Cambridge Judge Business School

SESSION 6
BUSINESS STRATEGY AND
GAME THEORY

Dr. Christos Genakos

Course overview
1) Understanding Demand
2) Understanding Costs Analysis
3) Firm Boundaries
4) Competition and Market Power
5) Strategic Pricing
6) Business Strategy and Game Theory
7) Information and Incentives
8) Risk and Uncertainty

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Business Strategy and Game Theory
Strategic Decisions and Game Theory
Solution Concepts and Equilibria
Repeated Games
Oligopoly and Quantity Competition
Oligopoly and Price Competition

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Strategic Decisions and Game Theory
● Strategic managerial decisions: Characterized by interactive payoffs in which
managers must explicitly consider the actions likely to be taken by their rivals in
response to their decisions

● Interactive: When the consequence of a manager’s decision depends on both

the manager’s own action and the actions of others.

● Strategy: Rule or plan of action for playing a game.

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

● No unconditional optimal strategies: There are no unconditional optimal

strategies in game theory; the optimality of a strategy depends on the situation
in which it is implemented.
If I believe that my competitors are rational and act to maximize their own payoffs, how should I
take their behavior into account when making my decisions?

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Strategic Decisions and Game Theory
The Beach Location Game

Beach Location Game

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

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

All game theoretic models are defined by four parameters:

1. The players: A player is an entity that makes decisions;

models describe the number and identities of players.
2. The feasible strategy set: actions with a nonzero probability of
occurring.
3. The payoffs: Every outcome has a defined payoff for every
player. Players are assumed to be rational, that is, to prefer a
higher payoff to a lower one.
4. The order of play: Play may be simultaneous or sequential.

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Strategic Decisions and Game Theory

Visual Representation of a Game:

Matrix form: a matrix that summarizes all possible outcomes

Extensive (or Game tree) form: a game tree that provides a

road map of players decisions and their timing

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A two-person SIMULTANEOUS game

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A two firm SEQUENTIAL pricing game

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A two firm SIMULTANEOUS pricing game

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Business Strategy and Game Theory
Strategic Decisions and Game Theory
Solution Concepts and Equilibria
Repeated Games
Oligopoly and Quantity Competition
Oligopoly and Price Competition

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Solutions Concepts and Equilibria

 Solution Concepts
• The key to the solution of game theory problems is the
anticipation of the behavior of others.
 Equilibria
• Equilibrium: When no player has an incentive to unilaterally
change his or her strategy
• No player is able to improve his or her payoff by unilaterally
changing strategy.

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Dominant strategies
● dominant strategy Strategy that is optimal no matter
what an opponent does.
Suppose Firms A and B sell competing products and are deciding whether to undertake
advertising campaigns. Each firm will be affected by its competitor’s decision.

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Dominant strategies

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Dominant strategies
● equilibrium in dominant strategies Outcome of a
game in which each firm is doing the best it can
regardless of what its competitors are doing.
Unfortunately, not every game has a dominant strategy for each player. To see this, let’s
change our advertising example slightly.

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The Nash equilibrium

 The Nash Equilibrium

Assuming that all players are rational, every player should
choose the best strategy conditional on all other players
doing the same.

Dominant Strategies: I’m doing the best I can no matter

what you do. You’re doing the best
you can no matter what I do.
Nash Equilibrium: I’m doing the best I can given what
you are doing. You’re doing the best
you can given what I am doing.

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The Nash equilibrium – new product introduction

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Sequential games
● Sequential game: Game in which players move in
turn, responding to each other’s actions and
reactions.
As a simple example, let’s think of a product choice problem where the two
firms think about this problem simultaneously.

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Sequential games
• Strategic Foresight: the use of Backwards Induction
• Strategic foresight: Manager’s ability to make decisions today that are rational given what is anticipated
in the future
• Backward induction: Used in game theory to solve games by looking to the future, determining what
strategy players will choose (anticipation), and then choosing an action that is rational, based on those
beliefs
• In sequential games, backward induction involves starting with the last decisions in the sequence and
then working backward to the first decisions, identifying all optimal decisions.

Product Choice Game in Extensive Form

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Business Strategy and Game Theory
Strategic Decisions and Game Theory
Solution Concepts and Equilibria
Repeated Games
Oligopoly and Quantity Competition
Oligopoly and Price Competition

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Repeated games

● repeated game Game in which actions are taken and payoffs

received over and over again.

