Managerial Economics
MBA ZC 416
Sidharth Mishra
Associate Professor, Management – Off Campus
Email: [email protected]
BITS Pilani
Pilani Campus
BITS Pilani
Pilani|Dubai|Goa|Hyderabad
Managerial Economics
Games, Information, and Strategy - Part 1
Agenda
• Introduction to Macro Economics
• National Income Measurement
• Introduction to Game Theory
• Strategy
• Dominant Strategy
• Nash Equilibrium
• First Mover Advantage
• Prisoner’s Dilemma
• Cooperative/ Repeated Games
• Trees and Sequential Games
• Economics of Information
BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956
Introduction to Macroeconomics
• Macroeconomics is the study of economic aspects of the
country as a whole. The studies concerning gross domestic
product, national income, government budget, balance of
payment etc. fall under the ambit of macroeconomics.
Microeconomics
Economic Territory
• An economic territory is a geographic territory administered by a government within
which persons, goods and capital freely circulate.
– Political frontiers including territorial waters and airspaces.
– Embassies, consulates, military bases located abroad but excluding the foreign
ones located within its own political frontiers.
– Etc.
• A Resident is a person or an institution whose centre of economic interest lies in the
economic territory of the country which he lives of is located.
– The resident lives or is located within the economic territory of the country.
(Indian nationals settled in US, Non-Resident Indians)
– The resident carries out the basic economic activities from that location.
National Income Aggregates
• Domestic Aggregates
– Measures of the value of production activity being carried out by
production units located within the economic territory of the
country.
• Gross Domestic Product (GDP), Net Domestic Product
• National Aggregates
– Measure of the contribution of residents of a country to production
inside and outside the economic territory of the country.
• Gross National Product(GNP), Net National Product
Gross Domestic Product (GDP)
• GDP at market prices
Gross Domestic Product at market prices is the value of
contribution to production by all the production units located
within the economic territory of a country, undiminished by the
Fertilizer subsidy: low price
consumption of fixed capital and indirect tax and
Rs. 100/kg, without
Rs. 60/kg, Rs. 40/kgadding
Govt.
subsidies. A: 100 carsX 5 lakh = Rs. 5 crore
B : 200 TV X Rs. 50000 = Rs. 1 crore
• GDP at Factor Costs* Rs. 6 crores
GST 10% Car : 5 lakh - !0%* 5 lakh = 450,000*100
– GDPfc = GDPmp – Indirect Taxes (GST) + Subsidies* TV: 50000 + 10000 = 60000 * 200 = 1.
5.7 cro
*Factor Costs: Costs incurred in terms of various factors (land, labour, capital) which have played a part in production and are exclusive of tax)
*Subsidies are a financial advantage granted to an individual, group or institution usually by the Govt.
Example
Two products. Cars, Fertilizer.
Production : 10,000 cars @ Rs 500,000 per car. 200,000 kg of fertilizer at Rs. 100 per kg.
GDP at market price = 10000 * 500,000 + 200000*100 = 502 Cr. (market prices)
1. GST is applicable only on cars @ 18%, Total GST = 10000*500,000*18% = 90 crore
2. Govt Subsidy on fertilizer is Rs. 20 per kg. Total subsidy = 200,000* 20 = Rs. 0.4 crore
GDP at factor cost = GDP at market price – GST+ Subsidy = 502 cr – 90 cr + 0.4 cr = 412.4 cr.
06/03/2016 MBA ZC416 Session 12
Net Domestic Product (NDP)
• NDP = GDP – Depreciation (Consumption of fixed capital)
• Depreciation is the fall in the value of fixed capital goods (like
building, machinery etc.) due to normal wear and tear and
obsolescence
• NDPmp = GDPmp – Depreciation (mp is market prices, fc: factor
cost)
• NDPfc = GDPfc – Depreciation = GDPmp – Indirect Taxes (GST) +
Subsidies - Depreciation = NDPmp – Indirect Taxes (GST)+
Subsidies
National Aggregates Gross National Product
• Measure of the contribution of residents to production both
inside and outside the economic territory of the country.
• (Gross/Net) National Product = (Gross/Net) Domestic Product –
Factor income paid to non-residents+ factor income received
from abroad by residents = (Gross/Net) Domestic Product+ Net
Factor income Received from Abroad (NFIA)
GNPmp/fc = GDPmp/fc + NFIA,
NNPmp/fc = NDPmp/fc + NFIA
*Factor income is flow of income derived from factors of production (Land – Rent, Labor – Wage, Capital – Profit)
Solved Example
• Calculate NDPfc and NNPfc with the following data.
