CHAPTER 13

Game Theory and

CHAPTER OUTLINE
Competitive Strategy 13.1 Gaming and Strategic
Decisions
13.2 Dominant Strategies
13.3 The Nash Equilibrium
Revisited
13.4 Repeated Games
13.5 Sequential Games
13.6 Threats, Commitments
and Credibility
13.7 Entry Deterrence
13.8 Auctions

Prepared by:
Fernando Quijano, Illustrator

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 13.1 Gaming and Strategic Decisions
● game Situation in which players (participants) make strategic
decisions that take into account each other’s actions and responses.

● payoff Value associated with a possible outcome.

● strategy Rule or plan of action for playing a game.

● optimal strategy Strategy that maximizes a player’s expected payoff.

If I believe that my competitors are rational and act to maximize their own
payoffs, how should I take their behavior into account when making my
decisions?

Determining optimal strategies can be difficult, even under conditions of

complete symmetry and perfect information.

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 Noncooperative versus Cooperative Games

● cooperative game Game in which participants can negotiate

binding contracts that allow them to plan joint strategies.
● noncooperative game Game in which negotiation and enforcement of
binding contracts are not possible.

It is essential to understand your opponent’s point of view and to deduce his

or her likely responses to your actions.

Note that the fundamental difference between cooperative and noncooperative

games lies in the contracting possibilities. In cooperative games, binding
contracts are possible; in noncooperative games, they are not.

HOW TO BUY A DOLLAR BILL

A dollar bill is auctioned, but in an unusual way. The highest bidder receives the
dollar in return for the amount bid. However, the second-highest bidder must
also hand over the amount that he or she bid—and get nothing in return.
If you were playing this game, how much would you bid for the dollar bill?
Classroom experience shows that students often end up bidding more than a
dollar for the dollar.
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 EXAMPLE 13.1 ACQUIRING A COMPANY

You represent Company A, which is considering acquiring Company T. You plan

to offer cash for all of Company T’s shares, but you are unsure what price to
offer. The value of Company T depends on the outcome of a major oil
exploration project.
If the project succeeds, Company T’s value under current management could be
as high as $100/share. Company T will be worth 50 percent more under the
management of Company A. If the project fails, Company T is worth $0/share
under either management. This offer must be made now—before the outcome
of the exploration project is known.
You (Company A) will not know the results of the exploration project when
submitting your price offer, but Company T will know the results when deciding
whether to accept your offer. Also, Company T will accept any offer by Company
A that is greater than the (per share) value of the company under current
management.
You are considering price offers in the range $0/share (i.e., making no offer at all)
to $150/share. What price per share should you offer for Company T’s stock?
The typical response—to offer between $50 and $75 per share—is wrong. The
answer is provided later in this chapter, but we urge you to try to find the answer
on your own.

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 13.2 Dominant Strategies
● dominant strategy Strategy that is optimal no matter what an
opponent does.

TABLE 13.1 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

Advertising is a dominant strategy for Firm A. The same is true for

Firm B: No matter what firm A does, Firm B does best by advertising. The
outcome for this game is that both firms will advertise.

● equilibrium in dominant strategies Outcome of a game in which each firm

is doing the best it can regardless of what its competitors are doing.

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 Unfortunately, not every game has a dominant strategy for each player.

TABLE 13.2 MODIFIED ADVERTISING GAME

Firm 2
Advertise Don’t advertise

Advertise 10, 5 10, 10

Firm 1
Don’t advertise 6, 8 20, 2

Now Firm A has no dominant strategy. Its optimal decision depends on what
Firm B does. If Firm B advertises, Firm A does best by advertising; but if Firm B
does not advertise, Firm A also does best by not advertising.

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 13.3 The Nash Equilibrium Revisited

Dominant Strategies: I’m doing the best I can no matter what you do.
You’re doing the best you can no matter what I do.
Nash Equilibrium: 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 PRODUCT CHOICE PROBLEM

Two new variations of cereal can be successfully introduced—provided that
each variation is introduced by only one firm.
TABLE 13.3 PRODUCT CHOICE PROBLEM
Firm 2
Crispy Sweet
Crispy –5, –5 10, 10
Firm 1
Sweet 10, 10 –5, –5

In this game, each firm is indifferent about which product it produces—so long as it does
not introduce the same product as its competitor. The strategy set given by the bottom left-
hand corner of the payoff matrix is stable and constitutes a Nash equilibrium: Given the
strategy of its opponent, each firm is doing the best it can and has no incentive to deviate.
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 THE BEACH LOCATION GAME

