinks
 Beach 200 yards long
 Sunbathers are spread evenly along the beach
 Price X = Price Y
 Customer will buy from the closest vendor
Ocean

D C
E
0 B Beach A 200 yards

▪ Question
▪ Where will the competitors locate (i.e. where is the Nash equilibrium)?

▪ Other examples of this decision problem include:

▪ Locating a gas station
▪ Presidential elections
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2.5 Pure & Mixed Strategies

▪ Pure Strategy
 Player makes a specific choice
▪ Mixed Strategy
 Player makes a random choice among two or more possible
actions based on a set of chosen probabilities

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 Two-Person, Zero-Sum Game

▪ When each player in a game adopts a single strategy as an

optimal strategy, the game is a pure strategy game. The value of a
pure strategy game is the same for both the offensive player and
the defensive player.
▪ In contrast, in a mixed strategy game, the players adopt a mixture
of strategies if the game is played many times.
▪ A pure strategy game can be solved according to the minimax
decision criterion where each player plays the game to minimize
the maximum possible losses.
▪ Principle:
▪ The offensive player selects the strategy with the largest of the
minimum payoffs (called the maximin strategy), and the defensive
player selects the strategy with the smallest of the maximum payoffs
(called the minimax strategy).

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 Two-Person, Zero-Sum Game: Pure strategy

▪ In our example involving the athlete's contract negotiation process,

the athlete will select the maximin strategy from strategies 1 and 2,
and the general manager will select the minimax strategy from
strategies A, B, and C.
▪ We will first discuss the athlete's decision, although in game theory
the decisions are actually made simultaneously
• With the minimax decision criterion, each player seeks to minimize
maximum possible losses; the offensive player selects the strategy with
the largest of the minimum payoffs, and the defensive player selects
the strategy with the smallest of the maximum payoffs.
• To determine the maximin strategy, the athlete first selects the
minimum payoff for strategies 1 and 2, as shown in Table E.2. The
maximum of these minimum values indicates the optimal strategy and
the value of the game for the athlete.
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 Two-Person, Zero-Sum Game: Pure strategy
Table: Payoff Table with Maximin Strategy

Athlete /Agent General Manager

A B C
1 $50,000 $35,000 $30,000*
2 $60,000 $40,000 $ 20,000
*=max.of min.payoffs

▪ The value $30,000 is the maximum of the minimum values for each of the athlete's
strategies. Thus, the optimal strategy for the athlete is strategy 1. The logic behind
this decision is as follows. If the athlete selected strategy 1, the general manager
could be expected to select strategy C, which would minimize the possible loss (i.e.,
a $30,000 contract is better for the manager than a $50,000 or $35,000 contract).
Alternatively, if the athlete selected strategy 2, the general manager could be
expected to select strategy C for the same reason (i.e., a $20,000 contract is better
for the manager than a $60,000 or $40,000 contract). Now, because the athlete has
anticipated how the general manager will respond to each strategy, he realizes that
he can negotiate either a $30,000 or a $20,000 contract. The athlete selects strategy
1 in order to get the larger possible contract of $30,000, given the actions of the
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• Simultaneously, the general manager applies the minimax decision criterion to
strategies A, B, and C. First, the general manager selects the maximum payoff for each
strategy
• The minimum of these maximum values determines the optimal strategy and the
value of the game for the general manager.

Table : Payoff Table with Minimax Strategy

Athlete /Agent General Manager

A B C
1 $50,000 $35,000 $30,000*
2 60,000 40,000 20,000
*=min.of the max.

• The value $30,000 is the minimum of the maximum values for each of the strategies
of the general manager. Thus, the optimal strategy for the general manager is C.
• The logic of this decision is similar to that of the athlete's decision. If the general
manager selected strategy A, the athlete could be expected to select strategy 2 with a
payoff of $60,000 (i.e., the athlete will choose the better of the $50,000 and $60,000
contracts). If the general manager selected strategy B, then the athlete could be
expected to select strategy 2 for a payoff of $40,000. Finally, if the general manager
selected strategy C, the athlete could be expected to select strategy 1 for a payoff of
$30,000.
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• Because the general manager has anticipated how the athlete will respond to each
strategy, he realizes that either a $60,000, $40,000, or $30,000 contract could possibly
be awarded.
• Thus, the general manager selects strategy C, which will result in the minimum
contract of $30,000. In general, the manager considers the worst outcome that could
result if a particular strategy were followed.
• Under the minimax criterion, the general manager will select the strategy that ensures
that the loses only the minimum of the maximum amounts that could be lost.