How does repetition change the likely outcome of the game?

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Repeated games

Pricing as a Prisoner’s Dilemma

• Repeated play can lead to cooperative behavior in a prisoner’s dilemma
game.
• Trust, reputation, promises, threats, and reciprocity are relevant only if there is
repeated play.
• Cooperative behavior is more likely if there is an infinite time horizon than if there
is a finite time horizon.
• If there is a finite time horizon, then the value of cooperation, and hence its
likelihood, diminishes as the time horizon is approached. Backward induction
implies that cooperation will not take place in this case.

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Business Strategy and Game Theory
Strategic Decisions and Game Theory
Solution Concepts and Equilibria
Repeated Games
Oligopoly and Quantity Competition
Oligopoly and Price Competition

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Oligopoly

• The Makings of Oligopolistic Competition

 In oligopolistic markets, the products may or may not be differentiated.
 What matters is that only a few firms account for most or all of total production.
 In some oligopolistic markets, some or all firms earn substantial profits over the
long run because barriers to entry make it difficult or impossible for new firms
to enter.
 Oligopoly is a prevalent form of market structure. Examples of oligopolistic
industries include automobiles, steel, aluminum, petrochemicals, electrical
equipment, and computers.

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Oligopoly
• Equilibrium in an Oligopolistic Market
When a market is in equilibrium, firms are doing the best they can and have
no incentive to unilaterally change their strategy.

Nash Equilibrium
Set of strategies or actions in which each firm does the best it can given
what its competitors are doing, and these competitors will do the best they
can given what that firm is doing.

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Oligopoly
● Cournot model Oligopoly model in which firms produce a homogeneous good, each firm
treats the output of its competitors as fixed, and all firms decide simultaneously how much to
produce.

Firm 1’s Output Decision

Firm 1’s profit-maximizing output depends on how much it
thinks that Firm 2 will produce.
If it thinks Firm 2 will produce nothing, its demand curve,
labeled D1(0), is the market demand curve. The corresponding
marginal revenue curve, labeled MR1(0), intersects Firm 1’s
marginal cost curve MC1 at an output of 50 units.
If Firm 1 thinks that Firm 2 will produce 50 units, its demand
curve, D1(50), is shifted to the left by this amount. Profit
maximization now implies an output of 25 units.
Finally, if Firm 1 thinks that Firm 2 will produce 75 units, Firm
1 will produce only 12.5 units.

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Oligopoly
● reaction curve Relationship between a firm’s profit-maximizing output and the amount
it thinks its competitor will produce.

Reaction Curves
and Cournot Equilibrium
Firm 1’s reaction curve shows how much it
will produce as a function of how much it
thinks Firm 2 will produce.
Firm 2’s reaction curve shows its output as a
function of how much it thinks Firm 1 will
produce.
In Cournot equilibrium, each firm correctly
assumes the amount that its competitor will
produce and thereby maximizes its own
profits. Therefore, neither firm will move from
this equilibrium.

● Cournot equilibrium Equilibrium in the Cournot model in which each firm correctly
assumes how much its competitor will produce and sets its own production level accordingly.

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Oligopoly
• The Linear Demand Curve—An Example
Duopolists face the following market demand curve
P = 30 – Q
Also, MC1 = MC2 = 0
Total revenue for firm 1: R1 = PQ1 = (30 –Q)Q1
then MR1 = ∆R1/∆Q1 = 30 – 2Q1 –Q2
Setting MR1 = 0 (the firm’s marginal cost) and solving for Q1, we find

Firm 1’s reaction curve: Q1 = 15- 1 Q2

2
1
By the same calculation, Firm 2’s reaction curve: Q2 = 15- 2 Q1

Cournot equilibrium: Q1 = Q2 = 10

Total quantity produced: = Q1 + Q2 = 20

Q

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Oligopoly
• The Linear Demand Curve—An Example

If the two firms collude, then the total profit-maximizing quantity can be obtained as follows:
Total revenue for the two firms: R = PQ = (30 –Q)Q = 30Q – Q2, then MR = ∆R/∆Q = 30 –
2Q
Setting MR = 0 (the firms’ marginal cost) we find that total profit is maximized at Q = 15.
Then, Q1 + Q2 = 15 is the collusion curve.
If the firms agree to share profits equally, each will produce half of the total output:
Q1 = Q2 = 7.5

