economic instructor manual

Chapter 14

GAME THEORY AND COMPETITIVE STRATEGY

QUESTIONS & ANSWERS

Q14.1 From a game theory perspective, how would you characterize the bargaining 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, one player’s gain is another player’s loss. In the options market, for example, any profit recorded by the buyer of an option is exactly matched by the loss suffered by the seller of that option. Similarly, the only way for the seller of an option to gain is by having the buyer record a loss. In many other game theory situations, individuals and firms find themselves in situations where there is the 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 for mutual loss, it is called a negative-sum game.

Q14.2 Suppose Exxon Mobil Corp. independently reduced the price of gasoline, and that this price cut was quickly matched by competitors. Could these actions be described as reflective of a cooperative game?

Q14.2 ANSWER

No. If Exxon Mobil independently reduced the price of 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, 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 simultaneous-move game.

Q14.3 ANSWER

In a sequential game, each player moves in succession, and each player is aware of all prior moves. The general principle for players in a 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. Even though the decisions may be made at different points

440 Chapter 14

in time, the game 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 how the Prisoner’s Dilemma example shows that rational self-interested 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 offer a strategy appropriate for situations in which no 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 outcome given the worst possible scenario. In the Prisoner’s Dilemma, the worst possible scenario for each suspect is that the other chooses to confess. Each suspect can avoid the worst possible outcome of receiving a harsh five years in prison sentence only by choosing to confess. For each suspect, the secure strategy is to confess, thereby becoming a prisoner, because neither could solve the riddle posed by the prisoner’s dilemma.

Q14.6 Define the Nash equilibrium concept.

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. The concept of Nash equilibrium is important because it characterizes a situation in which every player has achieved the highest possible payoff given the set of strategies adopted by opposing players.

Q14.7 Instructors sometimes use quizzes to motivate students to adequately prepare for class. However, preparing and grading quizzes can become time-consuming and tedious. Moreover, if students prepare adequately for class, there is no need for quizzes. What does game theory prescribe for instructors facing the problem of

Game Theory and Competitive Strategy 441

needing to motivate class preparation among students?

Q14.7 ANSWER

The on-going battle between instructors and their students concerning class preparation is a classic game theory problem. Instructors sometimes use quizzes to motivate students to adequately prepare for class. However, preparing and grading quizzes can be time-consuming and tedious. Moreover, if student prepare adequately for class, there is no need for quizzes. This is a classic game theory problem with no stable Nash equilibrium. If students prepare, there is no need for quizzes. However, if there is no quiz, there is no need for students to prepare. Game theory has a simple randomized strategy prescription for such situations: pop quizzes.

In a two-party game with no stable Nash equilibrium, a player’s preferred strategy changes once its rival has adopted its strategy. The classic case is where managers monitor worker performance. If a manager chooses to monitor worker performance, the worker will choose to perform as expected. 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. The lack of Nash equilibrium also provides incentives for randomized strategies whereby players flip a coin or otherwise randomly 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 perspective, explain why corporate governance experts advise that such executives be required to hold common stock worth 7-10 years of total compensation.

Q14.8 ANSWER

Boards of directors and stockholders face a classic end-of-game problem when it comes to the employment of top executives. To guard against shirking or malfeasance in the period just prior to retirement, savvy employers solve the end-of-game problem by using rewards or punishments that extend beyond the employment period. In the case of top executives, corporate governance experts insist that CEOs invest 7-10 years pay in company common stock as a means for insuring that managerial motivation coincides with stockholder incentives. In the case of managers and lower-level 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. Policemen and policewomen are modestly paid and often face strong temptation to accept bribes or give favors, especially late in their careers. To fight corruption, many cities require those convicted of corrupt behavior to forfeit all retirement pay and benefits. On Wall Street, investment bankers typically require traders and top managers to take a significant portion of

442 Chapter 14

total compensation in the form of pay tied to long-term stock-price appreciation. In some cases, 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: extend the game!

Q14.9 Describe the difference between limit pricing and predatory pricing strategies.