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 Pure –Dominant vs. Dominated Strategies

▪ Dominance occurs when all the payoffs for one strategy are better
than the corresponding payoffs for another strategy
▪ The values $30,000 and $20,000 are both lower than the
corresponding payoffs of $50,000 and $60,000 for strategy A and the
corresponding payoffs of $35,000 and $40,000 for strategy B.
▪ Because strategy C dominates A and B, these two latter strategies can
be eliminated from consideration altogether as they are dominated
strategies.
▪ Therefore, a strategy is dominated, and can be eliminated, if all its
payoffs are worse than the corresponding payoffs for another
strategy

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 Pure strategy–Equilibrium point

▪ The fact that the optimal strategy for each player in this game
resulted in the same pay-off game value of $30,000 is what classifies
it as a pure strategy game. In other words, because strategy 1 is
optimal for the athlete and strategy C is optimal for the general
manager, a contract for $30,000 will be awarded to the athlete.
▪ Because the outcome of $30,000 results from a pure strategy, it is
referred to as an equilibrium point (or saddle point).
▪ A point of equilibrium is a value that is simultaneously the minimum
of a row and the maximum of a column, as is the payoff of $30,000
▪ In a pure strategy game, the optimal strategy for each player results
in the same payoff, called an equilibrium, or saddle, point
▪ The equilibrium point in a game is simultaneously the minimum of
a row and the maximum of a column.
▪ The minimax criterion will result in the optimal strategies only if
both players use it.
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 Two-Person, Zero-Sum Game: Mixed strategy

▪ A mixed strategy game occurs when each player selects an optimal

strategy and the two strategies do not result in an equilibrium point (i.e.,
the same outcome) when the maximin and minimax decision strategies
are applied.
▪ Example:
The Coloroid Camera Company (which we will refer to as company I) is going to
introduce a new camera into its product line and hopes to capture as large an
increase in its market share as possible. In contrast, the Camco Camera Company
(which we will refer to as company II) hopes to minimize Coloroid's market share
increase.
Coloroid and Camco dominate the camera market, and any gain in market share
for Coloroid will result in a subsequent identical loss in market share for Camco.
The strategies for each company are based on their promotional campaigns,
packaging, and cosmetic differences between the products.
The payoff table, which includes the strategies and outcomes for each company
(I = Coloroid and II = Camco), is shown in ff Table. The values given on the Table
presented in the next slide are the percentage increases or decreases in market
share for company I. [email protected]
 Payoff Table for Camera Companies

Company II

A B C
1 9 7 2
Company I 2 11 8 4
3 4 1 7

• The first step is to check the payoff table for any dominant strategies.
• Doing so, we find that strategy 2 dominates strategy 1, and strategy B dominates
strategy A. Thus, strategies 1 and A can be eliminated from the payoff table

Payoff Table with Strategies 1 and A Eliminated

Company II
B C
Company I 2 8 4
3 1 7

• We apply the maximin decision criterion to the strategies for company I, as

shown in the ff Table . The minimum value for strategy 2 is 4%, and the minimum
value for strategy 3 is 1%. The maximum of these two minimum values is 4%;
thus, strategy 2 is optimal for company I

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 Payoff Table for Camera Companies

Company II

A B C
1 9 7 2
Company I 2 11 8 4
3 4 1 7

• The first step is to check the payoff table for any dominant strategies.
• Doing so, we find that strategy 2 dominates strategy 1, and strategy B dominates
strategy A. Thus, strategies 1 and A can be eliminated from the payoff table

Payoff Table with Strategies 1 and A Eliminated

Company II
B C
Company I 2 8 4
3 1 7

• We apply the maximin decision criterion to the strategies for company I, as

shown in the ff Table . The minimum value for strategy 2 is 4%, and the minimum
value for strategy 3 is 1%. The maximum of these two minimum values is 4%;
thus, strategy 2 is optimal for company I

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 Payoff Table with Maximin Criterion

Company II
B C
Company I 2 8 4*
3 1 7
*Max. of the min.values
▪ Next, we apply the minimax decision criterion to the strategies for company II in the ff Table. The
maximum value for strategy B is 8%, and the maximum value for strategy C is 7%. Of these two
maximum values, 7% is the minimum; thus, the optimal strategy for company II is C..
Company II
B C
Company I 2 8 4
3 1 7**
**min of max values

Company II
B C
Company I 2 8 4*
3 1 7*

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▪ We can see that the strategies selected by the companies do not result in an
equilibrium point. Therefore, this is not a pure strategy game.
▪ Company I maximizes its market share percentage increase by selecting strategy 2.
Company II selects strategy C to minimize company I's market share. However, as
soon as company I noticed that company II was using strategy C, it would switch to
strategy 3 to increase its market share to 7%. This move would not go unnoticed by
company II, which would immediately switch to strategy B to reduce company I's
market share to 1%. This action by company II would cause company I to immediately
switch to strategy 2 to maximize its market share increase to 8%. Given the action of
company I, company II would switch to strategy C to minimize company I's market
share increase to 4%.

