C H A P T E R 13 Game Theory and Competitive Strategy CHAPTER OUTLINE 13.1 Gaming and Strategic I n Chapter 12, we began to explore some of the strategic output and pricing decisions that firms must often make We saw how a firm can take into account the likely responses of its competitors when it makes these decisions However, there are many questions about market structure and firm behavior that we have not yet addressed For example, why firms tend to collude in some markets and to compete aggressively in others? How some firms manage to deter entry by potential competitors? And how should firms make pricing decisions when demand or cost conditions are changing or new competitors are entering the market? To answer these questions, we will use game theory to extend our analysis of strategic decision making The application of game theory has been an important development in microeconomics This chapter explains some key aspects of this theory and shows how it can be used to understand how markets evolve and operate, and how managers should think about the strategic decisions they continually face We will see, for example, what happens when oligopolistic firms must set and adjust prices strategically over time, so that the prisoners’ dilemma, which we discussed in Chapter 12, is repeated over and over We will show how firms can make strategic moves that give them advantages over competitors or an edge in bargaining situations, and how they can use threats, promises, or more concrete actions to deter entry Finally, we will turn to auctions and see how game theory can be applied to auction design and bidding strategies 13.2 13.3 13.4 13.5 13.6 13.7 *13.8 Decisions 487 Dominant Strategies 490 The Nash Equilibrium Revisited 492 Repeated Games 498 Sequential Games 502 Threats, Commitments, and Credibility 505 Entry Deterrence 510 Auctions 516 LIST OF EXAMPLES 13.1 Acquiring a Company 13.2 13.3 13.1 Gaming and Strategic Decisions 13.4 First, we should clarify what gaming and strategic decision making are all about A game is any situation in which players (the participants) make strategic decisions—i.e., decisions that take into account each other’s actions and responses Examples of games include firms competing with each other by setting prices, or a group of consumers bidding against each other at an auction for a work of art Strategic decisions result in payoffs to the players: outcomes that generate rewards or benefits For the price-setting firms, the payoffs are profits; 13.5 13.6 13.7 13.8 490 Oligopolistic Cooperation in the Water Meter Industry 501 Competition and Collusion in the Airline Industry 501 Wal-Mart Stores’ Preemptive Investment Strategy 509 DuPont Deters Entry in the Titanium Dioxide Industry 514 Diaper Wars 515 Auctioning Legal Services 522 Internet Auctions 522 487