Chapter 14 GAME THEORY AND COMPETITIVE STRATEGY
QUESTIONS & ANSWERS Q14.1
From a game game theory theory perspect perspective, ive, how would would you you character characterize ize the bargain bargaining ing between between a customer and a used car dealer?
Q14.1
ANSWER
This type of bargaining situation can be characterized as a cooperative zero-sum game. In a zero-sum game, game, one player’s gain is another player’s player’s loss. In the options market, market, for example, any profit recorded by the buyer of an option is exactly matched by the loss suffered suffered by the seller seller of that option. Similarly, Similarly, the only way for the seller seller of an option option to gain is by having the buyer buyer record record a loss. In many other other game theory theory situat situations ions,, individ individuals uals and firms firms find themse themselve lvess in situati situations ons where where there there is the potential potential for mutual gain or mutual harm. If parties are engaged in a game that holds the potential for mutual gain, it is called a positive-sum game. When conflict holds the potential potential for mutual mutual loss, loss, it is is called called a negative-sum negative-sum game. game. Q14.2
Suppose Exxon Mobil Corp. independently reduced the price of gasoline, and that this price price cut was quickly matched by competito competitors. rs. Could Could these actions be described described as reflective of a cooperative game?
Q14.2
ANSWER
No. If Exxon Mobil independently reduced reduced the price of gasoline, gasoline, and this price cut was quickly matched by competitors, these actions could be described as reflective of a noncooperative game. Cooperative games favor collaboration in decision making, making, and the decision to cut prices here was made without consultation among competitors. Q14.3
Characterize the essential difference between a sequential game and a simultaneousmove game.
Q14.3
ANSWER
In a sequential sequential game, each player moves in succession, and each player is aware of all prior moves. The general principle principle for players in a sequential sequential game is to look ahead and extrapolate back. A simultaneous game is one in which all players make decisions (or select a strategy) without knowledge of the strategies that are being chosen by other players. players. Even though the decisions may be made at different points in time, the game
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is synchronous because each player has no information about the decisions of others; it is as if the decisions are made simultaneously. Simultaneous games are solved using the concept of Nash equilibrium. Q14.4
Explain Explain how the Prisoner Prisoner’s ’s Dilemma Dilemma example example shows that rational rational self-inte self-intereste rested d play does not always result in the best solution for all parties.
Q14.4
ANSWER
In the classic prisoner's dilemma, if either prisoner knew the other prisoner would stay silent, their best move would be to betray. If either prisoner knew the other prisoner would betray, their best move would be still to betray. Betraying is a dominant strategy, but when both betray each prisoner is worse off than if both remained silent. Decisions based upon rational self-interest results in each prisoner being worse off than had they remained silent. The paradox of the situation lies in the fact that betray is the best individual strategy, but suboptimal for the pair. Q14.5
Does game theory theory offer offer a strategy strategy appropri appropriate ate for situations situations in which which no strategy strategy results in the highest payoff to a player regardless of the opposing player’s decision?
Q14.5
ANSWER
Yes. A secure strategy, sometimes called the maximin strategy, guarantees the best possible possible outcome given the worst possible scenario. scenario. In the Prisoner’s Prisoner’s Dilemma, Dilemma, the worst possible possible scenario scenario for each suspect is that the other chooses chooses to confess. Each suspect can avoid the worst possible possible outcome of receiving a harsh five years in prison sentence sentence only by choosing choosing to confess. confess. For each each suspect suspect,, the secure secure strategy strategy is to confess, confess, thereby thereby becoming a prisoner, because neither could solve the riddle posed by the prisoner’s dilemma. Q14.6
Define Define the Nash equilibri equilibrium um conce concept. pt.
Q14.6
ANSWER
A set of strategies constitute a Nash equilibrium if no player can unilaterally increase his or her payoff through a change in strategy, given the strategies adopted by all other players. players. The concept of Nash equilibrium equilibrium is important important because it characterizes characterizes a situation in which every player has achieved the highest possible payoff given the set of strategies adopted by opposing players. Q14.7
Instructo Instructors rs sometime sometimess use quizze quizzess to motivat motivatee students students to to adequate adequately ly prepare prepare for for class. class. Howeve However, r, preparing preparing and grading grading quizzes quizzes can become become time-cons time-consumin uming g and tedious. tedious. Moreover Moreover,, if students students prepare prepare adequate adequately ly for class, class, there there is no need need for quizze quizzes. s. What does game theory prescribe for instructors facing the problem of needing to motivate
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class preparation among students? Q14.7
ANSWER
The on-going battle between instructors and their students concerning class preparation is a classi classicc game game theory theory problem. problem. Instruct Instructors ors sometime sometimess use quizzes quizzes to motivat motivatee students students to adequately prepare for class. class. However, However, preparing and grading grading quizzes can be time-consumi time-consuming ng and tedious. tedious. Moreover, Moreover, if student prepare adequately adequately for class, there is no need for quizzes. This is a classic game ttheory heory problem with no stable Nash equilibrium. If students students prepare, there is no need for quizzes. However, if there is no quiz, there is no need for students students to prepare. Game theory theory has a simple randomized randomized strategy prescription for such situations: pop quizzes. In a two-par two-party ty game game with with no stable stable Nash Nash equilibr equilibrium ium,, a player’ player’ss preferr preferred ed strate strategy gy changes changes once its rival has adopted adopted its strateg strategy. y. The classic classic case is where where manage managers rs monitor monitor worker worker performanc performance. e. If a manage managerr chooses chooses to monitor monitor worker worker performance, performance, the worker will choose to perform perform as expected. expected. However, However, given that a worker has chosen to perform as expected, there is no need for managerial monitoring. In such instances, both workers and managers have strong incentives to keep their planned moves secret. secret. The lack of Nash equilibrium equilibrium also provides provides incentives incentives for randomi randomized zed strate strategies gies whereb whereby y players players flip flip a coin coin or otherwi otherwise se randoml randomly y choose choose among available strategies in order to keep rivals from being able to predict strategic moves. Q14.8
The typical CEO of a major U. S. corporation is 56-58 years old and gets paid $3-5 million per year. From a game-theory game-theory perspective, explain why why corporate governance governance experts advise that such executives be required to hold common stock worth 7-10 years of total compensation. compensation.
Q14.8
ANSWER
Boards Boards of direct directors ors and stockho stockholde lders rs face a classi classicc end-ofend-of-gam gamee proble problem m when when it comes to the employment employment of top executives. To guard against shirking or malfeasance in the period just prior to retirement, retirement, savvy employers solve the end-of-game end-of-game problem by using rewards or punishments punishments that extend beyond the employment employment period. In the case of top executives, corporate governance experts insist that CEOs invest 7-10 years pay in company common common stock as a means for insuring that managerial managerial motivation motivation coincid coincides es with stockhold stockholder er incentive incentives. s. In the case of managers managers and lower-l lower-level evel workers, employers are often asked to provide letters of recommendation to subsequent employers and can thereby punish workers who take advantage of the end-of-game problem. problem. Policemen Policemen and policewomen policewomen are modestly modestly paid and often face strong temptation temptation to accept bribes bribes or give favors, especially especially late in their careers. careers. To fight corrupti corruption, on, many many cities cities require require those convicte convicted d of corrupt corrupt behavior behavior to forfeit forfeit all retirement retirement pay and benefits. benefits. On Wall Street, Street, investment investment bankers typically typically require require traders and top managers to take a significant portion of total compensation in the form
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of pay tied to long-term long-term stock-price stock-price appreciation. appreciation. In some cases, cases, managers managers cannot liquidate stock or employee stock options until several years after retirement. In these and other cases, employers have settled on simple means for solving the end-of-game problem: problem: extend extend the game! game! Q14.9
Describe Describe the differ difference ence between between limit limit pricin pricing g and predatory predatory pricing pricing strateg strategies. ies.
Q14.9
ANSWER
Limit Limit pricing pricing and predator predatory y pricing pricing strateg strategies ies have signifi significant cant simila similarit rities ies,, but important important differences differences as well. Both pricing strategie strategiess have the potential to be used as means for making competition from smaller competitors unpalatable. However, limit pricing and predatory predatory pricing strategies differ differ in terms of when they are instituted instituted and in terms of the target. target. Before entry entry by a new and credible credible competitor, competitor, a limit pricing strategy is one where the incumbent charges such a low price that the entrant is discouraged by the potential for even a normal rate of return and decides not to enter the market. Limit pricing strategy is generally aimed at potential entrants. After entry by a new and viable competitor, competitor, a predatory predatory pricing strategy strategy is one where the incumbent lowers prices below marginal cost so that the entrant incurs losses and ulti ultima mate tely ly exit exitss the market market.. Pred Predat atory ory pric pricing ing stra strate tegy gy is gener generall ally y aimed aimed at established competitors. Q14.10
Explain Explain why the establishm establishment ent and exploitatio exploitation n of network effects effects are key elements elements in the competitive strategy of computer software provider Microsoft Corp.
