GSBS6410

Economics of Competitive Advantage

Week 9
Games & Bargaining
 OUTLINE

1. Readings
2. Nash equilibria
3. Prisoners’ dilemma
4. Bargaining strategies
5. Questions for discussions

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 GSBS6410
Readings for this lecture

• Froeb et al 2018, Managerial Economics, Chapters 15 & 16,

and one of the following
1. Arnold, Roger A., (2016) Microeconomics, 12th Edition,
Cengage. Chapter 11 (if you think our text is too simple).
2. Layton A, Robinson T, and Tucker I. (2016) Economics
For Today, Fifth Asia Pacific Edition, Cengage Learning
Australia, Melbourne. Chapter 9 (if you think our text is
too hard).
 Nash equilibrium
• A Nash equilibrium is a pair of strategies, one for each player, in
which each strategy is a best response against the other.
• When players act rationally, optimally, and in their own self-
interest, it’s possible to compute the likely outcomes (equilibria) of
games. By studying games, we learn not only where our strategies
are likely to take us, but also how to modify the rules of the game
to our own advantage.
• Equilibria of sequential games, where players take turns moving,
are influenced by who moves first (a potential first-mover
advantage, or disadvantage), and who can commit to a future
course of action. Credible commitments are difficult to make
because they require that players threaten to act in an unprofitable
way—against their self-interest.
• In simultaneous-move games, players move at the same time.

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 Prisoners’ dilemma
• In the prisoners’ dilemma, conflict and cooperation are in tension—
self-interest leads to outcomes that reduce both players’ payoffs.
Cooperation can improve both players’ payoffs.
• In a repeated prisoners’ dilemma, it is easier for players to learn to
cooperate. Here are some general rules of thumb:
– Be nice: No first strikes.
– Be easily provoked: Respond immediately to rivals.
– Be forgiving: Don’t try to punish competitors too much.
– Don’t be envious: Focus on your own slice of the profit pie, not on
your competitor’s.
– Be clear: Make sure your competitors can easily interpret your
actions.

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 Blu-ray
• In February 2002, nine electronics companies, led by Sony, announced
plans for the next big video recording format: Blu-Ray
• By August of that same year, Toshiba and NEC announced plans for a
rival technology: HD-DVD
• A common standard among all competitors (rather than two rival
technologies) would have best benefited consumers.
– With a common standard, demand for the new technology would have grown
more rapidly and all producers would have benefitted.
– But some producers would benefitted more than others: Sony would have
profited from the choice of Blu-ray while Toshiba would have preferred HD-
DVD.
• Both sides waged a “standards” war, recruiting big name entertainment
groups (such as Disney, Paramount Pictures, HBO, etc.) to take sides. In
the end, Blu-Ray won after Walmart announced it would sell only Blu-
Ray disc players. 6
 Game Theory
• In a standards war, the profit of one firm depends on
the actions of other firms, rivals, consumers, and
suppliers.
• This type of interdependence is characteristic of
games, and we analyze it using game theory.
• A “game,” has three elements: players,
options/moves available and the payoffs resulting
from each combination of moves.
• Assuming that each player acts optimally, rationally
and selfishly, the likely outcomes, or equilibria, of the
game can be computed.
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 Game Theory
• Aside from telling firms where competition is likely to lead
them, game theory can also offer advice to change the rules
of the game to one or both player’s advantage.
• For Sony and Toshiba, both realized there were two potential
equilibria to their game (Blu-ray vs. HD-DVD):
– Consumers, retailers, manufacturers, content providers, etc. would
coordinate on one of these standards
– The standards war was the result of each firm attempting to
convince the market participants and public that their respective
technology would become the standard (competition “for the
market”)
• Game theory also suggest strategies to reduce competitive
intensity to increase profit (“strategy” from ch. 11) 8
 Nash Equilibria
• Named for John Nash, mathematician and Nobel
laureate in economics.
– Nash is known as the “father” of non-cooperative game theory
– He proved the existence of equilibrium in all well-defined
games in his doctoral dissertation at Princeton.
• Definition
– A set of strategies, one for each player, such that no player has
incentive to unilaterally change her action.
– Players are in an equilibrium if a change in strategies by any one
of them would lead that player to earn less than if she
remained with her current strategy.

