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Game Theory and Competitive Strategy

In this 12th chapter, student will get an opportunity to explore pricing decision and pricing decision which firms that makes often. We watch how firm take into account various responses from competitors regarding the behaviour and market structure.

For instance, why do firms tend to make collusions in some market and to make a competition with others. How do firms manage to prevent entry of potential competitors? How firms do pricing of the product at the time when cost conditions and demand of the product are floating. This is the reason game theory is being is being introduced as a development of micro economics. This laid emphasis on the key aspects that how markets does evolve and operate.

Strategic decisions taken by the manager is also a part of the gaming operations as instance when oligopolistic firms make strategic decisions to do adjustment of prices. Right strategic move always help competitors in bargaining situations. Gaming operations also help in making best use of concrete, threats and promises and understand well the acts taken by your competitors. Game theory is well used in auction design and for bidding strategies how firms should apply.

13.1 Gaming and Strategic Decisions

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The first and foremost thing to do is to understand the concept of Gaming and strategic decisions. Game is that kind of situation, players consider to take the strategic decisions that are taken into account due to other people response and actions. Main examples of games that helps in explaining well about the concept is that firms compete with each other by group of consumers who are doing auction by the way of setting prices. It results into pay offs, rewards and benefits. For all price setting firms, pay offs are profits. For all bidders, at the time of auction, winner payoff is considered as consumer surplus. In other words, it is that value which placed the amount on artwork which is less than the amount a person makes a payment at the time of buying.

Main objective of Game Theory

The main aim of theory is to make determination of optimal strategies for each player. It is a plan of action to start a game. The price setting of the firms feel that price is high as the competitors set the price.  In bidders at an auction set the price $3000 to convince other bidder and if they will drop out other bidders in pushing price above $ 6000. The focus is to always to keep involvement of players. In real life, one may encounter at the competitors who are irrational, less capable as you expected by the consequences of action. So avoid all these, it is all wise to assume that your competitor is rational and smart equal to you.

Try to take the behaviour of competitor into account; I know it is not simple. In the starting to make a determination of optimal strategy can be difficult, if someone considers the situation of perfect information and complete symmetry. The matter of concern is when we have complex situations where we have to face varied information, different cost and various degrees of competitive “disadvantage” and  “advantage’’.

Graphical Models of Game Theory

Non-cooperative versus Cooperative Games

Firms can play economic games which are either being non-cooperative and cooperative. If we consider the cooperative game, players make negotiation in binding contracts for allowing plan joint strategies. In non-cooperative games, binding of contracts are not likely possible. For an example:  Cooperative game is like a bargaining between seller and buyer over a price of rug.

An example: If the cost of rug is $200 to produce and buyer value rug $400, only then it is possible to find a cooperative solution. The agreement of selling and buying then falls between $201 and $399.

Another cooperative game which is involving two firms making negotiation of developing of new technology. All a firm need to do is binding a contract to make the division of profits of the joint investment that leads to better cooperative outcome.

Example of Non cooperative game:  It is a situation when two firms are competing with each other and take into account their behaviour on independent basis.

What all strategies of a non-cooperative game?

  • Players should consider each other actions along with the responses for strategic decision
  • The value of its pay off value should be associated with possible outcome
  • There should be a strategy rule for playing a game
  • Optimal strategy which maximises players expected pay off.

To do bargaining over rug is constant sum game as no substance what the marketing price, sum of profit and consumer plus will be the same. Making negotiation on a joint venture is non-constant sum game. The total profits which results from venture depends on the outcome of the negotiation by independently setting prices. Each of these firms knows the strategy of undercutting its competitive which in result helps in capturing the market share well. In all this, there is a risk in setting off the price war.

If we talk about auction which is another non cooperative auction game, bidder make study of other bidder’s behaviour by determining the optimal strategy. The basic difference between non cooperative and cooperative games is only the contractual possibilities.

In cooperative game, binding contracts are completely possible but in non-cooperative games, it is not possible. The concern mostly is of non-cooperative games. But all can become easy if one easily understand the opponent’s POV.

How to make use of Dollar bill?