Q14.10
ANSWER
Microsoft Office Office, for There are strong network effects in computer software. Take Microsoft example. For many potential users of computer software like Microsoft Microsoft Office, prime considerations include how valuable having learned that office suite will prove to potential potential employers, and how widely widely that software software is adopted by other users. Because learning to use computer software takes many hours, users want to invest their time learning the office suite that will make them most attractive to potential employers, consulting clients, and so on. They also want to be able to share documents with a wide Excel attractive, and creates a barrier to entry range of other users. This makes learning Excel for providers of competitive spreadsheet software. In computer software, the name of the game is get ahead and stay ahead.
SELF-TEST SELF-TEST PROBLEMS PROBLEMS AND SOLUTIONS SOLUTIONS ST14.1 Game Theory Strategies. Strategies. Suppose two local suppliers are seeking to win the right to upgrade the communications capability of the internal “intranets” that link a number of customers with their their suppliers. The system quality quality decision facing each competitor, competitor, and potential profit payoffs, payoffs, are illustrated in the table. The first number listed in each
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cell is the profit earned by U.S. Equipment Supply; the second number indicates the profit profit earned earned by Business Business Systems, Systems, Inc. For example, example, if both competito competitors, rs, U.S. Equipme Equipment nt Supply Supply and Business Business Systems, Systems, Inc., pursue pursue a high-qua high-quality lity strategy, strategy, U.S. Equipme Equipment nt Supply Supply will earn earn $25,000 $25,000 and Busines Businesss Systems, Systems, Inc., Inc., will earn earn $50,000. $50,000. If U.S. Equipment Supply pursues a high-quality strategy while Business Systems, Inc., offers low-quality goods and services, U.S. Equipment Supply will earn $40,000; Business Business System Systems, s, Inc., Inc., will earn earn $22,000 $22,000.. If U.S. U.S. Equipmen Equipmentt Supply Supply offers offers low-qua low-quality lity goods goods while Business Business Systems, Systems, Inc., Inc., offers high-quality high-quality goods, goods, U.S. Equipme Equipment nt Supply will will suffer suffer a net net loss loss of $25,0 $25,000, 00, and Busines Businesss System Systems, s, Inc., Inc., will will earn earn $20,0 $20,000. 00. Finally, Finally, if U.S. Equipme Equipment nt Supply Supply offers offers low-quali low-quality ty goods goods while while Business Business Systems, Systems, Inc., offers offers low-qualit low-qualityy goods, goods, both both U.S. Equip Equipmen mentt Supply Supply and and Business Business Syste Systems, ms, Inc., Inc., will earn $25,000. Business Business Systems, Systems, Inc. Inc. Quality Strategy High High Quality Quality U.S. Equipment Supply
(“Up”) Low Quality Quality (“Down”)
High High Quality Quality (“Left”)
Low Quality Quality (“Right”)
$25,0 25,000 00,, $50 $50,0 ,00 00
$40,0 40,000 00,, $22 $22,0 ,00 00
-$25 -$25,0 ,000 00,, $20,0 20,000 00
$25, $25,00 000, 0, $25, $25,00 000 0
A.
Does U.S. Equipmen Equipmentt Supply Supply and/or and/or Business Business Systems, Systems, Inc., have have a dominant dominant strategy? strategy? If so, so, what what is it?
B.
Does U.S. Equipme Equipment nt Supply Supply and/or and/or Business Business Systems, Systems, Inc., have a secure secure strategy? strategy? If so, so, what what is it?
C.
What is the Nash equilibriu equilibrium m concept, concept, and why is it useful? useful? What What is the Nash equilibrium for this problem?
ST14.1
SOLUTION SOLUTION
A.
The dominant strategy for U.S. Equipment Supply is to provide high-quality goods. Irrespective Irrespective of the quality quality strategy strategy chosen by Business Systems, Inc., U.S. Equipment Equipment Supply can do no better than to choose a high-quality strategy. To see this, note that if Business Systems, Inc., chooses to produce high-quality goods, the best choice for U.S. Equipment Supply is to also provide high-quality goods because the $25,000 profit then earned is better than the $25,000 loss that would be incurred if U.S. Equipment Supply chose a low-quality low-quality strategy. strategy. If Business Business Systems, Systems, Inc., chose a low-quality low-quality strategy, the best choice by U.S. Equipment Supply would again be to produce highqualit quality y goods. goods. U.S. U.S. Equipme Equipment nt Supply’ Supply’ss high-qu high-qualit ality y strate strategy gy profit profit of $40,000 $40,000
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dominates the low-quality payoff for U.S. Equipment Supply of $25,000. Business Systems, Inc., does not have a dominant strategy. To see this, note that if U.S. Equipment Supply chooses to produce high-quality goods, the best choice for Business Systems, Inc., is to also provide high-quality goods because the $50,000 profit then earned is better than the $22,000 profit if Business Business Systems, Systems, Inc., chose a low-quality low-quality strategy. strategy. If U.S. Equipment Supply Supply chose a low-quality low-quality strategy, strategy, the best choice by Business Systems, Inc., would be to produce low-quality goods and earn $25,000 versus $20,000. B.
The secure ure st strate ategy fo for U. U.S. Equ Equiipm pmeent Suppl pply is is to to pr provide highigh-q qual uality ity goo goods ds.. By choosing to provide high-quality goods, U.S. Equipment Supply can be guaranteed a profit payoff payoff of at least $25,000. By pursuing pursuing a high-quality strategy, strategy, U.S. Equipment Equipment Supply can eliminate the chance of losing $25,000, as would happen if U.S. Equipment Supply chose a low-quality strategy while Business Systems, Inc., chose to produce high-quality goods. The secure strategy for Business Systems, Inc., is to provide low-quality goods. By choosing to provide high-quality goods, Business Systems, Inc., can guarantee a profit payoff of only $20,000. $20,000. Business Business Systems, Systems, Inc., can be assured assured of earning at least least $22,000 $22,000 with a low-qua low-qualit lity y strateg strategy. y. Thus, Thus, the secure secure strate strategy gy for Business Business Systems, Inc. is to provide low-quality goods. C. A set of strategies constitute a Nash equilibrium if, given the strategies of other players, players, no player can improve its payoff through through a unilateral unilateral change in strategy. The concept of Nash equilibrium is very important because it represents a situation where every player is doing the best possible in light of what other players are doing. Alth Althou ough gh usef useful ul,, the the noti notion on of a secu secure re stra strate tegy gy suff suffer erss from from a seri seriou ouss shortcoming. shortcoming. In the present example, example, suppose Business Business Systems, Systems, Inc., reasoned as follow follows: s: “U.S. “U.S. Equipme Equipment nt Supply will surely surely choose choose its high-q high-quali uality ty dom domina inant nt strate strategy. gy. Theref Therefore ore,, I should not choose choose my secure secure low-qual low-quality ity strategy strategy and earn earn $22,000. I should instead choose a high-quality strategy and earn $50,000.” A natural way of formalizing the “end result” of such a thought process is captured in the definition of Nash equilibrium. In the pres presen entt examp example le,, if U.S. U.S. Eq Equi uipme pment nt Suppl Supply y choose choosess a highhigh-qua quali lity ty strategy, the Nash equilibrium strategy is for Business Systems, Inc., to also choose a high-quality high-quality strategy. strategy. Similarly, Similarly, if Business Business Systems, Systems, Inc., chooses a high-quality high-quality strategy, the Nash equilibrium strategy is for U.S. Equipment Supply to also choose a high-qua high-qualit lity y strate strategy. gy. Thus, Thus, a Nash Nash equilib equilibrium rium is reached reached when when both both firms firms adopt high-quality strategies. Although some problems have multiple Nash equilibriums, that is not true in this case. case. A combinat combination ion of high-qual high-quality ity strateg strategies ies for both firms firms is the only set of strate strategies gies where no player player can improv improvee its payoff through through a unilate unilateral ral change change in strategy.