FIGURE 13.1
BEACH LOCATION GAME
You (Y) and a competitor (C) plan to sell soft drinks on a beach.
If sunbathers are spread evenly across the beach and will walk to the closest vendor, the
two of you will locate next to each other at the center of the beach. This is the only Nash
equilibrium.
If your competitor located at point A, you would want to move until you were just to the
left, where you could capture three-fourths of all sales.
But your competitor would then want to move back to the center, and you would do the
same.
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 Maximin Strategies

TABLE 13.4 MAXIMIN STRATEGY

Firm 2
Don’t invest Invest

Don’t invest 0, 0 –10, 10

Firm 1
Invest –100, 0 20, 10

In this game, the outcome (invest, invest) is a Nash equilibrium. But if

you are concerned that the managers of Firm 2 might not be fully informed or
rational—you might choose to play “don’t invest.” In that case, the worst that
can happen is that you will lose $10 million; you no longer have a chance of
losing $100 million.
● maximin strategy Strategy that maximizes the minimum gain that can be
earned.
MAXIMIZING THE EXPECTED PAYOFF
If Firm 1 is unsure about what Firm 2 will do but can assign probabilities to
each feasible action for Firm 2, it could instead use a strategy that maximizes
its expected payoff.

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 THE PRISONERS’ DILEMMA

TABLE 13.5 PRISONERS’ DILEMMA

Prisoner B
Confess Don’t confess

Confess –5, –5 –1, –10

Prisoner A
Don’t confess –10, –1 –2, –2

the ideal outcome is one in which neither prisoner

confesses, so that both get two years in prison. Confessing, however, is a
dominant strategy for each prisoner—it yields a higher payoff regardless of the
strategy of the other prisoner.

Dominant strategies are also maximin strategies. The outcome in which both
prisoners confess is both a Nash equilibrium and a maximin solution. Thus, in a
very strong sense, it is rational for each prisoner to confess.

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 Mixed Strategies
● pure strategy Strategy in which a player makes a specific choice
or takes a specific action.

MATCHING PENNIES

TABLE 13.6 MATCHING PENNIES

Player B
Heads Tails
Heads 1, –1 –1, 1
Player A
Tails –1, 1 1, –1

In this game, each player chooses heads or tails and the two players reveal
their coins at the same time. If the coins match Player A wins and receives a
dollar from Player B. If the coins do not match, Player B wins and receives a
dollar from Player A.
Note that there is no Nash equilibrium in pure strategies for this game. No
combination of heads or tails leaves both players satisfied—one player or the
other will always want to change strategies.

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 ● mixed strategy Strategy in which a player makes a random
choice among two or more possible actions, based on a set of chosen
probabilities..
Although there is no Nash equilibrium in pure strategies, there is a Nash
equilibrium in mixed strategies.
In the matching pennies game, for example, Player A might simply flip the coin,
thereby playing heads with probability 1/2 and playing tails with probability 1/2.
In fact, if Player A follows this strategy and Player B does the same, we will
have a Nash equilibrium: Both players will be doing the best they can given
what the opponent is doing. Note that although the outcome is random, the
expected payoff is 0 for each player.
It may seem strange to play a game by choosing actions randomly. But put
yourself in the position of Player A and think what would happen if you followed
a strategy other than just flipping the coin. Suppose you decided to play heads.
If Player B knows this, she would play tails and you would lose. Even if Player
B didn’t know your strategy, if the game were played repeatedly, she could
eventually discern your pattern of play and choose a strategy that countered it.
Once we allow for mixed strategies, every game has at least one Nash
equilibrium.
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 THE BATTLE OF THE SEXES

TABLE 13.7 THE BATTLE OF THE SEXES

Jim
Wrestling Opera

Wrestling 2, 1 0, 0
Prisoner A
Opera 0, 0 1, 2

There are two Nash equilibria in pure strategies for this game—the one in
which Jim and Joan both watch mud wrestling, and the one in which they both
go to the opera. This game also has an equilibrium in mixed strategies: Joan
chooses wrestling with probability 2/3 and opera with probability 1/3, and Jim
chooses wrestling with probability 1/3 and opera with probability 2/3.
Should we expect Jim and Joan to use these mixed strategies? Unless they’re
very risk loving or in some other way a strange couple, probably not. By
agreeing to either form of entertainment, each will have a payoff of at least 1,
which exceeds the expected payoff of 2/3 from randomizing.

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 13.4 Repeated Games
● repeated game Game in which actions are taken and payoffs
received over and over again.

TABLE 13.8 PRICING PROBLEM

Firm 2
Low price High price

Low price 10, 10 100, –50

Firm 1
High price –50, 100 50, 50

Suppose this game is repeated over and over again—for example, you and
your competitor simultaneously announce your prices on the first day of every
month. Should you then play the game differently?

TIT-FOR-TAT STRATEGY
In the pricing problem above, the repeated game strategy that works best is the
tit-for-tat strategy.