Dollar bill is actually auctioned in usual way. The bidder gets dollar in return when they go for the amount of bidding. The second highest bidder has to provide the amount he or she bids and sometimes they get no returns. One needs to be cautious at the time of playing this game ‘Dollar Bill’. The class room experience highlights the fact that students end up bidding by getting higher dollar. For instance, if one player bids for 20% and another for 30%, so lower bidder stand lost 20 cents, one can earn by raising a bid upto 40 cents. This escalation will remain continue as the player carry a bidding dollar to 90 cents. Now this amount has to choose for bidding $1.10 and this will be paying 90 cents.

In further chapter, you get examine about games that include, investment, advertising, decisions, pricing and many more. One can easily get the behavioural assumptions in the same. By using all this, one can determine its best strategy. But even for the simple games, one can able to find the best and accurate behavioural assumptions as all depends on the way of playing the game.

This chapter revolves around the main issues one faces at the time of making strategic decisions. One should know the importance of assessing the opponent’s position along with the rational response to the actions.

13.2 Dominant Strategies

How to make decision of the best strategy for playing any game? How to make determination of game outcome? There is a need to do something which helps in making determination about rational behaviour of a player which results in an equilibrium solution. The strategies can be proved successful if the competitors not make good choices. Other strategies also become successful regardless of the competitors activities. We make a start with actual concept of dominant strategy. The following example makes best illustration about two Firms A and B is making purchase of the competing products and making decision regarding the advertising campaigns. Firm will get affected by competitor’s decision. If Firm A gives an advertisement whereas Firm B does not go for it, Firm A will earn good and Firm B faces loss.

The question here is that what should firm chooses? First make consideration of the first firm. It should clearly go for advertisement no matter what the second firm will make decision, Firm A earns by the way of advertisement. If Firm B chooses to advertise, it is possible that Firm A can earn profit of 10. But if it goes for advertising only of 6, it doesn’t. The advertising could become dominant strategy for the first firm. It is similar for Firm B if it does an advertisement.

If Firm B goes with the similar strategy irrespective of the plans used by Firm A for advertisement, it is possible that Firm B can earn more through its own plan. Suppose both these firm are rational and going for dominant strategies, then we can predict the outcome. It is most likely that it will be equilibrium because of dominant strategies.

Every game does not require dominant strategy. For example, if the Firm A goes for big banners to advertise its product as compare to Firm B, it is likely that Firm A will earn more profit than Firm B. It is clear that Firm A’s intention is to beat Firm B by producing the expensive large banners for its products. It means advertise might cost you at earlier stage but you can get the returns when you sell the items.

Decision of Firm A depends on the decision of Firm B. If both firms make decision at the same time, then what would be the result? What should the Firm A have to do to increase its selling and earn profit? For this, Firm A should come to a point by checking the Firm B’s POV. It would definitely help in making a decision what Firm B is likely to do and how to overcome the situation.

Suppose Firm B has dominant strategy for advertising its products and services irrespective of what Firm A is trying to do. In this case, Firm A will definitely advertise but the winning strategy of Firm B is clear so it is possible that this firm will earn more profit than Firm A.

Graphical representation of the Dominant strategy

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13.3 Nash Equilibrium

 To make a determination of the outcome of a game one need to adopt a ‘’ self-enforcing and stable strategies as a dominant strategy is quite stable in nature. This is a kind of general equilibrium concept. This chapter 12 focus on the concept of ‘Nash Equilibrium’ which is intuitively appealing and applicable.

Nash equilibrium is basically a set of strategy in which participating players are doing their best and they have no way to deviate from decision.

For example, if the both the firms are satisfied with their respective decisions, then we look for Nash equilibrium. According to the Nash equilibrium, there is no reason to change the decision when both firms are satisfied. In Chapter 12, we have discussed Nash equilibrium how the output comes and it’s pricing by making use of the oligopolistic firms.

When we talk about Cournot model, each firm sets their own output and consider outputs of competitors are fixed. In Cournot equilibrium, firm has incentive to change the output. This is because each of the firm is doing its best when given decisions of competitor. We make examination of models if we choose the price, take price of the competitors. In the Nash equilibrium, every firm has the possibility of earning the large profit; it can give the price of competitors and has no other option if there are any changes in the prices. It will be helpful if you compare the concepts of Nash equilibrium along with the concepts of dominant strategies.