• GNPmp = Rs. 200 crore, NFIA = -4 (minus 4), Depreciation
(Consumption of fixed capital) = 10, GST: 20 crore, Subsidies : 4
crore.
• NDPfc = GDPfc – Depreciation = GDPmp – GST+ Subsidies –
Depreciation = GNPmp – NFIA – GST+ Subsidies – Depreciation =
200-(-4)-(20)+4-10 = 200+4-10-20+4 = Rs. 178 crore
• NNPfc = NDPfc + NFIA = 178+(-4) = Rs. 174 crores
Real GDP and Nominal GDP
• Nominal GDP (GDP at current prices) of a particular year is
calculated using the current market values of goods.
• Real GDP (GDP at constant prices) is calculated with reference
to the base year. The nominal GDP is divided with a price index
(calculated using the base year prices as reference) to give Real
GDP which removes the influence of inflation from Nominal
GDP.
Real GDP of year 2 = (Nominal GDP of year 2/Price index of year 2)*100
Per capita real GDP
• Per capita Real GDP = Total Real GDP / Total population
• Per capita real GDP is a measure of the per capita availability of
goods and services to the people of the country
Per capita GDP and Welfare
• Per capita GDP is a measure of the amount of goods and services made available to
the people of the country. In a materialistic way, a high per capita GDP is considered
to be a good sign.
• However it is not a perfect measure of economic welfare for the following reasons.
– Many goods and services are not included in calculation of GDP.
• Items for self consumption ( a parent teaching a child, a mother or housewife’s inputs)
– Changes in distribution of income may affect welfare
• Inequality of income and consumption.
– All products may not contribute equally to welfare.
• Medicines, Entertainment services
– Some of the products may have negative impact on welfare.
• Tobacco
– Externalities not considered.
Strategy
A distinguishing characteristic of rivalrous market structures is that
individual firm managers need to take into consideration the
reactions of rival firms before making key decisions relating to
pricing or profitability of the firm.
This is particularly important in an Oligopoly, since there are only a
few firms in the industry, and the actions of a particular firm can
potentially adversely impact the other firms
Strategic Behavior: the plan of action or behavior of an oligopolist,
after taking into consideration all possible reactions of its
competitors
Strategies: changes to product pricing, quantity of product
produced, level of advertising, etc.
Managerial Economics (MBA416)
Game Theory
Game Theory: the study of decision making in the context of
Oligopoly is known as Game Theory
Players: decision makers whose behavior we are trying to explain
Strategy: the choice made by a decision maker by sacrificing other
options
Payoff: benefit of choosing a particular strategy
Payoff matrix: analysis of the payoff from various choices
Managerial Economics (MBA416)
Types of games
Zero-sum games: Gain of one
player is exactly equal to the loss of
the other player
Nonzero-sum games: gains or
losses of one firm do not come at the
expense of or provide equal benefit to
other firms
Managerial Economics (MBA416)
Dominant strategy - Identification
We will now discuss the process by which players choose the
optimalstrategy that maximizestheirpayoff
Let us take the example of thesimplest type of game in an
industry
Letusassumethatthereare twofirms named Firm A and Firm B
Each firm has a choice of two strategies: to advertise or not
to advertise
The actual level of profits of firm A depends on whether firm
B advertisesornot and vice versa for Firm B
Managerial Economics (MBA416)
Game Theory Pay-Off Matrix
• The market size for a product is 1 million units where two firms
are competing with each other. The price of the product is $
20. If firm A launches an ad campaign spending U$ 5 million it
would have a market share of 70% with the remaining staying
with Firm B and vice versa. If both of them spend U$ 1 million,
the market gets equally divided them between them. With
Advertising and not advertising as the strategic alternatives,
draw up the pay-off matrix. The gross margins are 40% and
50% for firms A and B.
Game Theory Pay-off Matrix
B
Ad No ad
Alternative 1: Both A and B are doing Ads.