● tit-for-tat strategy Repeated-game strategy in which a player responds in

kind to an opponent’s previous play, cooperating with cooperative opponents
and retaliating against uncooperative ones.

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 INFINITELY REPEATED GAME
When my competitor and I repeatedly set prices month after month,
forever, cooperative behavior (i.e., charging a high price) is then the
rational response to a tit-for-tat strategy. (This assumes that my competitor
knows, or can figure out, that I am using a tit-for-tat strategy.) It is not rational to
undercut.
With infinite repetition of the game, the expected gains from cooperation will
outweigh those from undercutting. This will be true even if the probability that I
am playing tit-for-tat (and so will continue cooperating) is small.
FINITE NUMBER OF REPETITIONS
Now suppose the game is repeated a finite number of times—say, N months. (N
can be large as long as it is finite.) If my competitor (Firm 2) is rational and
believes that I am rational.
In this case, both firms will not consider undercutting until the last month, before
the game is over, so Firm 1 cannot retaliate.
However, Firm 2 knows that I will charge a low price in the last month. But then
what about the next-to-last month? Because there will be no cooperation in the
last month, anyway, Firm 2 figures that it should undercut and charge a low price
in the next-to-last month. But, of course, I have figured this out too. In the end,
the only rational outcome is for both of us to charge a low price every month.
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 TIT-FOR-TAT IN PRACTICE
The tit-for-tat strategy can sometimes work and cooperation can
prevail. There are two primary reasons.
First, most managers don’t know how long they will be competing with their rivals.
The unravelling argument that begins with a clear expectation of undercutting in the
last month no longer applies. As with an infinitely repeated game, it will be rational
to play tit-for-tat.
Second, my competitor might have some doubt about the extent of my rationality.
“Perhaps,” thinks my competitor, “Firm 1 will play tit-for-tat blindly, charging a high
price as long as I charge a high price.”
Just the possibility can make cooperative behavior a good strategy (until near the
end) if the time horizon is long enough. Although my competitor’s conjecture about
how I am playing the game might be wrong, cooperative behavior is profitable in
expected value terms. With a long time horizon, the sum of current and future
profits, weighted by the probability that the conjecture is correct, can exceed the
sum of profits from price competition, even if my competitor is the first to undercut.
Thus, in a repeated game, the prisoners’ dilemma can have a cooperative outcome.
Sometimes cooperation breaks down or never begins because there are too many
firms. More often, failure to cooperate is the result of rapidly shifting demand or cost
conditions.
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 EXAMPLE 13.2 OLIGOPOLISTIC COOPERATION IN THE WATER
METER INDUSTRY
For some four decades, almost all the water meters
sold in the United States have been produced by
four American companies: Rockwell International,
Badger Meter, Neptune Water Meter Company, and
Hersey Products.
Most buyers of water meters are municipal water
utilities, who install the meters in order to measure
water consumption and bill consumers accordingly.
With inelastic and stable demand and little threat of entry by new firms, the
existing four firms could earn substantial monopoly profits if they set prices
cooperatively. If, on the other hand, they compete aggressively, profits would fall
to nearly competitive levels.
The firms thus face a prisoners’ dilemma. Can cooperation prevail?
It can and has prevailed. There is rarely an attempt to undercut price, and each
firm appears satisfied with its share of the market. All four firms have been
earning returns on their investments that far exceed those in more competitive
industries.

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 EXAMPLE 13.3 COMPETITION AND COLLUSION IN THE AIRLINE
INDUSTRY
In March 1983, American Airlines proposed that all
airlines adopt a uniform fare schedule based on
mileage. This proposal would have done away with
the many different fares then available. Most other
major airlines reacted favorably to the plan and
began to adopt it.

Was it really to “help reduce fare confusion”? No, the aim was to reduce price
competition and achieve a collusive pricing arrangement. Prices had been driven
down by competitive undercutting, as airlines competed for market share. The
plan failed, a victim of the prisoners’ dilemma.

Each airline, therefore, has an incentive to lower fares in order to capture

passengers from its competitors. In addition, the demand for air travel often
fluctuates unpredictably. Such factors as these stand in the way of implicit price
cooperation. Thus, aggressive competition has continued to be the rule in the
airline industry. Discount airlines, reduction in fares in order to attract customers,
and “fare shopping” in the Internet have forced several major airlines into
bankruptcy and resulted in record losses for the industry.

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 13.5 Sequential Games
● sequential game Game in which players move in turn,
responding to each other’s actions and reactions.

The Stackelberg model discussed in Chapter 12 is an example of a sequential

game; one firm sets output before the other does. There are many other
examples of sequential games in advertising decisions, entry-deterring
investment, and responses to government regulations.
In a sequential game, the key is to think through the possible actions and
rational reactions of each player.