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Oligopoly
• The Linear Demand Curve—An Example
Duopoly Example

The demand curve is P = 30 − Q,

and both firms have zero marginal
cost. In Cournot equilibrium, each
firm produces 10.
The collusion curve shows
combinations of Q1 and Q2 that
maximize total profits.
If the firms collude and share profits
equally, each will produce 7.5.
Also shown is the competitive
equilibrium, in which price equals
marginal cost and profit is zero.

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Oligopoly
• First Mover Advantage—The Stackelberg Model
● Stackelberg model Oligopoly model in which one firm sets its output before other firms do.
Suppose Firm 1 sets its output first and then Firm 2, after observing Firm 1’s output, makes its output decision.
In setting output, Firm 1 must therefore consider how Firm 2 will react.
P = 30 – Q
Also, MC1 = MC2 = 0

Firm 2’s reaction curve: Q2= 15 − 1 Q1

2
Firm 1’s revenue: R1 = PQ1 = 30Q1 − Q12 − Q2Q1

And MR1 = ∆R1/∆Q1 = 15 – Q1

Setting MR1 = 0 gives Q1 = 15, and Q2 = 7.5

We conclude that Firm 1 produces twice as much as Firm 2 and makes twice as much profit. Going first gives
Firm 1 an advantage.

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Business Strategy and Game Theory
Strategic Decisions and Game Theory
Solution Concepts and Equilibria
Repeated Games
Oligopoly and Quantity Competition
Oligopoly and Price Competition

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Price competition
• Price Competition with Homogeneous
• Products—The Bertrand Model
● Bertrand model Oligopoly model in which firms produce a homogeneous good, each firm
treats the price of its competitors as fixed, and all firms decide simultaneously what price to
charge.
P = 30 – Q
MC1 = MC2 = $3
Q1= Q2 = 9, and in Cournot equilibrium, the market price is $12, so that each firm makes a profit of $81.
Nash equilibrium in the Bertrand model results in both firms setting price equal to marginal cost:
P1=P2=$3. Then industry output is 27 units, of which each firm produces 13.5 units, and both firms
earn zero profit.
In the Cournot model, because each firm produces only 9 units, the market price is $12. Now the
market price is $3. In the Cournot model, each firm made a profit; in the Bertrand model, the firms price
at marginal cost and make no profit.

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Price competition
• Price Competition with Differentiated Products
Suppose each of two duopolists has fixed costs of $20 but zero variable costs, and that they face the same
demand curves:
Q1 =12 − 2 P1 + P2
Firm 1’s demand:
Q2 = 12 − 2 P2 + P1
Firm 2’s demand:
Choosing Prices
π1 = PQ
1 1
− 20 = 12P1 − 2P12 + P1P2 − 20
Firm 1’s profit:

∆π1 / ∆P1 = 12 − 4 P1 + P2 =
0
Firm 1’s profit maximizing price:

P1= 3 + 1 P2
4
Firm 1’s reaction curve:

P2 = 3 + 1 P1
4
Firm 2’s reaction curve:

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Price competition
• Price Competition with Differentiated Products
Nash Equilibrium in Prices

Here two firms sell a differentiated product, and each

firm’s demand depends both on its own price and on its
competitor’s price. The two firms choose their prices at
the same time, each taking its competitor’s price as
given.
Firm 1’s reaction curve gives its profit-maximizing price
as a function of the price that Firm 2 sets, and similarly
for Firm 2.
The Nash equilibrium is at the intersection of the two
reaction curves: When each firm charges a price of $4,
it is doing the best it can given its competitor’s price
and has no incentive to change price.
Also shown is the collusive equilibrium: If the firms
cooperatively set price, they will choose $6.

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Next…

Information and Incentives

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Contact details

Dr Christos Genakos

University of Cambridge
Cambridge Judge Business School
Trumpington Street, Cambridge, CB2 1AG

T: +44 (0)12237 65330

E: c.genakos@jbs.cam.ac.uk
U: https://www.jbs.cam.ac.uk/faculty-research/faculty-a-z/christos-genakos/

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