ST14.2
Assume that Hewlett-Pa Hewlett-Packar ckard d (H-P) and Dell Computer Computer have a Nash Equilibrium. Assume
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large large invent inventory ory of perso persona nall compu computer terss that that they they would would like to sell sell befor beforee a new new generatio generation n of faster, faster, cheaper cheaper machine machiness is introduce introduced. d. Assume Assume that that the question question facing facing each competitor is whether or not they should widely advertise a “close out” sale on these discontinued items, or instead let excess inventory work itself off over the next few month months. s. If both both aggress aggressively ively promote promote their their produc products ts with a nationw nationwide ide advert advertising ising campaign, each each will earn profits of $5 million. million. If one advertises while while the other does not, the firm that advertises will earn $20 million, while the one that does not advertise will earn $2 $2 million. If neither advertises, advertises, both will will earn $10 million. million. Assume this this is a one-shot game, and both firms seek to maximize profits.
Dell Comp Computer uter
H-P
Promotion Promotion Strategy Strategy
Advertise Advertise (“Left”)
Don’t Advertis Advertisee (“Right”)
Advertise Advertise (“Up”)
$5 million, $5 million
$20 million, $2 million
Don’t Don’t advertis advertisee
$2 million, $20 million
$10 million, $10 million
(“Down”)
A.
What is the dominant dominant strategy for each firm? Are these also secure secure strategies?
B.
What is the Nash equilibrium?
C.
Would collusion work in this case?
ST14.2
SOLUTION SOLUTION
A.
The dominant strategy for both H-P H-P and Dell is to advertise. Neither could earn higher profits profits with a “don’t advertise” advertise” strategy, strategy, irrespective irrespective of what what the other other party chooses chooses to do. For example, if H-P chooses to advertise, Dell will also choose to advertise and earn earn $5 million million rather rather than $2 million. million. If H-P chooses chooses not to advertis advertise, e, Dell will choose to advertise and earn $20 $20 million rather than $10 million. No matter what H-P decides to do, Dell is better off by advertising. Similarly, if Dell chooses to advertise, H-P will also also choose to advertise advertise and earn $5 million rather than than $2 million. If Dell chooses not to advertise, H-P will choose to advertise and earn $20 million rather than $10 million. No matter what Dell decides to do, H-P is better off by advertising. These are also secure strategies for each firm because they ensure the elimination of worst outcome payoffs. With an advertising strategy, neither firm is exposed exposed to the possibility possibility of earning only $2 million. million.
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B.
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A set set of str strategies con constitute a Nash equ equilibrium if, if, given the str strategies of oth other players, players, no player can improve its payoff through through a unilateral unilateral change in strategy. The concept of Nash equilibrium is very important because it represents a situation where every player is doing the best possible in light of what other players are doing. In this case, the Nash equilibrium equilibrium is for each firm to advertise. advertise. Although Although some problems problems have multiple multiple Nash equilibriums equilibriums,, that is not true in this case. case. An advertising advertising strategy for both firms is the only set of strategies where no player can improve its payoff through through a unilate unilateral ral change in in strategy. strategy. C. Collusion will not work in this case because this is a “one shot” game where moves mov es are taken taken simult simultaneo aneously usly,, rather rather than in sequenc sequence. e. Sequent Sequential ial rounds rounds are necessary necessary with enforcement enforcement penalties penalties before successful successful collusion is possible. possible. If H-P and Dell “agreed” not to advertise in the hope of making $10 million each, both would have an incentive to cheat on the agreement in the hope of making $20 million. Without the possibility for a second round, enforcement is precluded, and collusion isn’t possible.
PROBLEMS & SOLUTIONS SOLUTIONS P14.1
each of the following statements statements as being true or Game Theory Concepts Concepts . Recognize each false and explai explain n why. why. A.
A set of strategies strategies constitute constitutess a Nash equilib equilibrium rium if no player player can improve improve their position position given given the the strateg strategies ies chosen chosen by by other other players. players.
B.
A secure secure strategy strategy is very conserva conservative tive and should should only be considere considered d if the rival’s optimal strategy is identical.
C.
A dominan dominantt strategy strategy is also a secure secure strategy, strategy, but every every secure secure strategy strategy is not necessarily a dominant strategy.
D.
In a one-shot one-shot game, the Nash Nash equilibriu equilibrium m is also the best outcome outcome that can be achieved under collusion.
E.
If a player player has no domina dominant nt strategy, strategy, it pays pays to look look at the game game from the rival’s rival’s perspectiv perspectivee and anticipa anticipate te the rival rival choosin choosing g its domi dominant nant strate strategy. gy.
P14.1
SOLUTION SOLUTION
A.
True. A set of strategies constitutes a Nash equilibrium if no player can improve their position position given the the strategies strategies chosen chosen by other other players. players.
B.
False. A secure strategy strategy is very conservative conservative and should only only be considered if the
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player has good reason to be extremely risk averse. The secure strategy strategy does not take into account the optimal decision of the rival and may thereby result in significant lost profits. profits. C.
False. There is no necessar necessary y relationship relationship between between dominant dominant and secure strateg strategies. ies. A dominant strategy is one that results in the highest payoff to a player regardless of the strate strategy gy chosen by the rival. rival. A secure strate strategy gy is one that guarante guarantees es the highest highest payoff given given the worst worst possible possible decision decision scenario scenario by the rival. rival.
D.
False. In a one-shot one-shot game, game, collusion collusion is not possible. possible. Collusion Collusion requires requires a repeated repeated game. A classic result result in game theory is that the Nash equilibrium equilibrium output is inferior inferior from the viewpoint of the competitors to the collusion or cartel profit-maximizing outcome.
E.
True. If a player has no dominant strategy, it pays to look at the game from the rival’s rival’s perspective perspective and anticipate anticipate the rival choosing its dominant strategy. strategy. Such strategic strategic game playing stems from the look ahead, extrapolate back principle of game theory.
P14.2
Prisoner’s Prisoner’s Dilemma. The classic prisoner's dilemma involves two suspects, A and B, who are arrested by the police. Because the police have insufficient evidence for conviction on a key charge, they place the prisoners in isolation and offer each of them the following deal: If one testifies for the prosecution against the other and the other remains silent, the betrayer goes free and the silent accomplice receives a 20-year sentence sentence.. If both stay silent, silent, both prisone prisoners rs are sentence sentenced d to only six months months in jail jail on a minor charge. If each betrays the other, each receives a five-year sentence. Each prisoner prisoner must must make make the choice choice of whether whether to betray betray the other other or to remain remain silent. silent. Neither Neither prisoner prisoner knows knows for sure what choice choice the other other prisoner prisoner will make. make. The dilemma is summarized as follows:
Prisoner Prisoner B Stays Silent Silent Prisoner A Stays Stays Silent Prisoner Prisoner A Betrays
P14.2
Each gets six month monthss
Prisoner Prisoner B Betrays
Prisoner Prisoner A gets gets 20 years years Prisoner Prisoner B goes goes free free
Prisoner Prisoner A goes goes free free Each gets 5 years years Prisoner Prisoner B gets gets 20 years years
A.
Describe Describe the best best strategy strategy for each each prisoner prisoner if neither neither knows what what the other other will do.
B.
What is the paradox of the situation?
SOLUTION SOLUTION
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A.
If either prisoner knew the other prisoner would stay silent, their best move would be to betray and walk free instead of receiving a 5-year sentence. If either prisoner knew the other prisoner would betray (defect), their best move would be still to betray and receive a lesser sentence than through silence. Betraying is a dominant strategy, but by both defecting defecting each prisoner prisoner is worse off than would be the case if both remained remained silent.
B.
Rational self-interested play results in each prisoner being worse off than if they had remained silent. The paradox of the situation lies in the fact that betray is the best individual strategy, but suboptimal for the pair.
P14.3
Conceive ive of two comp competi etitor torss facing facing import important ant strate strategic gic Dominant Dominant Strategies. Strategies. Conce decisi decision onss where where the payof payofff to each each decisio decision n depen depends ds upon upon the reacti reaction onss of the competitor. Firm A can choose either row in the payoff matrix matrix defined below, whereas firm B can choos choosee either either column column.. For firm firm A the choice choice is is either either “up” or or “down;” “down;” for firm B the choice choice is either either “left” or “right.” “right.” Notice Notice that neither neither firm can can unilaterally unilaterally choose choose a given given cell in the profit payoff payoff matrix. The ultimate ultimate result result of this one-shot, one-shot, simultane simultaneousous-mov movee game depen depends ds upon the the choices choices made made by both both competit competitors. ors. In this payoff payoff matrix, matrix, strategic strategic decisions decisions made by firm A or firm B could signify signify decisions decisions to offer a money-back money-back guarantee, lower lower prices, offer free shipping, and so on. The first number in each cell is the profit payoff to firm A; the second number is the profit payoff payoff to firm B. B. Firm B
Firm A
Competitive Strategy
Left
Right
Up
$5 million, $10 million
$7.5 million, $4 million
Down Down
$1 million million,, $3.5 million million
$5 million million,, $5 million million
A.