A Closed Loop
▪ In a mixed strategy game, a player switches decisions in response to the decision of
the other player and they eventually return to the initial decisions, resulting in a
closed loop.

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 Matching Pennies

Player B
Heads Tails

Heads 1, -1 -1, 1
Player A
Tails -1, 1 1, -1

• Observations
 Pure strategy: No Nash equilibrium
 Mixed strategy: Random choice is a Nash equilibrium
 Would a firm set price based on random choice assumption?

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 The Battle of the Sexes
Joan
Wrestling Opera

Wrestling 2,1 0,0

Jim
Opera 0,0 1,2

▪ Pure Strategy
 Both watch wrestling
 Both watch opera
▪ Mixed Strategy
 Jim chooses wrestling
 Joan chooses opera

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 2.6 Repeated Games

• Oligopolistic firms play a repeated game.

• With each repetition of the Prisoners’ Dilemma, firms can

develop reputations about their behavior and study the
behavior of their competitors.

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 Pricing Problem
Firm 2
Low Price High Price

Low Price 10, 10 100, -50

Firm 1
High Price -50, 100 50, 50

Observations
▪ Non-repeated game
 Strategy is Low1, Low2
• Repeated game
 Tit-for-tat strategy is the most profitable

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 Conclusion for repeated games

 With repeated game

• The Prisoners’ Dilemma can have a cooperative outcome
with tit-for-tat strategy
 This is most likely to occur in a market with:
• Few firms
• Stable demand
• Stable cost
 Cooperation is difficult at best since these factors may
change in the long-run.

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Example: Oligopolistic Cooperation in the Water Meter Industry
Four Producers Rockwell International (35%), Badger Meter, Neptune
Water Meter Company, and Hersey Products (Badger, Neptune, and
Hersey combined have about a 50 to 55% share)

▪ Characteristics of the Market

▪ Very inelastic demand
o Not a significant part of the budget
o Product is indispensable
▪ Stable demand
▪ Long standing relationship between consumer and producer
o Barrier
▪ Economies of scale
o Barrier
▪ This is a Prisoners’ Dilemma
o Lower price to a competitive level
o Cooperate
▪ Repeated Game
• Question
 Why has cooperation prevailed?

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 2.7 Sequential Games
▪ Players move in turn
▪ Players must think through the possible actions and rational
reactions of each player
▪ Examples
▪ Responding to a competitor’s ad campaign
▪ Entry decisions
▪ Responding to regulatory policy

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▪ Scenario
▪ Two new (sweet, crispy) cereals
▪ Successful only if each firm produces one cereal
▪ Sweet will sell better
▪ Both still profitable with only one producer

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 Modified Product Choice Problem

Firm 2
Crispy Sweet

Crispy -5, -5 10, 20

Firm 1
Sweet 20, 10 -5, -5

Question (1)
 What is the likely outcome if both make their decisions independently,
simultaneously, and without knowledge of the other’s intentions?

Question (2)
 Assume that Firm 1 will introduce its new cereal first (a sequential game).
 What will be the outcome of this game?

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 Using a Decision Tree

Work backward from the best outcome for Firm 1

Crispy -5, -5

Crispy Firm 2
Sweet 10, 20
Firm 1
Crispy 20, 10
Sweet Firm 2
Sweet -5, -5

The Advantage of Moving First - In this product-choice game, there

is a clear advantage to moving first.

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2.8 Threats, Commitments, & Credibility
▪ Strategic Moves
▪ What actions can a firm take to gain advantage in the
marketplace?
• Deter entry
• Induce competitors to reduce output, leave, raise price
• Implicit agreements that benefit one firm

▪ How To Make the First Move?