(3,4)
A’s case: Business : 500,000 units Ad (4.6, ---)
Revenue = 500,000*20 = U$ 10 Million
Gross Margin @ 40% = U$ 10 Million*40% = U$ 4 Million A
Ad Expense = U$ 1 Million
Net Margin = 4 M – 1M = U$ 3 M
B’s Business = 500,000 units No ad
Revenue = 500,000*20 = U$ 10 Million
Gross Margin@50% = 10 Million*50% = U$ 5 Million
Ad Expense = U$ 1 Million
Net Margin = 5-1 = 4 Million
Alternative 2: A –Ad, B- No Ad
A: 70% Market Share = 700,000 units = U$ 14 M dollar
Gross Margin @ 40% = 14*0,4 = U$ 5.6 M
Ad Expanse = 1 M
Net Margin = 5.6 -1 = 4.6M
Advertising Example 1
Firm B
Advertise Don't Advertise
Firm A Advertise (4, 3) (5, 1)
Don't Advertise (2, 5) (3, 2)
What is the optimal strategy for Firm A if Firm B chooses to advertise?
Firm B
Advertise Don't Advertise
Firm A Advertise (4, 3) (5, 1)
Don't Advertise (2, 5) (3, 2)
Managerial Economics (MBA416)
Advertising Example 1
What is the optimal strategy for Firm A if Firm B chooses
to advertise?
If Firm A chooses to advertise, the payoff is 4. Otherwise, the
payoff is 2. The optimal strategy is to advertise.
Firm B
Advertise Don't Advertise
Firm A Advertise (4, 3) (5, 1)
Don't Advertise (2, 5) (3, 2)
Managerial Economics (MBA416)
Advertising Example 1
What is the optimal strategy for Firm A if Firm B chooses
not to advertise?
If Firm A chooses to advertise, the payoff is 5. Otherwise, the
payoff is 3. Again, the optimal strategy is to advertise.
Firm B
Advertise Don't Advertise
Firm A Advertise (4, 3) (5, 1)
Don't Advertise (2, 5) (3, 2)
Firm B
Advertise Don't Advertise
Firm A Advertise (4, 3) (5, 1)
Don't Advertise (2, 5) (3, 2)
Managerial Economics (MBA416)
Advertising Example 1
Regardless of what Firm B decides to do, the optimal strategy for Firm
A is to advertise.The dominant strategy for Firm A is toadvertise.
Dominant strategy is a strategic choice that is the best for a given firm
irrespective of the choice made by the rival firm
Firm B
Advertise Don't Advertise
Firm A Advertise (4, 3) (5, 1)
Don't Advertise (2, 5) (3, 2)
Managerial Economics (MBA416)
Advertising Example 1
What is the optimal strategy for Firm B if Firm A chooses to advertise?
Firm B
Advertise Don't Advertise
Firm A Advertise (4, 3) (5, 1)
Don't Advertise (2, 5) (3, 2)
Managerial Economics (MBA416)
Advertising Example 1
What is the optimal strategy for Firm B if Firm A chooses
to advertise?
If Firm B chooses to advertise, the payoff is 3. Otherwise, the
payoff is 1. The optimal strategy is to advertise.
Firm B
Advertise Don't Advertise
Firm A Advertise (4, 3) (5, 1)
Don't Advertise (2, 5) (3, 2)
Managerial Economics (MBA416)
Advertising Example 1
What is the optimal strategy for Firm B if Firm A chooses not to
advertise?
Firm B
Advertise Don't Advertise
Firm A Advertise (4, 3) (5, 1)
Don't Advertise (2, 5) (3, 2)
Managerial Economics (MBA416)
Advertising Example 1
• What is the optimal strategy for Firm B if
Firm A chooses not to advertise?
• If Firm B chooses to advertise, the payoff is 5.
Otherwise, the payoff is 2. Again, the optimal
strategy is to advertise.
Firm B
Advertise Don't Advertise
Firm A Advertise (4, 3) (5, 1)
Don't Advertise (2, 5) (3, 2)
Managerial Economics (MBA416)
Advertising Example 1
Regardless of what Firm A decides to do, the optimal strategy for Firm
B is to advertise.The dominant strategy for Firm B is toadvertise.
Firm B
Advertise Don't Advertise
Firm A Advertise (4, 3) (5, 1)
Don't Advertise (2, 5) (3, 2)
Managerial Economics (MBA416)
Advertising Example 1
The dominant strategy for Firm A is to advertise and the
dominant strategy for Firm B is to advertise. The Nash
equilibrium is for both firms is to advertise.