Is there there a domin dominant ant strate strategy gy for for firm A? If so, what is it?
B.
Is there there a domin dominant ant strate strategy gy for for firm B? If so, what is it?
P14.3
SOLUTION SOLUTION
A.
Yes, the dominant strategy for firm firm A is “up.” Notice that if firm B chooses “left,” the highest payoff payoff of $5 million million can be achieved achieved if Firm A chooses chooses “up.” On the other hand, if firm B chooses “right,” the highest payoff of $7.5 million can be achieved if firm A again chooses “up.” No matter what firm B chooses, the highest payoff results for firm A occurs occurs if A chooses “up.” Therefore, Therefore, “up” is a dominant strategy strategy for firm
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A. B.
No, there is no dominant strategy strategy for firm B. If firm A chooses “up,” the highest payoff of $10 million million can be achieved if firm B chooses “left.” On the other hand, if firm A chooses “down” the highest payoff of $5 million can be achieved if firm B choose choosess “right.” “right.” Theref Therefore ore,, there is no dominant dominant strate strategy gy for firm B. The profit profit-maximizing choice by firm B depends upon the choice made by firm A.
P14.4
Secure Secure Strategies. Strategies. The Home Depot, Inc., and the Lowes Companies are locked in a vicious vicious struggle struggle for market share in the home improve improvemen mentt market. market. Suppose Suppose each competitor is considering the advisability of offering 90-day free financing as a means for boosting boosting sales during the important important spring spring season. season. The Home Depot Depot can choose choose either row in the payoff matrix defined below, whereas the Lowes Companies can choose either column. column. Neither firm can can unilaterally choose choose a give cell in the payoff matrix. The ultimate result of this one-shot, one-shot, simultaneous-move simultaneous-move game depends depends upon the choices choices made made by both both competit competitors. ors. The first first number number in each each cell cell is the profit profit payoff payoff to the Home Home Depot; Depot; the second second number number is the profit profit payoff payoff to the Lowes Lowes Companies.
Lowes Lowes Compa Companies nies Competitive Strategy
The Home Depot
90-day free financing financing
90-day free financing (“Left)
No free free financ financing ing (“Right”)
$20 $20 mil milli lio on, $20 $20 mill millio ion n
$40 $40 mil milli lion on,, $10 $10 mil milli lion on
$15 $15 mil milli lio on, $35 $35 mill millio ion n
$25 $25 mil milli lion on,, $25 $25 mil milli lion on
(“Up”) No free free financing financing (“Down”) A.
Is there there a secur securee strategy strategy for The The Home Home Depot? Depot? If so, so, what what is it?
B.
Is there there a secur securee strategy strategy for The The Lowes Lowes Compa Companies? nies? If so, so, what what is it?
P14.4
SOLUTION SOLUTION
A.
Yes, Yes, the the secur securee stra strate tegy gy for for Th Thee Home Home Depot Depot is to offe offerr 90-day 90-day free free fina financi ncing. ng. Irrespective of the choice made by the Lowes Companies, in its secure strategy The Home Depot can insure that it avoids the worst-possible outcome of earning only $15 million by choosing to offer 90-day free financing.
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B.
Yes, the secure strategy for the Lowes Companies is to offer 90-day free financing. Irrespective of the choice made by The Home Depot, Lowes’ secure strategy insures that it avoids the worst-possible outcome of earning only $10 million by choosing to offer 90-day free financing.
P14.5
Nash Equilibrium. Equilibrium. The breakfast breakfast cereal industry industry is heavily heavily concentrated. concentrated. Kellogg, General Mills, General Foods (Post) and Ralcorp account for over 85 per cent of industry sales. Advertising by individual individual firms does not convince convince more people to eat eat breakfast. Effective advertising advertising simply simply steals sales from rivals. Big profit profit gains could could be had if these these rivals could simply simply agree to stop advertising advertising.. Assume Assume Kellogg Kellogg and General General Mills are trying to set optimal optimal advertising advertising strategies. strategies. Kellogg Kellogg can choose either row in the payoff matrix defined below, whereas General Mills can choose either column. The first number in each cell is Kellogg’s Kellogg’s payoff; the second number number is the payoff to General Mills. This is a one-shot, simultaneous-move simultaneous-move game game and the first number in each each cell is the profit payoff to Kellogg. The second number number is the profit payoff payoff to General General Mills. Mills.
. General Mills
Kellogg Kellogg
Competitive Strategy
Advertise Advertise
Don’t Don’t Advertis Advertisee
(“Left”)
(“Right”)
Advertise Advertise (“Up”)
$800 $800 mil milli lion on,, $800 $800 mill millio ion n
$1.5 $1.5 bil billi lion on,, $600 $600 mil milli lion on
$600 mi million, $1 $1.5 bi billion
$1 bi billion, $1 $1 billion
Don’t Advertise Advertise (“Down”) A.
Briefly Briefly describ describee the Nash equilibri equilibrium um conce concept. pt.
B.
Is there there a Nash Nash equili equilibriu brium m strateg strategyy for each firm? firm? If so, so, what what is it?
P14.5
SOLUTION SOLUTION
A.
A set of strategies constitutes a Nash equilibrium if no player can improve their payoff through a unilateral change in strategy. The concept of Nash equilibrium is important because it represents represents a stable situation situation in which no player can improve their situation situation given the strategies adopted by other players.
B.
Yes. The Nash equilibrium strategy is for both Kellogg and General Mills Mills to advertise. Given that Kellogg chooses to advertise, General Mills makes the most profit by also
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choosing choosing to advertise. Similarly, Similarly, given that General Mills Mills has chosen to advertise, the best Kellogg Kellogg can do is to advertise advertise as well. Given the dual decision decision to advertise, advertise, neither competitor can improve profits by changing its advertising decision. P14.6
Collusion. Collusion. In the United States any contract, combination or conspiracy in restraint of trade is illegal. In practice, this means means it is against the law to control control or attempt to control the quantity, price or exchange exchange of goods and services. services. In addition to this legal prohibiti prohibition, on, potential potential conspira conspirators tors face practical practical problems problems in any overt overt or tacit attempt at collusion. collusion. To illustrate the problems problems encountered, encountered, consider the following following profit profit payoff payoff matrix matrix faced faced by two potential potential conspirato conspirators rs in a one-shot one-shot,, simultane simultaneousousmove game. game. The first number in each cell is firm A’s profit payoff; the second number number is the profit payoff to firm B.
Firm B Pricing Pricing Strategy Firm A
Low Price Price (“Up”) High Price Price (“Down”)
Low Price Price (“Left”)
High Price Price (“Right”)
$5 milli illio on, $5 million
$40 million, -$20 mill illion
-$2 -$20 mil milli lion on,, $4 $40 milli illio on
$25 $25 millio llion n, $25 $25 milli illio on
A.
Is there a dominan dominantt strategy and a Nash equilibrium equilibrium strategy strategy for each firm? If so, what what are are they? they?
B.
If the firms firms agreed agreed to collude collude and charge charge high prices, prices, both would would earn $25 million and joint profits of of $50 million would be be maximized. maximized. However, However, the joint high-price strategy strategy is not a stable stable equilibrium. Explain.
P14.6
SOLUTION SOLUTION
A.
In this problem, the low-price strategy strategy is a dominant strategy for both firms. firms. If firm B charged low prices, firm A will also choose to charge low prices because the $5 million profit then earned is more than the $10 million loss that would be suffered by firm A if it pursued a high-price strategy. If firm B charged high prices, firm firm A would still choose to charge low prices because the $40 million profit then earned is more than the $25 million profit that would be earned if firm A pursued a high-price strategy. strategy. If firm A charged low prices, prices, firm B will also choose to charge low prices prices because the $5 million profit then earned is more than the $10 million loss that would be suffered suffered by firm B if it pursued pursued a high-price high-price strategy. strategy. If firm A charged high
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prices, prices, firm B would still choose to charge low prices because the $40 million million profit then earned is more than the $25 million profit that would be earned if firm B pursued pursued a high-price strategy. In this case, if both firms pursue a low-price strategy a Nash equilibrium also results. results. A set of strategies strategies constitutes constitutes a Nash equilibrium equilibrium if no player can improve their payoff payoff through a unilateral unilateral change in strategy. strategy. The concept of Nash equilibrium equilibrium is important because it represents a stable situation in which no player can improve their situation given the strategies adopted by other players. B.
