Segment 5: Strategic Thinking
Background
If competition is imperfect, firms may have to consider the reactions of
rivals when determining pricing and other aspects of business strategy. The
tools of game theory are critical in this regard. Game theory is the formal
analysis of strategic interdependence. Strategic interdependence
refers to situations in which one party's outcome (profits, rewards, benefits
and so on) depends crucially on the decisions of one or more other parties and
vice versa. In such situations, each party has to anticipate the actions and
reactions of all other parties to make an optimal choice.
Through the use of game models, decision-makers can predict the actions
and reactions of competitors, partners, customers and others quite accurately.
In this way, game theory allows you to approach problems from other people's
perspectives, thereby improving your own decision-making abilities.
Game theory can give insights into the strategic interdependence between
market participants. Two instances of this are competition in oligopolies and
competition in situations where there are network effects. In oligopoly, the
interaction is between competitors whereas when there are network effects, the
interaction is between complementors. Nonetheless,
the same basic tools of game theory can be applied to each situation.
Suggested reading
·
Dixit and Nalebuff, chapter 2 and 3 provide a good introduction to
game theory. Chapter 6 provides an overview of the value of commitment, and
chapter 9 tackles issues in achieving co-operation.
·
Alternative treatments of oligopoly can be found in
McAfee (Chpts 2-3) and Besanko
et al. (chapters 7 – 9).
· Shapiro and Varian provide a good treatment of network effects and standard setting; in particular, chapters 7–9.
Besanko, D. et al. Economics of Strategy, 2nd ed.
Dixit, A. and B. Nalebuff, Thinking Strategically: The Competitive Edge
in Business, Politics, and Everyday Life,
McAfee, P. Competitive Solutions,
Shapiro, C. and H. Varian, Information
Rules: A Strategic Guide to the Network Economy,
Segment Overview
·
Topic 5.2 sets up the basic concepts of game theory including
defining players, strategies and payoffs.
· Topic 5.3 considers the classic game models, such as the
Prisoner’s Dilemma, the Chicken Game and the Deer Hunt, to introduce students
to game theory.
·
Topic 5.4 looks at simultaneous move games. The solution concepts
of iterated dominance and Nash equilibrium are introduced.
·
Topic 5.5 looks at sequential move games. This introduces the
solution concept of backward induction.
· Topic 5.6 applies this to oligopolistic
pricing with a presentation of the basic Cournot and
Bertrand models.
·
Topic 5.7 considers network effects and their role in technology
adoption.
This segment concludes with
a segment assignment in which you consider the games being currently played
between video game manufacturers. These games involve competition between those
manufacturers but network effects in terms of their interaction with consumers.
Your Learning Outcomes
At the end
of this segment, you should be able to
·
formulate a competitive situation in
game theoretic terms
·
analyse the equilibrium outcome of such
games
·
apply basic game theoretic notions to the
issues of oligopolistic pricing
Sources
Portions of this segment draw upon course materials
prepared by Robert Gertner (University of
Chicago University of Chicago University of Melbourne University of
Melbourne
Now go on to topic 5.2, “Using Game Theory”