TABLE 13.9 MODIFIED PRODUCT CHOICE PROBLEM

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

Suppose that both firms, in ignorance of each other’s intentions, must announce
their decisions independently and simultaneously. In that case, both will probably
introduce the sweet cereal—and both will lose money. In a sequential game, Firm
1 introduces a new cereal, and then Firm 2 introduces one.
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 The Extensive Form of a Game

● extensive form of a game Representation of possible moves in

a game in the form of a decision tree.

FIGURE 13.2
PRODUCE CHOICE GAME IN EXTENSIVE FORM

Although this outcome can be deduced from the payoff matrix in Table 13.9,
sequential games are sometimes easier to visualize if we represent the
possible moves in the form of a decision tree.
To find the solution to the extensive form game, work backward from the end.
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 The Advantage of Moving First
As in Chapter 12, we will use the example in which two duopolists face
the market demand curve 𝑃 = 30 − 𝑄.

TABLE 13.10 CHOOSING OUTPUT

FIRM 2
7.5 10 15
7.5 112.50, 112.50 93.75, 125 56.25, 112.50
FIRM 1
10 125, 93.75 100, 100 50, 75
15 112.50, 56.25 75, 50 0, 0

If both firms move simultaneously, the only solution to the game is that both
produce 10 and earn 100. In this Cournot equilibrium each firm is doing the
best it can given what its competitor is doing.

Compared to the Cournot outcome, when Firm 1 moves first, it does better—
and Firm 2 does much worse.

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 13.6 Threats, Commitments, and
Credibility
The product choice problem and the Stackelberg model are two examples of
how a firm that moves first can create a fait accompli that gives it an advantage
over its competitor.

In this section, we’ll consider what determines which firm goes first. We will
focus on the following question: What actions can a firm take to gain advantage
in the marketplace?

Recall that in the Stackelberg model, the firm that moved first gained an
advantage by committing itself to a large output. Making a commitment—
constraining its future behavior—is crucial.

If Firm 2 knows that Firm 1 will respond by reducing the output that it first
announced, Firm 2 would produce a large output. . The only way that Firm 1
can gain a first-mover advantage is by committing itself. In effect, Firm 1
constrains Firm 2’s behavior by constraining its own behavior.

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 In the product-choice problem shown in Table 13.9, the firm that introduces its
new breakfast cereal first will do best. Each has an incentive to commit itself
first to the sweet cereal.

Firm 1 must constrain its own behavior in some way that convinces Firm 2 that
Firm 1 has no choice but to produce the sweet cereal. Firm 1 might launch an
expensive advertising campaign, or contract for the forward delivery of a large
quantity of sugar (and make the contract public).

Firm 1 can’t simply threaten Firm 2 because Firm 2 has little reason to believe
the threat—and can make the same threat itself. A threat is useful only if it is
credible.

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 Empty Threats
As in Chapter 12, we will use the example in which two duopolists face
the market demand curve 𝑃 = 30 − 𝑄.

TABLE 13.11 PRICING OF COMPUTERS AND WORD

PROCESSORS
FIRM 2
High price Low price

High price 100, 80 80, 100

FIRM 1
Low price 20, 0 10, 20

As long as Firm 1 charges a high price for its computers, both firms can make a
good deal of money. Firm 1 would prefer the outcome in the upper left-hand
corner of the matrix. For Firm 2, however, charging a low price is clearly a
dominant strategy. Thus the outcome in the upper right-hand corner will prevail
(no matter which firm sets its price first).

Can Firm 1 induce Firm 2 to charge a high price by threatening to charge a low
price if Firm 2 charges a low price? No. Whatever Firm 2 does, Firm 1 will be
much worse off if it charges a low price. As a result, its threat is not credible.

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 Commitment and Credibility

TABLE 13.12 (a) PRODUCTION CHOICE PROBLEM

Race Car Motors
Small cars Big Cars

Far Out Small engines 3, 6 3, 0

Engines Big engines 1, 1 8, 3

Here we have a sequential game in which Race Car is the “leader.” Race Car
will do best by deciding to produce small cars. It knows that in response to this
decision, Far Out will produce small engines, most of which Race Car will then
buy. Can Far Out induce Race Car to produce big cars instead of small ones?

Suppose Far Out threatens to produce big engines. If Race Car believed Far
Out’s threat, it would produce big cars. But the threat is not credible. Far Out
can make its threat credible by visibly and irreversibly reducing some of its own
payoffs in the matrix, thereby constraining its own choices. It might do this by
shutting down or destroying some of its small engine production capacity. This
would result in the payoff matrix shown in Table 13.12(b).