If the firms agreed to collude and charge high prices, both would earn $25 million and joint profits profits of $50 million million would be maximized. maximized. However, However, the joint high-price high-price strategy strategy is not a stable equilibrium. equilibrium. To see the instability instability of having both firms firms choose high-price strategies, see how each firm has strong incentives to cheat on any covert or overt agreement agreement to collude. collude. If firm B chose chose a high-price strategy, strategy, firm A could could see profits profits jump from $25 million to $40 million by switching switching from a high-price to a low price strateg strategy. y. Similarly, Similarly, if firm firm A chose chose a high-price high-price strateg strategy, y, firm B could could see profits profits jump from $25 million million to $40 million million by switching switching from a high-price high-price to a low-price low-price strategy. strategy. Both firms have strong strong incentives to cheat on any covert or overt agreement agreement for both of them to charge charge high prices. Such situations situations are common and help help explain the difficulty of maintaining cartel-like agreements.
P14.7
Randomized Randomized Strategies. Strategies. Game theory can be used to analyze conflicts that arise betw betwee een n mana manage gers rs and and work worker ers. s. Mana Manage gers rs can can choo choose se to moni monito torr work worker er performa performance, nce, or not not monitor monitor worke workerr performan performance. ce. For their their part, part, workers workers can can choose choose to perform the requested task within the time frame requested, or fail to perform as requested requested.. The resulting resulting payoff matrix matrix for this one-shot, one-shot, simultaneo simultaneous us move game shows shows the payoff payoff to manag managers ers (first (first numbe number) r) and and worker workerss (second (second numb number). er).
Workers
Managers Managers
Work Strategy
Perform Perform
Fail to Perform Perform
(Left”)
(“Right”)
Monitor Monitor (“Up”) (“Up”)
-$1,000, -$1,000, $1,000 $1,000
$1,000, $1,000, -$1,00 -$1,000 0
Don’t Don’t Monitor Monitor (“Down”)
$1,000, -$1,000
-$1,000, $1,000
A.
Document Document the fact fact that that there there is no Nash Nash equili equilibrium brium strategy strategy for for each each player player..
B.
Explain Explain how each player player will have a preferen preference ce for secrecy in the absence absence of a Nash equilibri equilibrium um and how randomize randomized d strategie strategiess might might be favored favored in such circumstances.
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P14.7
SOLUTION SOLUTION
A.
In this game, if the manager monitors performance while the worker performs as expected, the manager loses $1,000 for unnecessary monitoring effort while the worker earns a $1,000 payoff for performing performing as expected. expected. However, However, if the manager monitors worker performance and the worker fails to perform, the manager earns $1,000 for succes successful sfully ly detecti detecting ng such such shirki shirking, ng, while while the worker worker loses loses $1,000 $1,000 for failing failing to perform perform as expected. In the same way, if the manager manager doesn’t monitor performance performance while while the worker worker performs performs as expected expected,, the manager manager gains gains $1,000 $1,000 for saving on unneces unnecessar sary y monitor monitoring ing costs costs while while the worker worker loses loses a $1,000 $1,000 for perfor performing ming as expected expected when such performance performance was not required. If the manager doesn’t doesn’t monitor worker performance and the worker fails to perform, the manager loses $1,000 for failing to detect shirking, while the worker wins $1,000 for getting paid despite failing to perform as expected. A set of strategies constitutes a Nash equilibrium if no player can improve their payoff through through a unilateral unilateral change in strategy. strategy. In this case, there is no Nash equilibrium. equilibrium. Notice that that in each each instance, instance, the counter-party counter-party would have have an incentive incentive to change strategies strategies given the strategy strategy chosen the other party. If the manager chooses chooses to monitor, workers would prefer to perform as expected. However, if workers choose to perform as expected, expected, managers would prefer not to monitor. Similarly, if managers choose not to monitor, monitor, workers would prefer prefer not to perform. However, However, if workers choose not to perform, managers would prefer to monitor.
B.
In the absence of Nash equilibrium, each player will have a preference for secrecy to mask moves moves and preferences. preferences. In the absence of a Nash equilibriu equilibrium, m, workers workers might choose randomized strategies of when to perform and when not to perform so as to thwart managers ability to know when when to monitor and when not to monitor. Similarly, managers may want to keep their monitoring intentions secret and randomize actual monitoring in order to avoid the necessity of monitoring performance all of the time.
P14.8
Prohibitions ons against against predatory predatory pricing pricing stem from big business business Predatory Predatory Pricing. Prohibiti conspiracy theories popularized in the late nineteenth century by journalists such as Ida Tarbell, Tarbell, author author of an influentia influentiall book titled titled History History of the Standard Standard Oil Compan Company. y. In that book, book, Tarbell Tarbell condemn condemned ed Standard Standard Oil's allegedly allegedly predatory predatory price cutting. cutting. Business Business historian historianss assert assert that that Tarbell Tarbell vilifie vilified d John John D. Rocke Rockefelle fellerr because because of persona personal l reasons, and not only because because of an interest in reshaping reshaping public policy. Standard Oil's low prices had driven the employer of Tarbell’s brother, the Pure Oil Company, out of the petroleum-refining business. According According to predator predatoryy pricing pricing theory, theory, the predatory predatory firm sets price below below margina marginall cost, cost, the relevant relevant cost of productio production. n. Competito Competitors rs must then lower their price price below marginal marginal cost, thereby thereby losing losing money money on each unit sold. sold. If competit competitors ors failed failed to match match the predatory predatory firm’s firm’s price cuts, cuts, they would would continue continue to lose market market share share until they were driven driven out of business. business. If competit competitors ors follow follow the lead of the predatory predatory pricing pricing firm and cut price below marginal marginal cost, cost, they will incur incur devastating devastating
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losses, and eventually eventually go bankrupt. bankrupt. Either way, the “deep “deep pockets” of the predatory predatory firm give give it the financi financial al muscle muscle and staying staying power power necess necessary ary to drive drive smaller, smaller, weaker weaker competitors out of business. business. After competition competition has been eliminated eliminated from the market, market, the predatory firm raises prices to compensate for money lost during its price war against smaller competitors, and earns monopoly profits forever thereafter.
P14.8
A.
The ban against predatory pricing is one of the most controversial U. S. antitrust policies. policies. Explain Explain why this ban ban is risky risky from from a public public policy policy perspec perspective, tive, and and why why predatory predatory pricing pricing strategy strategy can be criticized criticized as irrational irrational from a game theory theory perspectiv perspective. e.
B.
Explain Explain why the prohibitio prohibition n against against predatory predatory pricing pricing might might be politically politically popular popular even even if if predato predatory ry pricing pricing is implaus implausible ible from from an an econom economic ic perspec perspective. tive.
SOLUTION SOLUTION
DDDDDDDDDDDDDDDDDDDDDD DDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDD DDDDDDDDDDDDDDDDDDDDDDDDDDD DDDDDDDDDDDDDDDDDDD DDDDDD DDDDDDDDDDDDDDDDDDDDDD DDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDD DDDDDDDDDDDDDDDDDDDDDDDDDDD DDDDDDDDDDDDDDDDDDD DDDDDD DDDDDDDDDDDDDDDDDDDDDD DDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDD DDDDDDDDDDDDDDDDDDDDDDDDDDD DDDDDDDDDDDDDDDDDDD DDDDDD DDDDDDDDDDDDDDDDDDDDDD DDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDD DDDDDDDDDDDDDDDDDDDDDDDDDDD DDDDDDDDDDDDDDDDDDD DDDDDD DDDD DDDDD. D. Th Thee antit antitrus rustt ban ban on predat predator ory y pric pricing ing is risky risky from from a pub publi licc policy policy perspe perspect ctive ive because, because, like any limit on price competition, competition, a ban on predatory predatory pricing can retard beneficial beneficial price competition competition among firms. The theory of predatory predatory pricing has long held appeal for political scientists and journalists, but economic research for more than a generation has shown that predatory pricing strategy is an irrational means for trying to monopolize monopolize an industry. industry. Critics Critics of antitrust policy policy point out that there there has never been a single clear-cut clear-cut example of monopoly monopoly created by predatory predatory pricing. Claims Claims of economic damages due to predatory pricing are usually made by non-leading firms who are inefficient competitors that are either unwilling or unable to cut their own prices. prices. Economist Economist Harold Demsetz, Demsetz, among others, has h as charged that legal restrictions restrictions on price cutting in the name of combating “predation” are protectionist and anticonsumer. From From a game game theory theory perspect perspective, ive, predato predatory ry pricing pricing strate strategy gy seems seems irrati irrational onal because it is based upon output and pricing assumptions assumptions that are not credible. credible. For predatory predatory pricing to constitute constitute a profitable profitable competitive competitive strategy, strategy, smaller smaller competitors competitors and prospective entrants must believe that the incumbent will maintain the same predatory predatory pricing strategy for so long as potential potential competitors competitors remain viable. At the same time, the firm embarking on a money-losing strategy of price predation must anticipate anticipate a significant significant post-price war period when higher prices and monopoly monopoly prices become possible. possible. The “victims” “victims” of price predation predation must not be able to discern discern the long-term long-term pricing and monopoly monopoly profit objectives objectives of the price predator. predator. From a game theory perspective, the price predator and its victims are engaged in a multi-period game where the victims are unable to discern that the perpetrator’s threat of a perpetual price war war is not credible. credible.