For example, if we consider a single Nash equilibrium for both firms for the advertisement, it is impossible to predict the correct future statistics. It is always recommended not to have only one or single Nash equilibrium.

The Product choice problem

Here, just check some more examples to clarify about the Nash equilibrium. Let us take the example of breakfast cereal companies. Two companies produce different type of cereals and introduce the same in the market to earn profit. Each firm introduce a variation in their products to market this and earn profit. Both firms are willing to introduce ‘crispy’ cereal and ‘sweet’ cereal because of its increasing marketability.

In this particular game, every firm introduces different product and there is no point of competition in it. If there is any possibility of coordination, firm could agree to make division of the market. What happen started behaving in non-cooperative manner? For instance there is a new release? It is clear that Firm 1 indicates it is about to make introduction of new sweet cereal and Firm 2 after getting to know about the strategy of Firm 1 introduces  a crispy cereal. The action it believes considering the opponent, no firm has any option that they will deviate from proposed actions that give a payoff. If it deviates from the actual and opponent’s action, the payoff might goes down or it might become negative. Hence, the strategy set in payoff matrix will be stable and it will defiantly constitute Nash equilibrium.

Suppose any one of the firm is eager to produce on type of cereal. Then the Nash equilibrium will become stable and when the strategies are chosen, it is not possible for anyone to deviate from this. Well, we cannot conclude the fact who would win the game whether crispy or sweet cereal. It might goes in either ways.

Concept of the Beach location game

For instance, you are (Y) and the competitor is (c) make a planning to sell a soft drink. The beach is approx. 200 yards long and the sun bathers are spreading across the length. Both you and competitor have set same price for the drink, so in that situation, customer prefer to walk closest to the competitor. The question rises that in the building where your beach will locate and what do you think about the competitor that location he or she going to choose for making sale of the drinks. This is case of Nash equilibrium which calls both you and competitor in the centre of beach.

If you are supposed to know the reason why, then consider the competitor is located at other place. Let it be three quarters of the beach so the firm does not locate at centre. It should look for locating near its opponents. In this way, the firm is likely to increase its sales. Well, if the competitor moves towards the centre, then you should know the opponents’ move so that the firm can make changes to earn more profit.

Game Theory and Competitive Strategy 3” = C

Maximin strategies

The concept of Nash Equilibrium based on the individual’s rational behaviour. Here choice of strategy will depend on its own rationality and on rationality of the opponent. For example in which two firms complete its game, two firms make use of similar encryption standard, files that are encoded by one firm’s software. Here two firms complete in selling encrypted software by making use of same encryption standards. Nonetheless, Firm 1 should have large market share as compare to Firm 2. Moreover, both these firms will be looking forward to make an investment in new encryption standard.

Maximizing the expected payoff:

Let us consider that Firm 1 doesn’t know about any changes in the Firm 2’s marketing strategies. It can only do probabilities to make any changes so that the firm can remain in the market in a stable condition. Firm 1 will do this act by using strategies which is the expected payoff.

For example, if Firm 1 thinks about Firm 2 will take part in investing and the chance that it will not invest is about only 10%. In this case, Firm 1 will be looking for investing so that the profit can be generated.

On the other hand, if Firm 1 thinks about 30% chance of investment of Firm 2 in the near future. In this case, the Firm 1 will not going to invest before knowing the strategies of Firm B. So, the loss of expecting any chances will be reduced to a certain amount. To determined, this type of probabilities is quite beneficial to understand the future costs, over market conditions and the market demand in the best way possible.

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The Prisoners’ Dilemma

Here you get to know about relation of prisoners with Nash equilibrium. As per the concept of dilemma discussed in the chapter 12 and also referring to the diagram of Table 13.5, one can see the payoff matrix for Prisoner’s dilemma. The ideal outcome came as neither prisoner confesses, so in that case both will get a two years spending in prison. If one confesses, then strategy considered as dominant strategy. It results into higher pay off irrespective what is the strategy of other prisoner. In this case, Dominant strategies are also considered as Maximin strategy. This situation comes when both prisoners made a confession so it is both as Maximin solution and Nash equilibrium.