▪ Demonstrate Commitment
▪ Firm 1 must constrain his behavior to the extent Firm 2 is convinced
that he is committed

▪ Empty Threats
▪ A firm will be worse off if it charges a low price & the threat of a low
price is not credible in the eyes of the competitors

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 Pricing of computers and word processors

Question
 Can Firm 1 force Firm 2 to charge a high price by threatening to lower its price?

Firm 2
High Price Low Price

High Price 100, 80 80, 100

Firm 1

Low Price 20, 0 10, 20

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 Scenario
▪ Race Car Motors, Inc. (RCM) produces cars
▪ Far Out Engines (FOE) produces specialty car engines and sells most of them
to RCM
▪ Sequential game with RCM as the leader
▪ FOE has no power to threaten to build big since RCM controls output.

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 Production Choice Problem

Race Car Motors

Small cars Big cars

Small engines 3, 6 3, 0
Far Out Engines

Big engines 1, 4 8, 3

Question
▪ How could FOE force RCM to shift to big cars?

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 Modified Production Choice Problem

Race Car Motors

Small cars Big cars

Small engines 0, 6 0, 0
Far Out Engines

Big engines 1, 1 8, 3

Questions
1) What is the risk of this strategy?
2) How could irrational behavior give FOE some power to control output?

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 The Discount Store Preemption Game: Wal-
Mart Stores’ Preemptive Investment Strategy
Company X
Enter Don’t enter

Enter -10, -10 20, 0

Wal-Mart
Don’t enter 0, 20 0, 0

Question:
▪ How did Wal-Mart become the largest retailer in the U.S. when many
established retail chains were closing their doors?
Hint
▪ How did Wal-Mart gain monopoly power? Preemptive game with Nash
equilibrium

Solution
▪ Two Nash equilibrium: Low left, Upper right
▪ Must be preemptive to win

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 2.9 Entry Deterrence
▪ Strategy:
▪ To deter entry, the incumbent firm must convince any potential competitor
that entry will be unprofitable.

▪ Scenario:
 Incumbent monopolist (I) and prospective entrant (X)
 X single cost = $80 million to build plant
 If X does not enter I makes a profit of $200 million.
 If X enters and charges a high price I earns a profit of $100 million and X
earns $20 million.
 If X enters and charges a low price I earns a profit of $70 million and X
earns $-10 million.

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 Entry Possibilities
Potential Entrant
Enter Stay out

High price
100, 20 200, 0
(accommodation)

Incumbent
70, -10 130, 0
Low Price (warfare)

Question
▪ How could I keep X out?
▪ Is the threat credible?

How could I keep X out?

▪ Make an investment before entry (irrevocable commitment)
▪ Irrational behavior
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 Entry Possibilities
After $50 million Early Investment
Potential Entrant
Enter Stay out

High price 100, 20 200, 0

(accommodation)

Incumbent
70, -10 130, 0
Low Price (warfare)

Reflection
▪ Warfare likely
▪ X will stay out

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 Entry Deterrence: Airbus vs. Boeing

 Without Airbus being subsidized, the payoff matrix for the two
firms would differ significantly from one showing subsidization.



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 Development of a New Aircraft

Airbus
Produce Don’t produce

Produce 10, -10 100, 0

Boeing

Don’t produce 0, 100 0, 0

Reflection:
▪ Boeing will produce
▪ Airbus will not produce

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Development of Aircraft After European Subsidy

Airbus
Produce Don’t produce

Produce -10, 10 100, 0

Boeing

Don’t produce 0, 120 0, 0

Reflection
▪Airbus will produce
▪Boeing will not produce

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 Diaper Wars

▪ Even though there are only two major firms, competition is

intense.
▪ The competition occurs mostly in the form of cost-reducing
innovation.
Competing Through R & D

Kimberly-Clark
R&D No R&D

R&D 40, 20 80, -20

P&G

No R&D -20, 60 60, 40

• Reflection:
 Both spend on R&D
• Question
 Why not cooperate?
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 2.10 Bargaining Strategy
• Alternative outcomes are possible if firms or individuals can make
promises that can be enforced.

• Consider two firms introducing one of two complementary goods.

Firm 2
Produce A Produce B

Produce A 40, 5 50, 50

Firm 1

Produce B 60, 40 5, 45

With collusion: Produce A1B2

Without collusion: Produce A1B2
Nash equilibrium

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 Bargaining Strategy

▪ Suppose
 Each firm is also bargaining on the decision to join in a research
consortium with a third firm.

