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Brickley, Smith, and Zimmerman, Managerial Economics and Organizational Architecture, 4th ed. Chapter 9: Economics of Strategy: Game theory Game theory learning objectives • Structure a simple game in both matrix and tree formats • Specify a simple game • Identify Nash equilibria • Identify dominant strategies Game theory overview • General analysis of strategic interaction • Optimal decision making when – all decision agents are presumed rational – each attempts to anticipate actions of rivals Simultaneous-move, non-repeated interaction • Simultaneous? – Rivals must make decisions with no knowledge of each other’s decisions • Nonrepeated? – The interaction occurs only once Example • Boeing and Airbus individually choose and simultaneously submit a bid price (high or low) for 10 planes • Each cell entry represents the payoffs • A dominant strategy is one the firm chooses no matter what its rival does Strategic form dominant strategy Nash equilibrium revisited • In the absence of a dominant strategy, Nash equilibrium may predict outcome • Nash equilibrium is set of strategies where firm does its best given rival’s actions • Use arrow technique to identify Nash equilibrium Nash equilibrium Competition versus cooperation • Boeing and Airbus make simultaneous choices of new communications systems – two technologies: Alpha & Beta – both benefit with same choice • Results in two Nash equilibria – benefits from pre-commitment communication Coordination game two Nash equilibria Coordination/competition game Mixed strategies • Mixed strategy offers an element of surprise • Boeing and Airbus must simultaneously commit to an advertising campaign – Boeing benefits most from same strategy – Airbus benefits most from differentiation • Randomization with p=.5 is Nash equilibrium for both Mixed strategy Sequential interactions • Boeing & Airbus communications technology choice – Boeing chooses first • Analyze with backward induction – Boeing must take Airbus’s best response into account in making its choice – Boeing has first mover advantage • Credible commitment by second mover can alter first mover choice Extensive form sequential game Repeated strategic interaction • Boeing and Airbus compete often • Strategic choices can come to incorporate more than short-term payoffs Strategic interaction and organizational architecture • Kiana manages Lenin • Len must choose between working and shirking • Kiana must choose whether to incur monitoring costs • No pure strategy equilibrium exists Interactive game no pure strategy equilibrium