Mixed strategies

In these games, examination is done on the basis of considering strategies in which each player make the specific choices or take a specific action. No matter you advertise or not ,price remains to be fixed in this case. These are called as pure strategies. These are the games in which pure strategy will not be considered as the best strategies.

Matching Pennies: In this form of game play makes a choice between head and tails and two player reveal after tossing the coins, in case both coins match, player X wins and it will receive a dollar from Player Y. One need to understand that Nash equilibrium is not at all part of the pure strategies.

For instance, if Player X make choice of strategy playing head, in that case Player Y automatically needs to make choice of Player Y. Then visa-versa also happens, it is that no combination of tails and heads will bring satisfaction in the mind of players. One or other player needs to make changes in the strategy. Even we know there is no connection of Nash equilibrium when it is about pure strategies.

But in Mixed strategies, there is a presence of mixed strategies in which both the players should make random choices from the two possible situations and actions will be taken place on the basis of chosen possibilities. In this game, player A might simplifies flip the coin, playing Player X might flip coin so that the probability of ½ will be shown for playing with heads and tails. In case, Player A follows similar kind of strategy but not the Player B, it will be the case of Nash equilibrium.

Both players are playing the best in order to give answer to other opponent by the way of making choices. As the outcome is random as expected, the pay off also comes to 0 for each of the player. It may become strange to choose the actions randomly. If you put yourself into the shoes of another player, and started thinking about the outcome, if you have followed the same strategy, then will able to understand well the strategy of another player.

Even if Player Y didn’t know your strategy, it is likely that game might be played repeatedly. In case, you both have chosen head and tail randomly with ½ of the probability. No one has the incentive to change the strategies of the other.

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Battle of Sexses

In some games, there is use of Nash equilibrium both in pure and mixed strategies. For instance there is a game “Battle of Sexes” in which both Joan and Jim likes to spend whole Saturday night but having different tastes when it comes to entertainment. Jim prefers to Opera and Joan prefers wrestling. The payoff matrix shows, Jim only prefers to go opera along with Joan. And, Jim likes mud wrestling. Here, two Nash equilibriums will give one pure strategy. So, Joan will prefer watching mud wrestling is the one with which they go. Whatsoever the situation is, it is likely that the outcomes will be equilibrium. In second case, if both of them do not like to go for wrestling. The decision might get varied because of mud wrestling. In this case, there comes the probability of 2/3 for wrestling and 1/3 for opera. By these strategies anyone of them can enjoy to the fullest.

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13.4 Repeated Games

In chapter 12, we have studied about oligopolistic market, firms can find different ways out of dilemma so that coordination and support between the oligopolistic market. One must able to do the recognition of prisoner dilemma. We have described so far it is limited. Some prisoner has only one opportunity either to confess or not, we have most of the firms that set price and output continuously. In real life, these firms play games repeatedly in which one take actions and pay off need to be received also repeatedly. In repeated games, these strategies are quite complex mode. If prisoners’ dilemma repeated, each firm makes a reputation of its own behaviour and also that of study of behaviour of competition.

The question is that how repetition directly affects the outcome of a game? The answer to this can be explained with the help of examples. If you are firm 1 who presents in the prisoner dilemma which can be shown by payoff matrix, if you along your competitor can charge high price, you will both earn a profit, if you are afraid of charging a high price as your competitor has charged a lower price, then as a result you might lose money, just to add injury, the chance of your competitor gets rich is high. But if that game will repeat again and again, both of you should announce prices on first day (every month). You might use strategies to play differently every month by changing the price. This price change might be the reason of understanding the behaviour of your competitors. Interestingly, you can even ask your competitor to come with different price strategy so that the best strategy would win the game repeatedly.

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Tit for Tat strategy

The aim of this strategy is to find that is best among all other strategies. For instance here the Firm A start with the high price, as long as cooperation continuous. As you lower the price, however, firm should follow suit along with lower mine. The best part about this tit for tat strategy is that it helps competitor to behave in a cooperative manner.

What are infinitely repeated games?