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 Commitment and Credibility

TABLE 13.12 (b) MODIFIED PRODUCTION CHOICE PROBLEM

Race Car Motors
Small cars Big Cars

Far Out Small engines 0, 6 0, 0

Engines Big engines 1, 1 8, 3

Now Race Car knows that whatever kind of car it produces, Far Out will
produce big engines. Now it is clearly in Race Car’s interest to produce large
cars. By taking an action that seemingly puts itself at a disadvantage, Far Out
has improved its outcome in the game.

Although strategic commitments of this kind can be effective, they are risky and
depend heavily on having accurate knowledge of the payoff matrix and the
industry. Suppose, for example, that Far Out commits itself to producing big
engines but is surprised to find that another firm can produce small engines at
a low cost. The commitment may then lead Far Out to bankruptcy rather than
continued high profits.

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 THE ROLE OF REPUTATION

Developing the right kind of reputation can also give one a strategic advantage.

Suppose that the managers of Far Out Engines develop a reputation

for being irrational—perhaps downright crazy. They threaten to produce big
engines no matter what Race Car Motors does.

In gaming situations, the party that is known (or thought) to be a little crazy can
have a significant advantage. Developing a reputation can be an especially
important strategy in a repeated game.

A firm might find it advantageous to behave irrationally for several plays of the
game. This might give it a reputation that will allow it to increase its long-run
profits substantially.

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 Bargaining Strategy
TABLE 13.13 PRODUCTION DECISION
Firm 2
Produce A Produce B

Produce A 40, 5 50, 50

Firm 1
Produce B 60, 40 5, 45

Here, the firms produce two complementary goods. Because producing B is a

dominant strategy for Firm 2, (A, B) is the only Nash equilibrium.
Suppose, however, that Firms 1 and 2 are bargaining over to join a research
consortium that a third firm is trying to form, and Firm 1 announces that it will
join the consortium only if Firm 2 agrees to produce product A. In this case, it is
indeed in Firm 2’s interest to produce A (with Firm 1 producing B).
TABLE 13.14 DECISION TO JOIN CONSORTIUM
Firm 2
Work alone Enter consortium

Work alone 10, 10 10, 20

Firm 1
Enter consortium 20, 10 40, 40

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 EXAMPLE 13.4 WAL-MART STORES’ PREEMPTIVE INVESTMENT
STRATEGY
How did Wal-Mart Stores succeed where others
failed? The key was Wal-Mart’s expansion
strategy. To charge less than ordinary department
stores and small retail stores, discount stores rely
on size, no frills, and high inventory turnover.

Through the 1960s, the conventional wisdom held that a discount store could
succeed only in a city with a population of 100,000 or more. Sam Walton
disagreed and decided to open his stores in small Southwestern towns.

The stores succeeded because Wal-Mart had created 30 “local monopolies.”

Discount stores that had opened in larger towns and cities were competing with
other discount stores, which drove down prices and profit margins. These small
towns, however, had room for only one discount operation. There are a lot of
small towns in the United States, so the issue became who would get to each
town first. Wal-Mart now found itself in a preemption game of the sort illustrated
by the payoff matrix in Table 13.15.

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 EXAMPLE 13.4 WAL-MART STORES’ PREEMPTIVE INVESTMENT
STRATEGY
TABLE 13.15 THE DISCOUNT STORE PREEMPTION GAME
Company X
Enter Don’t enter

Enter –10 , –10 20, 0

Wal-Mart
Don’t enter 0, 20 0, 0

This game has two Nash equilibria—the lower left-hand corner and the upper
right-hand corner. Which equilibrium results depends on who moves first.
The trick, therefore, is to preempt—to set up stores in other small towns quickly,
before Company X (or Company Y or Z) can do so. That is exactly what Wal-Mart
did. By 1986, it had 1009 stores in operation and was earning an annual profit of
$450 million. And while other discount chains were going under, Wal-Mart
continued to grow. By 1999, Wal-Mart had become the world’s largest retailer,
with 2454 stores in the United States and another 729 stores in the rest of the
world, and had annual sales of $138 billion.
In recent years, Wal-Mart has continued to preempt other retailers by opening
new discount stores, warehouse stores (such as Sam’s Club), and combination
discount and grocery stores (Wal-Mart Supercenters) all over the world.
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 13.7 Entry Deterrence
To deter entry, the incumbent firm must convince any potential
competitor that entry will be unprofitable.
TABLE 13.16 (a) ENTRY POSSIBILITIES

Potential Entrant
Enter Stay out

High price (accommodation) 100, 20 200, 0

Incumbent
Low price (warfare) 70, –10 130, 0

If Firm X thinks you will be accommodating and maintain a high price after it
has entered, it will find it profitable to enter and will do so.