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EEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEE EEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEE EEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEE EEEEEEEEEEE EEEEEEEEEEEEEEEEE EEEEEEEEEEE EEEEEEEEEEE EEEEEEEE. EE. Predatory Predatory pricing theory gets virtually no respect from economists, but is still a popular legal and political theory for several reasons. Huge Huge sums sums of mo money ney are are invol involved ved in preda predato tory ry pric pricing ing liti litiga gati tion on and that that fact fact guarantees guarantees that the antitrust antitrust bar will be fond of the the theory of predatory predatory pricing. For example, during the 1970s, AT&T estimated that it spent over $100 million per year defending defending itself against claims claims of predatory pricing. pricing. In addition, the idea of predatory predatory pricing lends itself itself to political demagoguery. demagoguery. The idea that large, greedy corporations from from the United United States States and abroad might conspire conspire to drive drive out smaller, smaller, innocent innocent competitors competitors is extremely extremely popular in folk myth. Union leaders, leaders, trade associations, associations, and protectionist protectionist members members of Congress Congress frequently frequently invoke the predatory predatory pricing myth in attempts to protect workers and businesses from highly capable domestic and foreign competition. Anti-business groups and self-styled consumer activists also employ the tale of predatory pricing in their efforts to discredit capitalism and promote greater governmental governmental control control of industry industry and the economy. For example, example, when oil and gas prices go up, citizen citizen groups denounce alleged alleged price gouging. When prices go down, they sometimes claim that price reductions are designed to rid the market of smaller competitors. When prices remain remain constant, price-fixing is frequently asserted. During recent years, charges of predatory pricing have become a convenient weapon for businesse businessess that do not want to match competitor competitor price cutting. cutting. Filing an antitrust lawsuit is an easy alternative to competing by cutting prices or improving product quality. quality. Customers Customers appear to like the low prices offered offered by Wal-Mart; Wal-Mart; compet competitor itorss and union groups groups do not. Given Given the rapid rapid growth growth that Wal-Ma Wal-Mart rt has enjoyed for more than a generation, it is obvious that Wal-Mart enjoys a large and enthusiastic following following among among consumers. Competitors are not so sanguine. For many Wal-Mart competitors, it is easier to fight in antitrust court or in local zoning boards than it is to compete effectively in the consumer market place. P14.9
Gene Ge neral ral Cerea Cereals, ls, Inc. Inc. (GCI) (GCI),, produc produces es and and marke markets ts Non-price Non-price Competition. Competition. Sweeties!, a popular popular ready-to-eat breakfast breakfast cereal. In an effort to expand sales sales in the Secaucus, New Jersey, market, the company is considering a one-month promotion whereby GCI would distribute a coupon for a free daily pass to a local amusement park in exchange exchange for three three box tops, as sent in by retail customers. customers. A 25% boost in demand is anticipated, even though only 15% of all eligible customers are expected to redeem their coupons. coupons. Each redeemed redeemed coupon costs costs GCI $6, so the expected expected cost of this promotion is 30¢ (= 0.15 × $6 ÷ 3) per unit sold. Other marginal marginal costs for cereal producti production on and and distribu distribution tion are are constan constantt at $1 per unit. unit. Current demand and marginal revenue relations for Sweeties! are Q
= 16,000 - 2,000P,
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MR
= ΔTR/ΔQ ΔTR/ΔQ = $8 - $0.001Q. $0.001Q.
Demand Demand and margina marginall revenue revenue relations relations that reflect reflect the expected expected 25% boost boost in demand for Sweeties! are the following: Q MR
= 20,000 - 2,500P, = ΔTR/ΔQ ΔTR/ΔQ = $8 - $0.0008Q $0.0008Q..
A.
Calculate the profit-maximizing price/output and profit levels for Sweeties! prior to the coupon promotion.
B.
Calculate these same values subsequent to the Sweeties! coupon promotion and following following the expec expected ted 25% 25% boost boost in demand. demand.
P14.9
SOLUTION SOLUTION
A.
The profit-maximizing price/output combination is found by setting MR = MC and solving for Q: MR $8 - $0.001Q 0.001Q Q
= MC = $1 = 7 = 7,000 boxes
and, because: Q = 16,000 - 2,000P, P = $8 - $0.0005Q = $8 -$0.0 -$0.000 005(7 5(7,00 ,000) 0) = $4.5 $4.50 0 per per box box B.
The profit-maximizing price/output combination is found by setting the new relevant MR = MC and solving for Q: MR = MC $8 - $0.0008Q = $1 + $0.30
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0.0008Q = 6.7 Q = 8,375 boxes and, because: Q = 20,000 - 2,500P, P = $8 - $0.0004Q = $8 -$0.0 -$0.000 004(8 4(8,37 ,375) 5) = $4.6 $4.65 5 per per box box Thus, the benefits of the coupon promotion are reflected in 1,375 (= 8,375 -7,000) more units sold, and a 15¢ ($4.65 - $4.50) increase in price on all units.
P14.10
P14.10
Variability Variability of Business Business Profits. Near Near the checko checkout ut stand, stand, groce grocery ry stores stores and and convenience stores prominently display low-price impulse items like candy, gum and soda that that custome customers rs crave. crave. Despite Despite low prices prices,, such produc products ts generate generate enviab enviable le profit profit margins for retailers and for for the companies that produce produce them. For example, Hershey Hershey Foods Foods Corp. Corp. is the larges largestt U.S. produc producer er of chocola chocolate te and noncho nonchocola colate te confectio confectionary nary (sugared) products. products. Major brands include include Hershey’s, Reese’s, Reese’s, Kit Kat, Almond Joy, Joy, and Milk Duds. While Hershey Hershey’s ’s faces increasing increasing competition competition from other other candy compan companies ies and and snacksnack-foo food d produc producers ers of energy energy bars, bars, the compan companyy is extrem extremely ely profitable profitable.. Hershey’s Hershey’s rate rate of return on stockho stockholder’ lder’ss equity, equity, or net income divided divided by book book value value per share, share, routine routinely ly excee exceeds ds 30% per year, year, or about about three three times times the publicly publicly-trad traded ed company company average. average. Profit Profit margins, margins, or net income per dollar dollar of sales revenue, generally exceed 13%, and earnings grow in a predictable fashion by more than 10 percent per year. A.
Explain Explain how the failure failure to reflect reflect intangible intangible assets, assets, like the value of brand brand names, names, might might cause cause He Hersh rshey’ ey’ss accoun accountin ting g profit profitss to overst overstate ate He Hersh rshey’ ey’ss economic profits.
B.
Explain Explain why high economic economic profit profit rates rates are a necessary necessary but not sufficien sufficient t condition for the presence of monopoly profits.