In this both you and competitor repeatedly make changes of the price month after month. Cooperative behaviour in these strategies counted as charging of high price so as to get rational response. In one month, suppose competitor set a low price and undercut you. In that month he or she will earn good profit. But competitor knows that following that month, you will definitely set low price. This game will infinitely goes on repeating, the cumulative loss of profits will be then results in outweigh of any short-term gain during first month of the undercutting. Hence, this value is not rational to the undercut.

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Finite Number of Repetitions

You can play any game repeatedly number of time. It is like a single play of game which is repeated is known as the stage game. Observers should see and watch all the previous play. For every history that you have observed, you could have a different response.

Suppose the game can be repeated played for number of times say N month. In this case take Firm 2 is rational and competitor to Firm 1 who is playing tit-for-tat. In this case, it is possible to make large profits so that the game could get over. This is because the rational outcome will be greater when the charge gets low.

Tit-For-Tat in Practice

Many of us did not expect how something would live forever; unravelling argument seems to make TIT FOR TAT Strategy a little more value and leave the person living in prisoner dilemma. In this practice, managers not know how long they stay in competition with the rivals. It serves how to make cooperative behaviour and strategy. If a person does not able to know the end pointed of a repeated game, unravelling argument with clear expectation of the undercutting in last month that no longer will apply. With repeated game infinitely, it would become a rational for the firm so that it would go fortit-for-tat.

Secondly my competitors have any doubts of the extent of rationality and thinks that he needs to be certain as it is playing for tit-for-tat. In a repeated game, prisoner’s dilemma has cooperative outcomes. In different markets, game repeated for long and uncertain time. Managers get in doubt that how much perfection “rationally” they and the competitors are operating. In some industries, when few firms are competing for a long period of time (conditions remain with stable demand and cost), the cooperation prevails and no contractual arrangements made.

Cooperation get breaks down when there are many firms. Furthermore, when cooperation breaks down is a result rapidly shifting of demand and cost conditions. Situation of uncertainty and demand cost makes it difficult for firms to reach to a level of implicit and understand what the cooperation should entail.  Explicit understanding arrives by the way of discussions, meetings and that leads to anti-trust violation.

Suppose for an example, cost differences about demand leads one firm so that it concludes that cooperation of the two means the charging of $50 and in this case, the second firm thinks to charge$40. When the second firm is willing to charge $40, first firm might consider how to grab for market share. It will then respond accordingly, in the way of tit-for-tat, with $35 price that results into development of price war.

13.5 Sequential Games

In most of games, we noticed that both players move together. If we consider the Cournot model of duopoly, both firms set the time of getting output same. In sequential games, there is another strategy for players to move in turn. Stackelberg model discusses in previous lesson i.e., lesson no 12 is actually an instance of sequential game which any given firm or producer sets is result before the submission of other firms. It also talks about the factor that what could happen if the action is not taken beforehand. An advertising decision is taken by one firm or another firm. The response of the competitor is like an entry-deterring venture by an obligatory firm and the verdict whether to arrive in the industry by a possible contestant; or a new govt. controlling strategy and the venture and output reply of the structured companies. This chapter contains different sequential games. There are often easy to do analysing the games. It is a key to think through possible actions and reactions of player. For example, let us get back to product choice difficulties problem first discussed in previous section.

This problem is about two companies facing the market and two new differences of breakfast food that is cereal can be positively presented till each firm present only one difference. Let us alter the payoff matrix a bit and see what happens. The new cereal (sweet) will inescapably be a good or effective vendor as compared to the recent crunchy cereal, which is gaining a benefit of 20 instead of 10. In this situation both of them will be in a profitable situation. Moreover it is introduced by one single firm.

If a Firm 1 gears up its creation quicker and introduces new cereal first and after that Firm 2 introduces. Can anyone guess the result of this game? While formulating the decisions, the first company might consider that the rational response to its rival. It is evident that whatever produce is manufactured by the same, second company or firm will introduce another kind of it and it is for sure. Thus it will familiarize cereal, having known that second firm will answer by familiarizing the crunchy one.

Game Theory and Competitive Strategy 9” = C

The Extensive Form of a Game

The outcome can easily be reduced from pay off matrix. Although the consequence can be assumed as per the outcomes of payoff matrix, consecutive games are calmer to envisage if it is represented in the possible moves that too through decision chain. This illustration is known as the widespread method of a game and it can be shown through different illustrations.