Q14.9 ANSWER

Limit pricing and predatory pricing strategies have significant similarities, but important differences as well. Both pricing strategies have the potential to be used as means for making competition from smaller competitors unpalatable. However, limit pricing and predatory pricing strategies differ in terms of when they are instituted and in terms of the target. Before entry by a new and credible 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, a predatory pricing strategy is one where the incumbent lowers prices below marginal cost so that the entrant incurs losses and ultimately exits the market. Predatory pricing strategy is generally aimed at established competitors.

Q14.10 Explain why the establishment and exploitation of network effects are key elements in the competitive strategy of computer software provider Microsoft Corp.

Q14.10 ANSWER

There are strong network effects in computer software. Take Microsoft Office, for example. For many potential users of computer software like Microsoft Office, prime considerations include how valuable having learned that office suite will prove to potential employers, and how widely that 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 range of other users. This makes learning Excel attractive, and creates a barrier to entry for providers of competitive spreadsheet software. In computer software, the name of the game is get ahead and stay ahead.

SELF-TEST PROBLEMS AND SOLUTIONSST14.1 Game Theory 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 suppliers. The system quality decision facing each competitor, and potential profit payoffs, are illustrated in the table. The first number


listed in each cell is the profit earned by U.S. Equipment Supply; the second number indicates the profit earned by Business Systems, Inc. For example, if both competitors, U.S. Equipment Supply and Business Systems, Inc., pursue a high-quality strategy, U.S. Equipment Supply will earn $25,000 and Business Systems, Inc., will earn $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 Systems, Inc., will earn $22,000. If U.S. Equipment Supply offers low-quality goods while Business Systems, Inc., offers high-quality goods, U.S. Equipment Supply will suffer a net loss of $25,000, and Business Systems, Inc., will earn $20,000. Finally, if U.S. Equipment Supply offers low-quality goods while Business Systems, Inc., offers low-quality goods, both U.S. Equipment Supply and Business Systems, Inc., will earn $25,000.

Business Systems, Inc.

U.S. Equipment Supply

Quality StrategyHigh Quality

(“Left”)

Low Quality

(“Right”)

High Quality

(“Up”)$25,000, $50,000 $40,000, $22,000

Low Quality

(“Down”)-$25,000, $20,000 $25,000, $25,000

A. Does U.S. Equipment Supply and/or Business Systems, Inc., have a dominant strategy? If so, what is it?

B. Does U.S. Equipment Supply and/or Business Systems, Inc., have a secure strategy? If so, what is it?

C. What is the Nash equilibrium concept, and why is it useful? What is the Nash equilibrium for this problem?

ST14.1 SOLUTION

A. The dominant strategy for U.S. Equipment Supply is to provide high-quality goods. Irrespective of the quality strategy chosen by Business Systems, Inc., U.S. 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 strategy. If Business Systems, Inc., chose a low-quality strategy, the best choice by U.S. Equipment Supply would again

444 Chapter 14

be to produce high-quality goods. U.S. Equipment Supply’s high-quality strategy profit of $40,000 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 Systems, Inc., chose a low-quality strategy. If U.S. Equipment Supply chose a low-quality 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 strategy for U.S. Equipment Supply is to provide high-quality goods. By choosing to provide high-quality goods, U.S. Equipment Supply can be guaranteed a profit payoff of at least $25,000. By pursuing a high-quality strategy, U.S. 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. Business Systems, Inc., can be assured of earning at least $22,000 with a low-quality strategy. Thus, the secure strategy for 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, no player can improve its payoff through a 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.

Although useful, the notion of a secure strategy suffers from a serious shortcoming. In the present example, suppose Business Systems, Inc., reasoned as follows: “U.S. Equipment Supply will surely choose its high-quality dominant strategy. Therefore, I should not choose my secure low-quality strategy and 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 present example, if U.S. Equipment Supply chooses a high-quality strategy, the Nash equilibrium strategy is for Business Systems, Inc., to also choose a high-quality strategy. Similarly, if Business Systems, Inc., chooses a high-quality strategy, the Nash equilibrium strategy is for U.S. Equipment Supply to also choose a high-quality strategy. Thus, a Nash equilibrium is reached when both firms adopt high-quality strategies.