Suppose you threaten to expand output and wage a price war in order to keep
X out. If X takes the threat seriously, it will not enter the market because it can
expect to lose $10 million. The threat, however, is not credible. As Table
13.16(a) shows, once entry has occurred, it will be in your best interest to
accommodate and maintain a high price. Firm X’s rational move is to enter the
market; the outcome will be the upper left-hand corner of the matrix.

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 TABLE 13.16 (b) ENTRY DETERRENCE
Potential Entrant
Enter Stay out

High price (accommodation) 50, 20 150, 0

Incumbent
Low price (warfare) 70, –10 130, 0

If you can make an irrevocable commitment to invest in additional capacity, your

threat to engage in competitive warfare is completely credible. With the
additional capacity, you will do better in competitive warfare than you would by
maintaining a high price. Meanwhile, having deterred entry, you can maintain a
high price and earn a profit of $150 million.
If the game were to be indefinitely repeated, then the incumbent might have a
rational incentive to engage in warfare whenever entry actually occurs. Why?
Because short-term losses from warfare might be outweighed by longer-term
gains from preventing entry.
Finally, by fostering an image of irrationality and belligerence, an incumbent firm
might convince potential entrants that the risk of warfare is too high.

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 Strategic Trade Policy and International Competition

Given the virtues of free trade, how can government intervention in an

international market ever be warranted? In certain situations, a country can
benefit by adopting policies that give its domestic industries a competitive
advantage.

By granting subsidies or tax breaks, the government can encourage domestic

firms to expand faster than they would otherwise. This might prevent firms in
other countries from entering the world market, so that the domestic industry
can enjoy higher prices and greater sales.

Such a policy works by creating a credible threat to potential entrants. Large

domestic firms, taking advantage of scale economies, would be able to satisfy
world demand at a low price; if other firms entered, price would be driven below
the point at which they could make a profit.

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 THE COMMERCIAL AIRCRAFT MARKET
Suppose that Boeing and Airbus (a European consortium that includes
France, Germany, Britain, and Spain) are each considering developing
a new aircraft. The ultimate payoff to each firm depends in part on what the other
firm does. Suppose it is only economical for one firm to produce the new aircraft.

TABLE 13.17(a) DEVELOPMENT OF A NEW AIRCRAFT

Airbus
Produce Don’t produce

Produce –10, –10 100, 0

Boeing
Don’t produce 0, 100 0, 0

If Boeing has a head start in the development process, the outcome of the game
is the upper right-hand corner of the payoff matrix.
European governments, of course, would prefer that Airbus produce the new
aircraft. Can they change the outcome of this game? Suppose they commit to
subsidizing Airbus and make this commitment before Boeing has committed itself
to produce. If the European governments commit to a subsidy of 20 to Airbus if it
produces the plane regardless of what Boeing does, the payoff matrix would
change to the one in Table 13.17(b).
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 TABLE 13.17(b) DEVELOPMENT OF AIRCRAFT AFTER
EUROPEAN SUBSIDY
Airbus
Produce Don’t produce

Produce –10, –10 100, 0

Boeing
Don’t produce 0, 120 0, 0

Boeing knows that even if it commits to producing, Airbus will produce as well,
and Boeing will lose money. Thus Boeing will decide not to produce, and the
outcome will be the one in the lower left-hand corner.
A subsidy of 20, then, changes the outcome from one in which Airbus does not
produce and earns 0, to one in which it does produce and earns 120. Of this, 100
is a transfer of profit from the United States to Europe. From the European point
of view, subsidizing Airbus yields a high return. European governments did
commit to subsidizing Airbus, and during the 1980s, Airbus successfully
introduced several new airplanes.
As commercial air travel grew, it became clear that both companies could
profitably develop and sell new airplanes. Nonetheless, Boeing’s market share
would have been much larger without the European subsidies to Airbus.
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 EXAMPLE 13.5 DUPONT DETERS ENTRY IN THE TITANIUM DIOXIDE
INDUSTRY
In the early 1970s, DuPont and National Lead each accounted for about a third of
U.S. titanium dioxide sales. In 1972, DuPont was considering whether to expand
capacity. New regulations and higher expected input prices would give DuPont a
cost advantage. Because of these cost changes, DuPont anticipated that National
Lead and some other producers would have to shut down part of their capacity.
DuPont’s competitors would in effect have to “reenter” the market by building new
plants. Could DuPont deter them from taking this step?
DuPont considered the following strategy: invest nearly $400 million in increased
production capacity—much more than what was actually needed. The idea was to
deter competitors from investing.
Scale economies and movement down the learning curve would not only make it
hard for other firms to compete, but would make credible the implicit threat that in
the future, DuPont would fight rather than accommodate.
By 1975, however, things began to go awry. Demand grew by much less than
expected, and environmental regulations were only weakly enforced, so
competitors did not have to shut down capacity as expected. Finally, DuPont’s
strategy led to antitrust action by the Federal Trade Commission in 1978. The
FTC claimed that DuPont was attempting to monopolize the market. DuPont won
the case, but the decline in demand made its victory moot.
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 EXAMPLE 13.6 DIAPER WARS