Firm 2
Work alone Enter consortium

Work alone 10, 10 10, 20

Firm 1
Enter
20, 10 40, 40
consortium

Dominant strategy, Both enter

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 Linking the Bargain Problem
 Firm 1 announces it will join the consortium only if Firm 2 agrees to
produce A and Firm 1 will produce B.
• Firm 1’s profit increases from 50 to 60

▪ Strengthening Bargaining Power

 Credibility
 Reducing flexibility

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 2.11 Game Theory & Auction Strategy

• Auction Formats

 Traditional English (oral)

 Dutch auction
 Sealed-bid
• First price
• Second price

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 Examples

Many economic transactions are conducted through auctions

▪ treasury bills ▪ art work

▪ foreign exchange ▪ antiques
▪ publicly owned companies ▪ cars
▪ mineral rights ▪ houses
▪ airwave spectrum rights ▪ government contracts

Also can be thought of as auctions

▪ takeover battles
▪ queues
▪ wars of attrition
▪ lobbying contests

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 Auction Formats
1. Open bid auctions
1.1 ascending-bid auction
⋆ aka English auction, open-outcry
⋆ price is raised until only one bidder remains, who wins and pays
the final price
1.2 descending-bid auction
⋆ aka Dutch auction, open-outcry
⋆ price is lowered until someone accepts, who wins the object at the current price
2. Sealed bid auctions
2.1 first price auction
⋆ known as discriminatory auction when multiple items are being auctioned
⋆ highest bidder wins; pays the bid
2.2 second price auction known as uniform-price auction ...
⋆ aka Vickrey auction
⋆ highest bidder wins; pays the second highest bid

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 Auction Formats

Auctions also differ with respect to the valuation of the bidders

1. Private value auctions
▪ each bidder knows only her own value
▪ artwork, antiques, memorabilia
2. Common value auctions
▪ actual value of the object is the same for everyone
▪ bidders have different private information about that value
▪ oil field auctions, company takeovers

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 Strategically Equivalent Formats

English Auction Second Price

First Price
Dutch Auction

67
 Why Auction?

▪ Ans: Because many markets are imperfect and it is hard to discover

potential buyers’ true valuations of your asset. Auctions help to
discover this information.
 Types of Auctions
• English auction:
 bids are public announcements
 bid price rises until there are no further bids
 highest bid wins
 winner pays his bid.
• Sealed-bid first-price auction:
 bids are private information
 bids are made simultaneously
 highest bid wins
 winner pays his bid.
• Sealed-bid second-price auction:
 bids are private information
 bids are made simultaneously
 highest bidder wins
 winner pays second-highest bid
 also known as a Vickrey auction.
• Dutch auction:
 auctioneer announces a high bid and then gradually lowers the bid
 first buyer to accept wins and pays that price.
 Economists’ Classification of Auctions

▪ Private-value auctions:
 every potential buyer knows for sure her own valuation of the item
for sale
 all these individual valuations are independent of each other.
▪ Common-value auctions:
 item for sale has the same value to every potential buyer
 potential buyers differ in their own estimates of this common value.
 Auction Design
▪ Goals:
 Pareto efficiency
 maximization of the seller’s profit.
▪ Pareto efficiency:
 the item must sell to the buyer with the highest valuation of the
item.
▪ Which auctions are Pareto efficient?
 Auctions and Efficiency

▪ English auction with no reserve price must be efficient since, if a

buyer with a low valuation was about to buy, the highest
valuation buyer would bid higher.
▪ English auction with a reserve price need not be efficient since if
the reserve price is set above the (unknown to the seller) highest
buyer valuation, then there will be no sale and so no gains-to-
trade.
▪ Dutch auction need not be efficient. No buyer knows other
buyers’ valuations, so the highest valuation buyer may delay too
long and lose to another bidder.
• Sealed-bid first-price auction need not be efficient. No buyer
knows other buyers’ valuations, so the highest valuation buyer
may bid too low and lose to another bidder.
• Sealed-bid second-price auction is Pareto efficient even though
no buyer knows the other buyers’ valuations (more on this later).
 Why Use a Reserve Price?
▪ Suppose there are 2 buyers. The seller believes each buyer’s
valuation is $20 with chance 1/2 and $50 with chance 1/2.
▪ I.e. with chance 1/4 each, the seller believes she faces buyer
valuations ($20,$20), ($20,$50), ($50,$20) and ($50,$50).
▪ Use an English auction.
▪ Bids must be raised by at least $1.
▪ With chance 1/4 each, winning bids will be $20, $21, $21 and $50
if there is no reserve price.
▪ Seller’s expected revenue is
($20 + $21 + $21 + $50)/4 = $28 with no reserve price.
▪ With chance 1/4 each, the seller believes she faces buyer
valuations ($20,$20), ($20,$50), ($50,$20) and ($50,$50).
▪ Set a reserve price of $50.
▪ With chance 1/4 there will be no sale.
▪ With chance 3/4 the winning bid will be $50.
 Why Use a Reserve Price?