In order to find the exact remedy for the far-reaching form of sequential game one should always work from the behind. Considering the first firm or initial mover, the best sequence is considered to be the one through which it can easily gain 20 and second firm gains 10. It should be done in order to deduce that both the firms should manufacture sweet cereal as the second firm can place the best response or reply in the market as well to its competitor by producing crunchy cereals to deliver in the market.

The advantage of moving first

For the purpose of clarifying the extent of the perks of first initiator, it is very useful to consider or to review the model given by Stackelberg. In this content it is also important to make a difference through the Cournot model and it would be helpful to identify the outputs of both the manufacturers all together.

Threat, commitments and credibility

The model given by Stackelberg as well as product choice problem are two prominent instances of how a producer which initiate the first position can generate a fait accompli which provide it a benefit over its competitor. The section which is explained below is mainly deals with the wide-spread overview about the benefit which a producer can gain only by initiating the first position or by moving at the first position. This section also deals with the fact that what are the factors which determines the reasons about which company moves first. Along with that the readers will also get the answer for questions like what movements can a company take to get an advantage in the marketplace? Recalling the Stackelberg model, moves first gain the advantage of giving commitment to a larger output.

In order to make a promise which will be constraining the future behaviour of the firm it is very crucial to review all the methods. It is because, suppose the initial mover or the first firm can change its mind in the later stage just because to respond to the action taken by second firm. Then can anyone have the idea about the consequences? The second firm will be producing a large output. And it will also respond or reply through eliminating the output which was declared initially. The only left option which the first company can apply is to profit by gaining the perks of being the first one to initiate the position through committing it by itself. As a result it will constrain the nature of the second firm. The indication of compelling your own conduct to obtain a benefit might seem inconsistent.

13.6 Commitment and Credibility

Firm might increase the credibility of threat and to see how, there are following examples. Companies like Race Motors and Far out engines manufacture superior quality of engines to be used in the vehicles. The latter retails most engines produced to Race Car Motors and very few the vendors those are not directly linked with the industry now this make its production decision in response to car production plans. So, eventually we have the consecutive game in the company named Race car is considered to be leading from the front. This is one of the factors which will decide that what kind of the vehicles to be manufactured in future

Suppose no other producer easily satisfies the need of race car. If the company names Race Car consider the danger held by Far Out’s then the company can manufacture giant vehicles. And if it is not the scenario then the company will have difficulty in evaluating engines specifically for its small cars. Another consequence will be there that it would manage to gain $1million in place of $3 million. At the same point is crucial to mention that the threat or the danger related to it is not reliable. It can also be said that as soon as Race Car will declare that it is having some sort of plans to manufacture small cars, Far Out will be having no incentive to continue with this danger in the market as they will be left with no other options.

Far out can create a threat credible perceptibly and irrevocably minimising some of payoffs in matrix by constraining own choices. Far out engines should eliminate the share of benefit from small engines which they were manufacturing. It can also be said that it is possible just by terminating or closing down its ability to manufacture small engines. And this will also affects its payoff matrix.

Bargaining strategy

The discussion of credibility and commitment applies to the bargaining problems. The outcome of bargaining situation depends on the aptitude on any of the side to take action that alter bargaining situation. Let us consider an example, suppose there are 2 different firms and both of them are planning to announce products which are corresponding to each other. As per the payoff matrix it can be said that the first firm which will be having advantage of cost over company 2. So, it is quite obvious that of both the companies start producing A, them the first company will be able to maintain a low cost and then can earn maximum benefit from the market. In such a way it can also be said that, the second firm has advantage of cost over the firm 1 in manufacturing different product. Now the fact is if both the companies come to a point that which company will produce what then it is quite obvious that the rational outcomes will be the one in the upper right segment.

13.7 Entry Deterrence

The presence of barriers to entry is an essential cause of monopoly influence and benefits which arises naturally sometimes. For instances, barrier occurs in the form of licences, patents and economies of scale. Apart from that contact to important inputs can also create barrier. All that leads to deter entry of potential competitors. To enter an incumbent, firm must able to convince potential competitor that their entry might be unprofitable.