For more than two decades, the disposable diaper

industry in the United States has been dominated by
two firms: Procter & Gamble and Kimberly-Clark.
Competition, mostly in the form of cost-reducing
innovation is intense. The key to success is to produce
diapers in high volume and at low cost—about 3000 diapers per minute at about
10 cents per diaper. Improvements in the manufacturing process can result in a
significant competitive advantage.

TABLE 13.18 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

Spending money on R&D is a dominant strategy.

In addition to brand name recognition, these two firms have accumulated so
much technological knowhow and manufacturing proficiency that they would have
a considerable cost advantage over any firm just entering the market.
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 13.8 Auctions
● auction market Market in which products are bought and
sold through formal bidding processes.

Auctions are used for differentiated products, especially unique items that don’t
have established market values, such as art, antiques, sports memorabilia and
the rights to extract oil from a piece of land.

They are likely to be less time-consuming than one-on-one bargaining, and

they encourage competition among buyers in a way that increases the seller’s
revenue.

Auctions create large savings in transaction costs and thereby increases the
efficiency of the market.

The design of an auction, which involves choosing the rules under which it
operates, greatly affects its outcome. A seller will usually want an auction
format that maximizes the revenue from the sale of the product. On the other
hand, a buyer collecting bids from a group of potential sellers will want an
auction that minimizes the expected cost of the product.

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 Auction Formats

● English (or oral) auction Auction in which a seller actively solicits

progressively higher bids from a group of potential buyers.

● Dutch auction Auction in which a seller begins by offering an item at a

relatively high price, then reduces it by fixed amounts until the item is sold.

● sealed-bid auction Auction in which all bids are made simultaneously in

sealed envelopes, the winning bidder being the individual who has submitted
the highest bid.

● first-price auction Auction in which the sales price is equal to the highest
bid.
● second-price auction Auction in which the sales price is equal to the
second-highest bid.

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 Valuation and Information

● private-value auction Auction in which each bidder knows his or her

individual valuation of the object up for bid, with valuations differing from bidder
to bidder.

● common-value auction Auction in which the item has the same value to
all bidders, but bidders do not know that value precisely and their estimates of it
vary.

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 Private-Value Auctions
In private-value auctions, bidders have different reservation prices for
the offered item. For an open English auction, the bidding strategy is a
choice of a price at which to stop bidding. For a Dutch auction, the strategy is the
price at which the individual expects to make his or her only bid. For a sealed-bid
auction, the strategy is the choice of bid to place in a sealed envelope. The
payoff for winning is the difference between the winner’s reservation price and
the price paid; the payoff for losing is zero.
English oral auctions and second-price sealed-bid auctions generate nearly
identical outcomes. In the second-price sealed-bid auction, bidding truthfully is a
dominant strategy—there is no advantage to bidding below your reservation
price. If you bid below your reservation price, you risk losing to the second-
highest bidder. If you bid above your reservation price, you risk winning but
receiving a negative payoff.
Similarly, in an English auction the dominant strategy is to continue bidding until
the second person is unwilling to make a bid. Then the winning bid will be
approximately equal to the reservation price of the second person. In any case,
you should stop bidding when the bidding reaches your reservation price. If you
continue beyond your reservation price, you will be guaranteed a negative
payoff. Likewise, in the sealed-bid auction the winning bid will equal the
reservation price of the second-highest bidder.
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 Common-Value Auctions
Suppose that you and four other people participate in an oral auction to
purchase a large jar of pennies, which will go to the highest bid. Once
you have estimated the number of pennies in the jar, what is your optimal bidding
strategy? This is a classic common-value auction, because the jar has the same
value for all bidders, but its value for you and other bidders is unknown.
You might be tempted to bid up to your own estimate of the number of pennies in
the jar, and no higher, but this is not the best way to bid. If each bidder bids up to
his or her estimate, the winning bidder is likely to be the person with the largest
positive error—i.e., the person with the largest overestimate of the number of
pennies.
THE WINNER’S CURSE
● winner’s curse Situation in which the winner of a common-value auction is
worse off as a consequence of overestimating the value of the item and thereby
overbidding.