Although some problems have multiple Nash equilibriums, that is not true in this case. A combination of high-quality strategies for both firms is the only set of strategies where no player can improve its payoff through a unilateral change in strategy.


ST14.2 Nash Equilibrium. Assume that Hewlett-Packard (H-P) and Dell Computer have a large inventory of personal computers that they would like to sell before a new generation of faster, cheaper machines is introduced. Assume that the question 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 months. If both aggressively promote their products with a nationwide advertising campaign, each will earn profits of $5 million. If one advertises while the other does not, the firm that advertises will earn $20 million, while the one that does not advertise will earn $2 million. If neither advertises, both will earn $10 million. Assume this is a one-shot game, and both firms seek to maximize profits.

Dell Computer

H-P

Promotion StrategyAdvertise

(“Left”)

Don’t Advertise

(“Right”)

Advertise

(“Up”)$5 million, $5 million

$20 million,$2 million

Don’t advertise

(“Down”)$2 million, $20 million

$10 million,$10 million

A. What is the dominant strategy for each firm? Are these also secure strategies?

B. What is the Nash equilibrium?

C. Would collusion work in this case?

ST14.2 SOLUTION

A. The dominant strategy for both H-P and Dell is to advertise. Neither could earn higher profits with a “don’t advertise” strategy, irrespective of what the other party chooses to do.

For example, if H-P chooses to advertise, Dell will also choose to advertise and earn $5 million rather than $2 million. If H-P chooses not to advertise, Dell will choose to advertise and earn $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 choose to advertise and earn $5 million rather 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

446 Chapter 14

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 to the possibility of earning only $2 million.

B. A set of strategies constitute a Nash equilibrium if, given the strategies of other players, no player can improve its payoff through a 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 is for each firm to advertise. Although some problems have multiple Nash equilibriums, that is not true in this case. An advertising strategy for both firms is the only set of strategies where no player can improve its payoff through a unilateral change in strategy.

C. Collusion will not work in this case because this is a “one shot” game where moves are taken simultaneously, rather than in sequence. Sequential rounds are necessary with enforcement penalties before successful collusion is 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

P14.1 Game Theory Concepts. Recognize each of the following statements as being true or false and explain why.

A. A set of strategies constitutes a Nash equilibrium if no player can improve their position given the strategies chosen by other players.

B. A secure strategy is very conservative and should only be considered if the rival’s optimal strategy is identical.

C. A dominant strategy is also a secure strategy, but every secure strategy is not necessarily a dominant strategy.

D. In a one-shot game, the Nash equilibrium is also the best outcome that can be achieved under collusion.

E. If a player has no dominant strategy, it pays to look at the game from the rival’s perspective and anticipate the rival choosing its dominant strategy.

P14.1 SOLUTION

A. True. A set of strategies constitutes a Nash equilibrium if no player can improve


their position given the strategies chosen by other players.

B. False. A secure strategy is very conservative and should only be considered if the player has good reason to be extremely risk averse. The secure strategy does not take into account the optimal decision of the rival and may thereby result in significant lost profits.

C. False. There is no necessary relationship between dominant and secure strategies. A dominant strategy is one that results in the highest payoff to a player regardless of the strategy chosen by the rival. A secure strategy is one that guarantees the highest payoff given the worst possible decision scenario by the rival.

D. False. In a one-shot game, collusion is not possible. Collusion requires a repeated game. A classic result in game theory is that the Nash equilibrium output is 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 perspective and anticipate the rival choosing its dominant strategy. Such strategic game playing stems from the look ahead, extrapolate back principle of game theory.