▪ Set a reserve price of $50.

▪ With chance 1/4 there will be no sale.
▪ With chance 3/4 the winning bid will be $50.
▪ Seller’s expected revenue is

3 1
 $50 +  $0 = $37  50  $28.
4 4
 Reserve Price and Efficiency

▪ The reserve price causes an efficiency loss since, with chance

1/4, there is no trade.
 Second-Price, Sealed-Bid Auction

▪ No bidder knows any other bidder’s true valuation of the item

for sale.
▪ Yet, it is individually rational for each bidder to state truthfully
his own valuation. Why?
▪ E.g. two bidders with true valuations v1 and v2 & bids of b1 and
b2, the expected gain to bidder 1 is
( v1 − b2 ) Pr( win ) + 0  Pr( lose)
= ( v1 − b2 ) Pr(b1  b2 ).
 Second-Price, Sealed-Bid Auction
▪ Expected gain to bidder 1 is ( v1 − b2 ) Pr(b1  b2 ).
▪ How is this maximized?
▪ If v1 > b2, then maximize the prob. of winning; i.e. set b1 = v1.
▪ If v1 < b2, then minimize the prob. of winning; i.e. set b1 = v1.
▪ Either way, telling the truth is best!
▪ Since truth-telling is best for every bidder, the highest valuation
bidder will win.
▪ Hence the second-price, sealed-bid auction is Pareto-efficient.
 Common-Value Auctions

▪ The item for sale has the same value to every potential buyer.
▪ Potential buyers differ in their own estimates of this common
value.
▪ Bidder i’s estimate is vi = v +  i where v is the common
value and is bidder i’s estimation error.
• If every bid is truthful, the winner is  i the bidder with the
largest estimation error
• so a truthful winner on average pays more than the true value -
- - the winner’s curse.
 Common-Value Auctions

• If every bid is truthful, the winner is the bidder with the largest
estimation error  i --- call it  imax
• If  imax  0 then a truthful winner on average pays more than the
v
true value --- the winner’s curse.
v
• So bids should on average be less than in a common-value
auction.
 What is mechanism design?

▪ In mechanism design, we get to design the game (or mechanism)

❑ e.g. the rules of the auction, marketplace, election, …
▪ Goal is to obtain good outcomes when agents behave
strategically (game-theoretically)
▪ Mechanism design often considered part of game theory
▪ Sometimes called “inverse game theory”
❑ In game theory the game is given and we have to figure out

how to act
❑ In mechanism design we know how we would like the agents

to act and have to figure out the game

▪ 2007 Nobel Prize in Economics!
 Example: (single-item) auctions

▪ Sealed-bid auction: every bidder submits bid in a sealed envelope

▪ First-price sealed-bid auction: highest bid wins, pays amount of own
bid
▪ Second-price sealed-bid auction: highest bid wins, pays amount of
second-highest bid

bid 1: $10

first-price: bid 1 wins, pays $10

bid 2: $5 second-price: bid 1 wins, pays $5

bid 3: $1
0
 Which auction generates more revenue?

• Each bid depends on

 bidder’s true valuation for the item (utility = valuation - payment),
 bidder’s beliefs over what others will bid (→ game theory),
 and... the auction mechanism used
• In a first-price auction, it does not make sense to bid your true valuation
 Even if you win, your utility will be 0…
• In a second-price auction, (we will see later that) it always makes sense to
bid your true valuation

bid 1: $10
a likely outcome bid 1: $5 a likely outcome
for the first-price bid 2: $4 for the second- bid 2: $5
mechanism price mechanism
bid 3: $1 bid 3: $1
0 0
Are there other auctions that perform better? How do we know when we have found the best one?
 Bidding truthfully is optimal in the Vickrey
auction!
• What should a bidder with value v bid?

Option 1: Win the

item at price b, get
utility v - b Would like to win if and
b = highest bid only if v - b > 0 – but
among other bidding truthfully
bidders accomplishes this!

Option 2: Lose the

item, get utility 0

We say the Vickrey auction is

strategy-proof
0
Discussion

Session

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I Thank You

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