Nash Equilibrium is a game outcome in which each
player obtains the best possible result given the strategy
of the rival firm.
Firm B
Advertise Don't Advertise
Firm A Advertise (4, 3) (5, 1)
Don't Advertise (2, 5) (3, 2)
Managerial Economics (MBA416)
THANK YOU
Managerial Economics
MBA ZC 416
Krishnamurthy Bindumadhavan, CFA, FRM
Associate Professor, Management - Finance
Email:
[email protected] BITS Pilani
Pilani Campus
BITS Pilani
Pilani|Dubai|Goa|Hyderabad
Managerial Economics
Games, Information, and Strategy - Part 1
Agenda
• Strategy
• Game Theory
• Dominant Strategy
• Nash Equilibrium
• First Mover Advantage
• Prisoner’s Dilemma
• Cooperative/ Repeated Games
• Trees and Sequential Games
• Economics of Information
BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956
Nash equilibrium
Not all games have a dominant strategy for each
player
In the real world, one or both players may not have
a dominant strategy
In the example that follows, Firm B has a
dominant strategy, but firm A does not have a
dominant strategy
If at least one of the players has a dominant
strategy then a Nash equilibrium can still occur (as
we will see in this example)
Managerial Economics (MBA416)
Advertising Example 2
What is the optimal strategy for Firm A if Firm B chooses to advertise?
Firm B
Advertise Don't Advertise
Firm A Advertise (4, 3) (5, 1)
Don't Advertise (2, 5) (6, 2)
Managerial Economics (MBA416)
Advertising Example 2
What is the optimal strategy for Firm A if Firm B chooses
to advertise?
If Firm A chooses to advertise, the payoff is 4. Otherwise, the
payoff is 2. The optimal strategy is to advertise.
Firm B
Advertise Don't Advertise
Firm A Advertise (4, 3) (5, 1)
Don't Advertise (2, 5) (6, 2)
Managerial Economics (MBA416)
Advertising Example 2
What is the optimal strategy for Firm A if Firm B chooses not to
advertise?
Firm B
Advertise Don't Advertise
Firm A Advertise (4, 3) (5, 1)
Don't Advertise (2, 5) (6, 2)
Managerial Economics (MBA416)
Advertising Example 2
What is the optimal strategy for Firm A if Firm B chooses
not to
advertise?
If Firm A chooses to advertise, the payoff is 5. Otherwise, the
payoff is 6. In this case, the optimal strategy is not to
advertise.
Firm B
Advertise Don't Advertise
Firm A Advertise (4, 3) (5, 1)
Don't Advertise (2, 5) (6, 2)
Managerial Economics (MBA416)
Advertising Example 2
The optimal strategy for Firm A depends on which strategy is chosen by
Firms B.
In other words, FirmA does not have a dominant strategy.
Firm B
Advertise Don't Advertise
Firm A Advertise (4, 3) (5, 1)
Don't Advertise (2, 5) (6, 2)
Managerial Economics (MBA416)
Advertising Example 2
What is the optimal strategy for Firm B if Firm A chooses to advertise?
Firm B
Advertise Don't Advertise
Firm A Advertise (4, 3) (5, 1)
Don't Advertise (2, 5) (6, 2)
Managerial Economics (MBA416)
Advertising Example 2
What is the optimal strategy for Firm B if Firm A chooses
to advertise?
If Firm B chooses to advertise, the payoff is 3. Otherwise, the
payoff is 1. The optimal strategy is to advertise.
Firm B
Advertise Don't Advertise
Firm A Advertise (4, 3) (5, 1)
Don't Advertise (2, 5) (6, 2)
Managerial Economics (MBA416)
Advertising Example 2
What is the optimal strategy for Firm B if Firm A chooses not to
advertise?
Firm B
Advertise Don't Advertise
Firm A Advertise (4, 3) (5, 1)
Don't Advertise (2, 5) (6, 2)
Managerial Economics (MBA416)
Advertising Example 2
• What is the optimal strategy for Firm B if
Firm A chooses not to advertise?
• If Firm B chooses to advertise, the payoff is 5.
Otherwise, the payoff is 2. Again, the optimal
strategy is to advertise.