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 Entry “game”
• Suppose a potential entrant is deciding whether to
enter an industry in competition with an incumbent
firm/monopoly.
• If the entrant decides to enter the industry, the
incumbent has two paths of action:
– Accommodate the entry; or
– Fight the entry.
• By modeling the situation using game theory, we find
that accommodating an entrant leads to profits while
fighting an entrant leads to losses.
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Modeling entry decision

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 Modeling entry decision (cont’d.)
• To find the best strategy in a sequential game put two
lines through the paths that present suboptimal
choices.
• In this game, equilibrium is {In, Acc}:

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 Deterring Entry
• Part of game theory is figuring out how to change the game to
your own advantage.
– In the current game, if the incumbent firm can deter entry, it would
earn $10 profit, instead of only $5.
• One way of deterring entry is to threaten (in such a manner as to
be truly believable) to “commit” to fight the entry and price low.
– To model this commitment, take away one of the incumbent’s options,
the ability to accommodate entry.
• By committing to fight entry, the incumbent can benefit, even
though the incumbent would be worse off if entry did occur, and
the incumbent had to fight.
– In other words, the best threat is one you do not have to use.

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Types of games: Simultaneous-move

• The second type of game is simultaneous-move. In

this type of game players move simultaneously.
– This does not literally require players moving at same
time, just that each player plans a move without
knowing the other player’s move in advance
• To analyze a simultaneous-move game we use a
matrix or “reduced-form” of the game.
• Again the likely outcomes are Nash equlibria,
where no player has an incentive to change, i.e.,
each player is doing the best they can.

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 Simultaneous-move games (cont’d.)
• In a two-player game, each player’s payoffs can be
modeled in a table/matrix by assigning player One to
choose row strategies and player Two to choose column
strategies.
• If player one’s strategy payoffs are in rows 1,2,3,4,5 and
player two’s strategy payoffs are in columns A,B,C,D,E then
the actual payoff can be found by locating the cell in which
the two strategy decisions (row, column) meet.
• Compute Nash Equilibrium by finding pairs of strategies
where both players are choosing the best possible
response to their competitor’s strategy
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 Modeling simultaneous-move games
Player Two

A B C D E

Pla 1 9, 9 7, 1 5, 6 3, 4 1, 1
yer
On 2 7, 8 5, 2 3, 6 1, 4 3, 3
e
3 5, 6 3, 3 1, 8 9, 7 1, 5

4 3, 9 1, 9 9, 4 7, 9 5, 9

5 1, 2 9, 8 7, 7 5, 6 3, 7

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Analyzing simultaneous-move games
• For player one:
– For each of player Two’s strategies (each column), select the row
(underline it) that maximizes One’s profits.
– For example if Two plays column A, One would do best to use
strategy 1, which earns a nine dollar payoff. For each column
underline player one’s best response.
• For player two:
– Examine each of player One’s strategies (each row) and select the
column strategy that maximizes player Two’s profits
– For example on row 4, player Two would be indifferent between
A,B,D, and E because each earns a $9 payoff. Underline all four best
responses.
• To find the game equilibria, locate the cell (or cells) in which
both numbers have been underlined—these are best
responses to each other.
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 Finding Equilibria
Player Two

A B C D E

1 9, 9 7, 1 5, 6 3, 4 1, 1
Pla
yer 2 7, 8 5, 2 3, 6 1, 4 3, 3
On
e 3 5, 6 3, 3 1, 8 9, 7 1, 5

4 3, 9 1, 9 9, 4 7, 9 5, 9

5 1, 2 9, 8 7, 7 5, 6 3, 7

• This game has three equilbria, where each player is

responding optimally to their rival, i.e., neither player has
incentive to change strategy
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 The prisoners’ dilemma game
• The police suspect that Frank and Jesse robbed a bank, but
they have no direct evidence. They picked them up in their
car, a parole violation which carries a sentence of two years.
The US attorney offers both the same deal:
– If only one confesses, the one who confesses goes free, while the
other one receives ten years in jail.
– If they both confess, each receives five years in jail.
– If neither confesses, they both serve two years for violating parole.
Frank
Jes Confess Say nothing
se Confess -5 , -5 0 , -10
Say nothing -10 , 0 -2 , -2

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 Why the PD is interesting
• The only equilibrium is for both to confess and serve five
years
• But BOTH would be better off if neither confessed
• By following self interest, the players thus make the group
worse off
• The tension between conflict (self interest) and cooperation
(group interest) is inherent in the prisoners’ dilemma game.
• If the players/prisoners could cooperate, they make
themselves better off.
– Prosecutors separate defendants for precisely this reason, i.e., to
make cooperation more difficult.