P14.2 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. If both stay silent, both prisoners are sentenced to only six months in jail on a minor charge. If each betrays the other, each receives a five-year sentence. Each prisoner must make the choice of whether to betray the other or to remain silent. Neither prisoner knows for sure what choice the other prisoner will make. The dilemma is summarized as follows:

Prisoner B Stays Silent Prisoner B Betrays

Prisoner A Stays Silent Each gets six monthsPrisoner A gets 20 yearsPrisoner B goes free

Prisoner A BetraysPrisoner A goes freePrisoner B gets 20 years

Each gets 5 years

A. Describe the best strategy for each prisoner if neither knows what the other will do.

448 Chapter 14

B. What is the paradox of the situation?

P14.2 SOLUTION

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 each prisoner is worse off than would be the case if both 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 Dominant Strategies. Conceive of two competitors facing important strategic decisions where the payoff to each decision depends upon the reactions of the competitor. Firm A can choose either row in the payoff matrix defined below, whereas firm B can choose either column. For firm A the choice is either “up” or “down;” for firm B the choice is either “left” or “right.” Notice that neither firm can unilaterally choose a given cell in the profit payoff matrix. The ultimate result of this one-shot, simultaneous-move game depends upon the choices made by both competitors. In this payoff matrix, strategic decisions made by firm A or firm B could signify decisions to offer a money-back guarantee, 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 to firm B.

Firm B

Firm A

Competitive Strategy Left Right

Up $5 million, $10 million $7.5 million, $4 million

Down $1 million, $3.5 million $5 million, $5 million

A. Is there a dominant strategy for firm A? If so, what is it?

B. Is there a dominant strategy for firm B? If so, what is it?

P14.3 SOLUTION

A. Yes, the dominant strategy for firm A is “up.” Notice that if firm B chooses “left,”


the highest payoff of $5 million can be achieved if Firm A 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 if A chooses “up.” Therefore, “up” is a dominant strategy for firm A.

B. No, there is no dominant strategy for firm B. If firm A chooses “up,” the highest payoff of $10 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 chooses “right.” Therefore, there is no dominant strategy for firm B. The profit-maximizing choice by firm B depends upon the choice made by firm A.

P14.4 Secure Strategies. The Home Depot, Inc., and the Lowes Companies are locked in a vicious struggle for market share in the home improvement market. Suppose each competitor is considering the advisability of offering 90-day free financing as a means for boosting sales during the important spring season. The Home Depot can choose either row in the payoff matrix defined below, whereas the Lowes Companies can choose either column. Neither firm can unilaterally choose a give cell in the payoff matrix. The ultimate result of this one-shot, simultaneous-move game depends upon the choices made by both competitors. The first number in each cell is the profit payoff to the Home Depot; the second number is the profit payoff to the Lowes Companies.

Lowes Companies

The Home Depot

Competitive Strategy

90-day free financing

(“Left)

No free financing

(“Right”)

90-day free financing

(“Up”)$20 million, $20 million $40 million, $10 million

No free financing

(“Down”)$15 million, $35 million $25 million, $25 million

A. Is there a secure strategy for The Home Depot? If so, what is it?

B. Is there a secure strategy for The Lowes Companies? If so, what is it?

P14.4 SOLUTION

450 Chapter 14

A. Yes, the secure strategy for The Home Depot is to offer 90-day free financing. 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.

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. The breakfast cereal industry is heavily concentrated. Kellogg, General Mills, General Foods (Post) and Ralcorp account for over 85 per cent of industry sales. Advertising by individual firms does not convince more people to eat breakfast. Effective advertising simply steals sales from rivals. Big profit gains could be had if these rivals could simply agree to stop advertising. Assume Kellogg and General Mills are trying to set optimal advertising strategies. 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 payoff; the second number is the payoff to General Mills. This is a one-shot, simultaneous-move game and the first number in each cell is the profit payoff to Kellogg. The second number is the profit payoff to General Mills.

.

General Mills

Kellogg

Competitive Strategy

Advertise

(“Left”)

Don’t Advertise

(“Right”)

Advertise

(“Up”)$800 million, $800 million $1.5 billion, $600 million

Don’t Advertise

(“Down”)$600 million, $1.5 billion $1 billion, $1 billion

A. Briefly describe the Nash equilibrium concept.

B. Is there a Nash equilibrium strategy for each firm? If so, what is it?

P14.5 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 a stable situation in which no player can improve their situation given the strategies adopted by other players.