Firm B
Advertise Don't Advertise
Firm A Advertise (4, 3) (5, 1)
Don't Advertise (2, 5) (6, 2)
Managerial Economics (MBA416)
Advertising Example 2
Regardless of what Firm A decides to do, the optimal strategy for Firm
B is to advertise.The dominant strategy for Firm B is toadvertise.
Firm B
Advertise Don't Advertise
Firm A Advertise (4, 3) (5, 1)
Don't Advertise (2, 5) (6, 2)
Managerial Economics (MBA416)
Advertising Example 2
The dominant strategy for Firm B is to advertise. If Firm B
chooses to advertise, then the optimal strategy for Firm A is
to advertise. The Nash equilibrium for both firms is to
advertise.
This example illustrates the use of a iterative dominance
strategy (by firm A) that is arrived at after considering the
possible game outcomes and identifying the dominated rival
strategies.
Firm B
Advertise Don't Advertise
Firm A Advertise (4, 3) (5, 1)
Don't Advertise (2, 5) (6, 2)
Managerial Economics (MBA416)
First Mover Advantage
In this example (from textbook, page 424) there is more than
one Nash equilibrium.
If play is simultaneous then the results are unpredictable,
however if we assume that one of the firms makes the entry
first then we can indeed predict what the other firm will do
once it is able to observe the action of the rival.
This example illustrates the first mover advantage that
accrues to the player who makes the first strategic choice in a
sequential game.
Firm B
Enter Do not enter
Firm A Enter (7, 7) (10, 8)
Do not enter (8, 10) (7, 7)
Managerial Economics (MBA416)
Prisoners’ Dilemma
Two suspects are arrested for armed robbery.
They are immediately separated.
However, the evidence is not sufficient to convict them of
more than the crime of possessing stolen goods, which
carries a sentence of only 1 year.
Managerial Economics (MBA416)
Cooperative Games
Situation where decisions are made collectively by two or more
players
However in most countries antitrust laws prohibit collusion in
decisions relating to pricing, market share, etc.
But the OPEC cartel is an example of a cooperative game where there
is explicit collusion
Managerial Economics (MBA416)
Repeated Games
In many business situations games are not one shot games but rather
played over and over again
This is particularly true in advertising and pricing decisions
In situations where the game may be repeated over and over again
(infinitely), a form of collusion called “tacit collusion” may
spontaneously occur
Managerial Economics (MBA416)
Repeated Games - Pricing
In this example (from textbook, page 428) the Nash
equilibrium (one shot) is for both firms to charge a low price
However if both agree to charge a High price then they will
make huge profits (this cannot be done explicitly)
However there is an incentive to defect but since the game is
repeated the defector will be penalized in the next period due
to the presence of a credible threat
Firm B
High Price Low Price
Firm A High Price (20, 20) (-20, 60)
Low Price (60, -20) (0, 0)
Managerial Economics (MBA416)
Trees and Sequential Games
Sequential games are typically analyzed using a decision tree analysis
method
A decision tree is a diagram that maps out the strategy (or game) in
the form of a tree with decision nodes and branches
Backward induction is used to identify the optimal decisions by
working backwards through the tree starting from the best outcome
for each player.
Managerial Economics (MBA416)
Economics of Information
Information is typically neither free nor complete
Search costs are the economic costs associated with searching,
obtaining and analyzing information before we make a decision
The tools of marginal analysis can be applied to optimize search costs
Asymmetric Information is the situation where one party to a
transaction has more information than the other
Adverse Selection is the situation where the information relating to a
transaction attracts undesirable customers
Moral Hazard is the phenomenon of engaging in risky behavior by
one party of a transaction to the detriment of the counter party
Asymmetry and Moral Hazard typically occur when one party has
private information that is relevant but unavailable to the counterparty
Monitoring Costs are costs incurred to ensure compliance to the
terms of the agreement
Signaling is an alternative way of communicating otherwise
unobservable information
Managerial Economics (MBA416)
Joint Product Pricing
• Joint Products that are interdependent in production and one
necessarily results in the production of the other. The product
with higher economic value is called the main product while
the one with lower economic value is called the by-product.
– Steel – Cement
– Rice – Straw (Paddy cultivation)
– Wool-Meat (Sheep rearing)
– The by-product may come in a fixed proportion or a variable
proportion.
06/03/2016 MBA ZC416 Session 12
06/03/2016 MBA ZC416 Session 12
THANK YOU