SOLUTION SOLUTION
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Business profit is often measured in dollar terms or as a percentage of sales revenue, called profit margin. margin. The economist's economist's concept of a normal rate rate of profit is typically typically assessed in term termss of the the real realize ized d rate rate of return return on stock stockhol holde ders rs'' equit equity y (ROE (ROE). ). Retu Return rn on stockholders' equity is defined as accounting net income divided by the book value of the firm. Average Average ROE for the typical publicly-trade publicly-traded d corporation average average about 10 percent per year, after the predictable predictable adjustments adjustments for extraordinary extraordinary items. items. ROE for the most successful publicly-traded companies falls in a broad range around 15 to 25 percent per year. Although Although an average annual ROE of roughly 10 percent can be regarded as a typical or normal rate of return in the United States and Canada, this standard is routinely exceeded by companies such as Hershey’s, which has consistently earned a ROE in excess of 30 percent per year. Reported Reported profit rates can overstate overstate differences in economic economic profits profits if accounting accounting error or bias causes investments with long-term benefits to be omitted from the balance sheet. For example, example, current accounting practice practice often fails to consider advertising advertising or resear research ch and developm development ent expendit expenditure uress as intangib intangible le investm investment entss with with long-ter long-term m benefits. benefits. Because advertising advertising and research research and development development expenditures expenditures are immediately expensed rather than capitalized and written off over their useful lives, intangible intangible assets can be grossly understated understated for certain certain companies. The balance sheet of Hershey’s does not reflect the hundreds of millions of dollars spent to establish and maintain the brand-name recognition of Almond for example. example. Merck's Merck's balance balance Almond Joy, for sheet fails to reflect research dollars spent to develop important product names like Vasotec (for the treatment of high blood pressure), Zocor Zocor (an antiarthritic drug), and (asthma medication). medication). As a result, result, business business profit profit rates for for both Hershey’s, Hershey’s, Singulair (asthma Merck, and other advertising and research and development-intensive firms tend to overstate true economic performance. GGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGG GGGGGGGGGGGGGGGGGGGGGGGGGGGGG GGGGGGGGGGGGGGGGGGGGGGGGGG GGGGGGGGGG GGGGGGGGGGGGGGGGGGGGGGGGGGGGG GGGGGGGGGGGGGG GGGGGGGGGGGGGGGGGGGGGGGGGGGGGGG GGGGGGGGGGGGGGGGGGGGGGGGGG GGGGGGGGGG GGGGGGGGGGGGGGGGGGGGGGGGGGGGG GGGGGGGGGGGGGG GGGGGGGGGGGGGGGGGGGGGGGGGGGGGGG GGGGGGGGGGGGGGGGGGGGGGGGGG GGGGGGGGGG GGGGGGGGGGGGGGGGGGGGGGGGGGGGG GGGGGGGGGGGGGG GGGGGGGGGGGGGGGGGGGGGGGGGGGGGGG GGGGGGGGGGGGGGGGGGGGGGGGGG GGGGGGGGGG GGGGG. GGGGG. In economic economic terms, terms, monopoly monopoly profits profits are the unwarrante unwarranted d payoff received received by firms for the raw exercise exercise of pricing power. power. Implicit Implicit in the concept of monopoly monopoly profits is the notion that the monopoly firm does not earn above-normal returns due to superior productivity, productivity, sometimes sometimes called Ricardian rents. In the absence of raw pricing power, the monopoly firm would be expected to earn only a risk-adjusted normal rate of return on investment. High economic profit rates are a necessary but not sufficient condition for the presence presence of monopoly profits. When properly measured, high accounting profit rates can be a useful indicator of above-normal profits, but these above-normal profits can represent a warranted economic compensation for superior efficiency, innovation, or productive productive capability. capability. It is also important to remember remember that reported reported profits fluctuate fluctuate widel widely. y. Some Some of the the variat variatio ion n in ROE ROE seen seen among among public publicly ly-t -tra raded ded compan companie iess represents the influence of accounting mismeasurement or bias; some of this variation also reflects the fact that accounting profit rates are not adjusted for risk differences.
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In the candy business, the economic value of brand name advertising is not reflected in accounting accounting value of the firm. In an economic sense, sense, advertisers advertisers like Hershey’s Hershey’s have a right to expect to earn a fair return on risky intangible assets derived from advertising and product promotion. promotion. Accounting Accounting rates of return for advertising-i advertising-intensive ntensive firms firms shoul should d be highe higherr than than averag averagee to compe compensa nsate te brand brand name name leade leaders rs for highhigh-ri risk sk promotional promotional strategies. strategies. A similar similar situation situation exists for firms with significant significant research research and development development activity. activity. In the pharmaceuticals pharmaceuticals industry, industry, for example, example, hoped-for discoveries of effective therapies for important diseases are often a long shot at best. Thus, profit rates reported by Merck and other leading pharmaceutical companies overstate the relative profitability of the drug industry; it could be cut by one-half with proper risk risk adjustment adjustment..
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CASE STUDY FOR CHAPTER 14 Time Warner, Inc., Is Playing Games with Stockholders
Time Warner, Inc., the world’s largest media and entertainment company, is best known as the publisher publisher of magazine magaziness such as Fortune, Fortune, Time, Time, People, People, and Sports Illustra Illustrated. ted. The Company Company is a media powerhouse comprised of Internet technologies and electronic commerce (America Online), cable television systems, filmed entertainment and television production, cable and broadcast television, recorded music and music publishing, magazine publishing, book publishing and direct marketing marketing.. Time Warner Warner has the potential potential to profit profit whether people people go to theaters, theaters, buy or rent videos, watch cable or broadcast TV, or listen to records. Just as impressive impressive as Time Warner’s Warner’s comman commanding ding presence presence in the entertainm entertainment ent field is its potential for capitalizing on its recognized strengths during coming coming years. Time Warner is a leader in terms of embracing new entertainment-field entertainment-field technology. technology. The company’s company’s state-of-the-art cable systems allow subscribers to rent movies, purchase a wide array of goods and services, and participa participate te in game game shows shows and and consum consumer er surveys surveys--all --all within within the privac privacyy of their their own own homes. homes. Wide channel flexibility also gives the company the opportunity to expand pay-per-view TV offerings to meet meet demand demand from specialized specialized market market niches. niches. In areas where cable cable systems have sufficien sufficient t capacity, HBO subscribers subscribers are now offered a choice of programming programming on different channels. Time Warner also has specialized networks, like TVKO, to offer special events on a regular pay-perview basis. Time Warner is also famous for introducing common stockholders to the practical use of game theory concept concepts. s. In 1991, the company company introduced introduced a controversial controversial plan to raise new equity capital through through use of a complex “contingent” “contingent” rights offering. After months of of assuring Wall Street that it was close to raising new equity from other firms through strategic alliances, Time Warner instead instead asked its shareholders to ante up more more cash. Under the plan, the company company granted granted holders holders of its 57.8 57.8 million million share sharess of common common stock stock the the rights rights to 34.5 34.5 million million share sharess of new new common, or 0.6 rights per share. Each right enabled a shareholder shareholder to pay Time Warner $105 for an unspecified number number of new common common shares. Because the number number of new shares that might be purchase purchased d for $105 was unspecifi unspecified, ed, so too was the price per share. Time Warner’s Warner’s Wall Street advisers structured the offer so that the new stock would be offered at cheaper prices if fewer sharehol shareholders ders chose chose to exerc exercise ise their their rights rights.. In an unusual arrangem arrangement, ent, the rights from all participatin participating g shareholders shareholders were were to be placed placed in a pool to determ determine ine their their pro rata share share of the 34.45 34.45 million million shares shares to be distrib distributed uted.. If 100% of Time Warner shareholders chose to exercise their rights, the price per share would be $105, $105, the number number of shares shares owned owned by each each shareh sharehold older er would would increa increase se by 60%, 60%, and each sharehol shareholder der would retain retain his or her same proportio proportionate nate ownershi ownership p in the company. company. In the event event that less than 100% of the shareholders chose to participate, participating shareholders would receive a discount price and increase increase their proportionate interest interest in the company. If only 80% of Time Warner shareholders chose to exercise their rights, the price per share would be $84; if 60% chose to exercise their rights, rights, the price per share would be $63. These lower prices reflect reflect the fact that if only 80% of Time Warner shareholders chose to exercise their rights, each $105 right would purchase 1.25 shares; if 60% chose to exercise their rights, each $105 right would purchase roughly 1.667 shares. shares. Finally, to avoid the possibility possibility of issuing equity at fire-sale fire-sale prices, Time