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The Prisoners’ Dilemma in business
• A pricing dilemma frequently faced by businesses selling
substitute products has the same logical structure as the
prisoners’ dilemma
– Two competing firms would both be better off if they
could price high
• BUT that outcome is not an equilibrium
– If the competing firms could “coordinate” pricing, they
would make themselves better off.
• BUT beware of violating antitrust laws

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 Bargaining
• There are two complementary ways to look at
bargaining:
– the strategic view analyzes bargaining using the tools of
game theory (ch 15). Bargaining can be viewed as either a
simultaneous-move game with two equilibria or a
sequential-move game, where one player gains an
advantage by committing to a position.
– the non-strategic view acknowledges that real life
negotiations don’t have fixed rules as formal games do. This
view postulates that the alternatives to agreement
determine the terms of agreement, regardless of the rules
of the negotiating game.
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 Strategic view of bargaining
• Strategic view of bargaining: model as either a
simultaneous-move or sequential-move game.
• A player can gain bigger share of the \“pie” by
– changing a simultaneous-move game into a sequential-
move game with a first-mover advantage;
or by
– committing to a position.
• Credible commitments (threats) are difficult to make
because they require players to commit to a course of
action against their self-interest. Thus, the best threat is
one you never have to use.
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 • continued
Strategic view of bargaining
• The strategic view of bargaining focuses on how the outcome of
bargaining games depends on who moves first and who can
commit to a bargaining position, as well as whether the other
player can make a counteroffer.
• The non-strategic view of bargaining focuses on the gains and
alternatives to agreement to determine the outcome of
bargaining.
– Main insight: The gains from agreement relative to the
alternatives to agreement determine the terms of any agreement.
– Anything you can do to increase your opponent’s relative gains
from reaching agreement or to decrease your own will improve
your bargaining position.

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 Bargaining: a simultaneous-move game

• Example: Wage negotiations

– Management and labor are bargaining over a fixed sum
of $200 million
• Two possible strategies are available to each player:
“bargain hard” or “accommodate.”
– If both bargain hard, no deal is reached. Neither side
gains.
– If both accommodate, they split the gains from trade.
– If one player bargains hard and the other accommodates,
then the player who bargains hard takes 75% of the “pie”

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Bargaining: a simultaneous game (cont.)

• There are two equilibria for this game

– Management prefers the lower-left equilibrium
– Labor prefers the upper-right.
• This bargaining game has the same structure
as a game of “chicken”
– Each party can gain by committing to a position,
which turns it into a sequential game
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Bargaining: a sequential-move game
• In sequential-move bargaining the first “player” makes an
offer that the second “player” can accept or refuse.
• Again to analyze a sequential-move game look ahead and
reason back.
– The first-mover “looks ahead and reasons back” to determine the
how her rival will react to each possible move. Then the first-
mover can determine the consequences of each possible move.
• In this case, the sequential-move games present a “first-
mover advantage,” i.e., by moving first a player can gain an
advantage.
• Using the same wage negotiation example, we can look at
sequential-move bargaining and first-mover advantage.

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 Bargaining game: first-mover advantage

• Management “wins” by moving first and

making a low offer
Management

low offer generous offer

Union

strike accept strike accept

0,0 150 , 50 0,0 50 , 150

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 Bargaining game: first-mover advantage
• Union can change the outcome by credibly
committing to strike if a low offer is made
Management

low offer generous offer

Union

strike strike accept

0,0 0,0 50 , 150

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 Sequential-move bargaining (cont.)
• Because the management has the first-mover
advantage, it is in their best interest to make a low offer,
and it is in the union’s best interest to accept that offer.
• However, if the union can effectively threaten to strike
(in such a way that the management believes them)
they can change the outcome of the game despite
management’s first-mover advantage.
– Credible threats are hard to make because they require the
union act against its self-interest.
– If management doesn’t believe the threat, the union might
actually have to follow through on the threat.
• So, again, the best threat is one you never have to use.

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How Nash’s view differs from strategic
• The strategic view of bargaining places a
greater emphasis on timing and commitment
in determining the outcome of the game.
– With the labor/management example, the
union’s commitment to strike, or
management making the first move,
changes the equilibrium of the game.
– But neither action changes the gains of the
agreement so neither would affect the Nash
bargaining outcome.

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How Nash’s view differs from strategic
• The Nash bargaining outcome incorporates the idea
that if you decrease your own gain to agreement you
become a better bargainer.
– EXAMPLE: the best time to ask for a raise is when
you have another attractive offer waiting for you,
you have less to gain by reaching agreement. Your
bargaining position improves.
– This is similar to the idea of “opportunity cost.”
The opportunity cost of staying at your current job
is giving up the new offer; if the new job pays
more, your costs (bottom line) go up.

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 Questions for Discussion

1. Microsoft and a smaller rival often have to select from one

of two competing technologies. The rival always prefers to
select the same technology as Microsoft (because
compatibility is important), while Microsoft always wants to
select a different technology from its rival. Describe the
equilibrium of this game.
2. American Airlines and British Airways are proposing to
merge. If British pilots and American pilots are represented by
different unions, how would this merger affect airline costs? 

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