Let us consider an instance. Say there is a company named X and it is about the way how to entering the industry. Now the company names X have to make a payment of a worth of $80 million for building a factory. Now, you as a potential competitor would definitely like to convince the company X to stay back from the industry and will resist entering into the market. Now, suppose, firm X remains out of the competition, then you as a potential competitor can carry on to imply a maximum price and can easily cherish your complete domination over the market.

Game Theory and Competitive Strategy 10” = C

13.8 Auctions

Here we will discuss facts related to auction markets where bidding of products is done. The product can be of varied size and shape as per its utilization. Especially some unique items are listed in the auction market such as arts and antiques. Sometimes auction items also include special equipment because it becomes easy and convenient to encourage competition along with increase in the revenue of the product.

For example, auction of fresh tuna at a fish market (in Tokyo) is much better than selling. It is not only time-consuming but the factors like bargaining diminished. Eventually, it increases the seller’s revenue without any headache.

Auction Formats

In real, different auction formats are used and the choice of this format specify the generation of revenue for sellers-

  1. Oral Auction or English Auction

All participants have to bid on a particular product and when no one is willing to bid further, the auction stops at higher bid amount.

  1. Sealed-bid Auction

Every bidder has to bid simultaneously and submit his/ her sealed envelope. Whoever is the person, the bidder who bids the highest amount wins.

  1. Dutch Action

Sometimes no bidder is interested by the offering of seller so he/she has to reduce the amount of product. The first bidder who accepts this deal buys the product by paying the amount.

Valuation and Information

When sellers want to bid any specific item such as painting, they should know the preferences of bidders. Two cases are preferred for the same-

  1. Private-Value Actions
  2. Common-Value Actions

Private-Value Auctions

In this type of preference, bidders have their own reserved prices. It will be the seller who has to decide whether he/she want to accept the condition and produce the item for bidding.

If the English auction is considered, it is possible to choose the price at which bidding will be stopped. If the Dutch auction is considered, one has to stick to a particular price for auction. And, for sealed-bid auction, it is possible to choose the bid amount before sealing the envelope.In this type of auction, English auction format and sealed-bid envelope format generate almost similar revenue.

Common-Value Auctions

Sometimes oral auction is done on jar of pennies. In this case, the value of pennies will be same for everyone there for auction. The amount of pennies is not disclosed to anyone but they can pick the jar and count number of pennies (without opening it). This type of bidding is considered as common-valued auctions.

In this type of auctions, the winner is often in the losing side because no one is able to judge the actual amount of money present in the jar. Suppose you have considered 540 pennies and bid for $5.20. After getting the jar, you see the actual amount is 480 pennies. Thus, it is the winner’s curse. And there is a possibility that winner’s curse can be raised to another higher amount because of overly optimistic.

Winner’s curse can also be seen in the oil companies who bid for an offshore oil reserve whose outcome is uncertain. The calculated statistics estimate the value and Oil Company reserves this place for years.

Maximizing Auction Revenue

For maximizing the auction revenue, one should know the ways how to produce their items. Some essential tips are listed below-

  • For private-value auction, sellers should encourage number of bidders to join the group and increase the valuation of the product.
  • Moreover, set the bidding value to a higher amount which is feasible so that you get the amount for keeping other items for future deals without any loss.
  • For common-value auction, open auction is quite beneficial than sealed auction to generate more revenue for the selling of same item.

In short, when you know the information of the bidders and take this thing into consideration, the risk of not generating enough revenue can be sorted out. You become confident about your deal and the possibility of bidders to come into the winner’s curse increase.

Bidding and Collusion

We have gone through the auctions of different products where we have seen how different types of auction format are helpful to the seller as well as buyer. Suppose collusion or an agreement has been made between seller and buyer beforehand (which is quite impossible) in order to get the item so it violates antitrust law.

In case of open bidding, the possibility of getting the product is more than sealed envelope bidding procedure. But the fact is that if someone detects the colluding, then it will be a case of cheating and punishable offence.

Note:

In the mid-1980s, baseball owners were guilty for collusion and similar case was seen in two famous auction houses- Christie’s and Sotheby’s in 2001. Alfred Taubman was sentenced to jail because of the involvement in the collusion act.

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