To avoid the winner’s curse, you must reduce your maximum bid below your
value estimate by an amount equal to the expected error of the winning bidder.
The more precise your estimate, the less you need to reduce your bid. The
winner’s curse is more likely to be a problem in a sealed-bid auction than in a
traditional English auction.
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 Maximizing Auction Revenue
Here are some useful tips for choosing the best auction format.
1. In a private-value auction, you should encourage as many bidders as
possible.
2. In a common-value auction, you should (a) use an open rather than a sealed-
bid auction because, as a general rule, an English (open) common-value auction
will generate greater expected revenue than a sealed-bid auction; and (b) reveal
information about the true value of the object being auctioned.
3. In a private-value auction, set a minimum bid equal to or even somewhat
higher than the value to you of keeping the good for future sale.

In a common-value auction, the greater the uncertainty about the true value of
the object, the greater the likelihood of an overbid, and therefore the greater the
incentive for the bidder to reduce his bid.

However, the bidder faces less uncertainty in an English auction than in a

sealed-bid auction because he can observe the prices at which other bidders
drop out of the competition

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 Bidding and Collusion
Buyers can increase their bargaining power by reducing the number of
bidders or the frequency of bidding. In some cases this can be accomplished
legally through the formation of buying groups, but it may also be accomplished
illegally through collusive agreements that violate the antitrust laws.

Collusion among buyers is not easy, because even if an “agreement” is

reached, individual buyers will have an incentive to cheat by increasing their
bids at the last minute in order to obtain the desired item. However, repeated
auctions allow for participants to penalize those that break from the agreement
by outbidding the “cheater” again and again.

Buyer collusion is more of a problem in open-bid auctions than in the case of

sealed bids because open auctions offer the best opportunity for colluding
bidders to detect and punish cheating.

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 EXAMPLE 13.7 AUCTIONING LEGAL SERVICES

In the United States, plaintiff attorneys often bring cases in which they represent
classes of individuals who were allegedly harmed by defendants’ actions that
adversely affect human health or well-being. The attorneys are typically paid on a
contingent fee basis, which means they are paid nothing if they lose the case, or a
percentage of the amount recovered, typically around 30%.
In some cases, the percentage fee awards have been seen as unreasonably large
relative to the efforts made by the attorneys. What could be done about this? A
number of federal judges had a solution: hold auctions in which attorneys bid for
the right to represent the class of potential plaintiffs.
In a typical such auction, attorneys would offer a percentage fee as part of a
sealed-bid process.
In one unusual auction following on a criminal verdict against auction houses
Sotheby’s and Christie’s, Judge Lewis Kaplan of the Southern District of New York
allowed law firms to offer a broader range of payment terms as part of their bids. It
turned out that the winning bidder was the law firm of Boies, Schiller & Flexner.
Months after taking the case, David Boies settled with defendants for $512 million,
earning the attorneys a $26.75 million fee (25 percent of the $107 million excess
over the minimum of $425 million) and generating just over $475 million for
members of the class.

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 EXAMPLE 13.8 INTERNET AUCTIONS

The popularity of auctions has skyrocketed in recent years

with the growth of the Internet. Indeed, the Internet has
lowered transaction costs by so much that individuals
anywhere in the world can now trade relatively low-value
items without leaving the comfort of home. The most popular
Internet auction site in the United States is www.ebay.com.

Internet auctions are subject to very strong network externalities. Both sellers and
buyers gravitate to the auction site with the largest market share. In China, eBay
had to compete with Taobao, whose managers decided not to charge sellers any
commissions, so that most of its revenue was from advertising. While its revenue
was limited by this strategy, Taobao quickly became the dominant Internet auction
site in China. And eBay likewise lost out in Japan, this time to Yahoo! Japan
Auctions, which aggressively obtained an early market share lead. The strong
network effect then made it nearly impossible for eBay (or anyone else) to
challenge Yahoo!’s dominance in Japan.

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 EXAMPLE 13.8 INTERNET AUCTIONS

eBay uses an increasing price auction which works roughly

as follows: bids must be increased with minimum increments.
The highest bidder at the close of the auction wins and pays
the seller a price equal to the second-highest bid plus the
minimum increment by which bids are increased. There is a
fixed and known stopping time, which can cause bidders to
place bids strategically at the end of the auction.
Many Internet auctions are dominated by private-value items. The emphasis of
these auctions is on items of considerable value to particular bidders. You needn’t
worry so much about the prior history of bidding: The bids of others tell you about
their preferences, but the value that you place on the object is personal to you. The
winner’s curse needn’t be a concern: You can’t be disappointed if your value for the
object is more than what you paid for it.
eBay’s profit from most auctions comes from the fees paid by the seller. The fee is
like a tax. The burden of the fees will depend on the relative elasticities of demand
and supply.
It is always possible that sellers may file spurious bids in order to manipulate the
bidding process. Thus, “caveat emptor” (buyer beware) is a sound philosophy when
buying items on the Internet.

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