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Warner reserved the privilege to cancel the equity offering entirely if fewer than 60% of holders chose to exercise their rights. The The terms terms of the offer offer were were design designed ed to make make Time Time Warner Warner sharehol shareholder derss feel feel compelled to exercise their rights in hopes of getting cheap stock and avoiding seeing their holdings holdings diluted. diluted. Although Although such contingen contingentt rights offerings offerings are a common common capital-ra capital-raising ising technique in Britain, prior to the Time Warner offering they had never been proposed on such a large large scale in the United United States. Wall Street Street traders and investme investment nt bankers lauded lauded the Time Warner offer as a brilliant coercive device--a view that might have been colored by the huge fees they stood stood to make on the offering. offering. Advisory Advisory fees for Merrill Merrill Lynch and Time Warner’s Warner’s seven other key advisers were projected at $41.5 million to $145 million, depending on the number of participa participating ting sharehold shareholders. ers. An additiona additionall $20.7 million million to $34.5 million million was set aside aside to pay other other investme investment nt bankers for soliciting soliciting shareholders shareholders to exercise exercise their rights. Time Time Warner’s Warner’s advisers argued that their huge fees totaling 5.22% of the proceeds to the company were justified because the offering offering entered uncharted uncharted ground in terms of of Wall Street experience. experience. Disgruntled sharehol shareholders ders noted noted that that a similar contin contingen gentt rights offerin offering g by Bass PLC PLC of Britain Britain involved involved a fee of only 2.125% of the proceeds to the company, despite the fact that the lead underwriter Schroders PLC PLC agreed to buy and resell any new stock that wasn’t claimed by rights rights holders. This led to charges that Time Warner’s advisers were charging underwriters’ fees without risking any of their own capital. Proceeds Proceeds from the offering were earmarke earmarked d to help pay down the $11.3 billion debt Time Inc. Inc. took on to buy Warner Warner Communic Communication ationss Inc. Time Time Warner maintaine maintained d that it was in intensive talks with potential strategic partners and that the rights offering would strengthen its hand in those negotiations by improving improving the company’s balance sheet. sheet. Time Warner said that the rights offering would enhance its ability to enter into strategic alliances or joint ventures with partners partners overseas. overseas. Such alliances alliances would help the company company penetrate penetrate markets markets in Japan, Japan, Europe, and elsewhere. elsewhere. Critics of the plan argued that the benefits benefits from strategic alliances alliances come in small increments and that Time Warner had failed to strike any such deals previously because it wants both managem management ent control control and a premium premium price from potential potential partners. partners. These These critics also maintained that meaningful revenue from any such projects is probably years away. Stockholder reaction to the Time Warner offering was immediate and overwhelmingly negative. On the day the offering was announced, announced, Time Warner Warner shares closed closed at $99.50, down $11.25, $11.25, in New York Stock Exchange Exchange composi composite te trading. trading. This is in addition addition to a decline decline of $6 suffered suffered the previous previous day on the basis of a report report in The Wall Street Street Journal Journal that some form of equity offering was being being considered. considered. After trading above above $120 per share in the days days prior to the first reports reports of a pending pending offer, Time Warner shares shares plummete plummeted d by more than 25% to $88 per share share within within a matter matter of days. days. This is yet one more disappoi disappointme ntment nt for the company company’s ’s long suffering suffering common common stockhold stockholders. ers. During During the summer summer of 1989, 1989, Time Time cited a wide range range of synergist synergistic ic benefits benefits to to be gained gained from from a merger merger with with Warner Warner Commu Communica nications tions and spurne spurned d a $200 $200 per share share buyout buyout offer from Paramount Paramount Commun Communicat ications, ions, Inc. This is despite despite the fact that the Paramoun Paramountt offer represente represented d a fat 60% premium premium to the then prevailing prevailing market price of $125 for Time stock. During the succeeding succeeding two-year period, Time Warner Warner stock failed to rise above this $125 level and traded as low as $66 per share during during the fall of 1990. Meanwhile, Meanwhile, the hoped-for Time Warner synergy has yet to emerge.
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A.
Was Paramount’s above-market offer for Time, Inc. consistent with the notion that the prevailin prevailing g market market price for common common stock is an accurate accurate reflection reflection of the discount discounted ed net present value of of future cash flows? Was management’s management’s rejection of Paramount’s Paramount’s above-market above-market offer for Time, Inc. consistent with the value-maximization value-maximization concept?
B.
Assume Assume that that a Time Time Warner Warner shareho shareholder lder could could buy buy additiona additionall shares shares at a marke markett price price of $90 or participa participate te in the company’s company’s rights rights offering. offering. Construc Constructt the payoff payoff matrix that correspond to a $90 per share purchase decision versus a decision to participate in the rights offering with subsequent 100%, 80%, and 60% participation by all Time Warner shareholders.
C.
Describe Describe the the secure secure game game theory theory strategy strategy for for Time Warne Warnerr sharehold shareholders. ers. Was there there a dominant strategy?
D.
Explain Explain why the the price of Time Time Warner Warner common common stock stock fell following following the announc announceme ement nt of the company’s controversial controversial rights offering. Is such an offering in the best interests of shareholders?
CASE STUDY SOLUTION A.
These are, of course, controversial questions designed to spur debate on the issues of capital market efficiency and the convergence or divergence between shareholder and managerial interests. Paramount’s 1989 above-market offer for Time, Inc. is consistent with the notion that the prevailing market price for common stock is an accurate reflection of the discounted net present value of future cash flows to the extent that such a merger promised significant synergistic benefits. As a separate separate entity, the stock market estimated the discounted net present value of Time, Inc. Inc. at $125 per share. It is possible possible that advantages from combining Paramount Paramount and Time might have led to such a dramatic improvement in cash flows that a $200 versus $125 market price per share could could be justified justified.. However However,, subsequ subsequent ent events events may call this interpret interpretatio ation n into into question. Paramount and Warner have many similarities, and Time Warner’s failure to generate generate such synergies makes the magnitude magnitude of such benefits questionable. questionable. Still, one might argue that Paramount management headed by Marvin Davis might have better managed the combined company than the Time Warner management team headed by Stephen Ross. Ross. On the other hand, if the 1989 offer offer of $200 per share was above the the fair value of Time, Inc., then perhaps hubris on the part of Paramount management is to blame. In light of Time Warner Warner’s ’s subsequent subsequent performance, performance, the fact that such such an attractive Paramount offer was turned down by Time management suggests that they neglected to fully consider shareholder interests.
B.
The payoff matrix that corresponds to a $90 per share purchase decision versus a decis decisio ion n to parti particip cipate ate in the right rightss offe offeri ring ng in light light of 100% 100%,, 80%, 80%, and 60% 60% participation participation by all all Time Time Warner Warner shareholders shareholders is: is:
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Share Purchase Cost Payoff Matrix States of Nature
60% Pa Participation
80% Pa Participation
100% Pa Participation
Market Purchase
$90
$90
$90
Rights Offering Participation
$63
$84
$105
Decision Alternatives
Note that that investors investors wish to minimize minimize the cost of of additional additional share purchases purchases.. Therefore, Therefore, a payoff is realized in terms of a lower share purchase price. C.
A secure strategy, sometimes called the maximin strategy, guarantees the best possible outcome given the worst possible scenario. scenario. In this case, the worst possible scenario for current shareholders would occur if they chose to participate and all other shareholders also decided decided to participate in the rights rights offering. In that case, everybody everybody would pay $105 per share. To avoid that outcome, outcome, the secure strategy for current current shareholders shareholders is not to participate in the rights offering, and to instead buy additional shares in the marketplace marketplace for $90. Because the best best possible outcome outcome cannot be assured assured without knowledge of the actions of other participating shareholders, there is no dominant strategy in this case.
D.
The price of Time Warner common stock fell subsequent to the announcement of the company’s controversial rights offering for a number of reasons. The uncertain nature of the contingent rights offering increases the risk of Time Warner stock and, absent any offsetting increase in cash flows, thereby reduces the risk-adjusted net present value of future future cash flows. Thus, the contingent contingent nature of the rights rights offering offering has the predictable predictable effect of reducing reducing the market price price of Time Warner stock. stock. The simple fact that the company wanted to sell additional common stock at a market price of $105 per share also seems to suggest suggest that management management views this price as “high,” and indicates indicates some lack of confidence confidence in the company’s future prospects. prospects. And finally, finally, the cohesive nature of the offering might drive down the price of the company’s stock because it suggests an adversarial rather than cooperative relationship between management and stockholders. Intere Interesti stingl ngly, y, in light light of the furor caused caused by its contingent contingent rights offering, offering, Time Time Warner decided to withdraw the offer a few weeks after it had been announced. In its place, the company decided to offer current shareholders shareholders the right to purchase purchase up to 34.45 million new shares at a fixed price of $80 per share. The company’s investment bankers also also took a haircut on commission commissions, s, reducing their their take to a total of 3% of the amount amount raised and agreed agreed to purchase purchase for their their own account any unsold unsold shares. shares. Obviously, Obviously, the initial contingent contingent rights offering offering was a bad idea. Both large and small
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investors heralded the company’s change in the offering as a victory for shareholders.