B. Yes. The Nash equilibrium strategy is for both Kellogg and General Mills to advertise. Given that Kellogg chooses to advertise, General Mills makes the most profit by also choosing to advertise. Similarly, given that General Mills has chosen to advertise, the best Kellogg can do is to advertise as well. Given the dual decision to advertise, neither competitor can improve profits by changing its advertising decision.

P14.6 Collusion. In the United States any contract, combination or conspiracy in restraint of trade is illegal. In practice, this means it is against the law to control or attempt to control the quantity, price or exchange of goods and services. In addition to this legal prohibition, potential conspirators face practical problems in any overt or tacit attempt at collusion. To illustrate the problems encountered, consider the following profit payoff matrix faced by two potential conspirators in a one-shot, simultaneous-move game. The first number in each cell is firm A’s profit payoff; the second number is the profit payoff to firm B.

Firm B

Firm A

Pricing Strategy

Low Price

(“Left”)

High Price

(“Right”)

Low Price

(“Up”)$5 million, $5 million $40 million, -$20 million

High Price

(“Down”)-$20 million, $40 million $25 million, $25 million

A. Is there a dominant strategy and a Nash equilibrium strategy for each firm? If so, what are they?

B. If the firms agreed to collude and charge high prices, both would earn $25 million and joint profits of $50 million would be maximized. However, the joint high-price strategy is not a stable equilibrium. Explain.

P14.6 SOLUTION

A. In this problem, the low-price strategy is a dominant strategy for both firms. If firm

452 Chapter 14

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 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. If firm A charged low prices, firm B 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 B if it pursued a high-price strategy. If firm A charged high prices, firm B 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 B pursued a high-price strategy.

In this case, if both firms pursue a low-price strategy a Nash equilibrium also results. 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 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 of $50 million would be maximized. However, the joint high-price strategy is not a stable equilibrium. To see the instability of having both firms choose high-price strategies, see how each firm has strong incentives to cheat on any covert or overt agreement to collude. If firm B chose a high-price strategy, firm A could see profits jump from $25 million to $40 million by switching from a high-price to a low-price strategy. Similarly, if firm A chose a high-price strategy, firm B could see profits jump from $25 million to $40 million by switching from a high-price to a low-price strategy. Both firms have strong incentives to cheat on any covert or overt agreement for both of them to charge high prices. Such situations are common and help explain the difficulty of maintaining cartel-like agreements.

P14.7 Randomized Strategies. Game theory can be used to analyze conflicts that arise between managers and workers. Managers can choose to monitor worker performance, or not monitor worker performance. For their part, workers can choose to perform the requested task within the time frame requested, or fail to perform as requested. The resulting payoff matrix for this one-shot, simultaneous move game shows the payoff to managers (first number) and workers (second number).

Workers

ManagersWork

StrategyPerform

(Left”)

Fail to Perform

(“Right”)

Monitor (“Up”) -$1,000, $1,000 $1,000, -$1,000


Don’t Monitor (“Down”)

$1,000, -$1,000 -$1,000, $1,000

A. Document the fact that there is no Nash equilibrium strategy for each player.

B. Explain how each player will have a preference for secrecy in the absence of a Nash equilibrium and how randomized strategies might be favored in such circumstances.

P14.7 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 as expected. However, if the manager monitors worker performance and the worker fails to perform, the manager earns $1,000 for successfully detecting such shirking, while the worker loses $1,000 for failing to perform as expected. In the same way, if the manager doesn’t monitor performance while the worker performs as expected, the manager gains $1,000 for saving on unnecessary monitoring costs while the worker loses a $1,000 for performing as expected when such performance was not required. If the manager 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 a unilateral change in strategy. In this case, there is no Nash equilibrium. Notice that in each instance, the counter-party would have an incentive to change strategies given the strategy chosen the other party. If the manager chooses to monitor, workers would prefer to perform as expected. However, if workers choose to perform as expected, managers would prefer not to monitor. Similarly, if managers choose not to monitor, workers would prefer not to perform. 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 and preferences. In the absence of a Nash equilibrium, workers might choose randomized strategies of when to perform and when not to perform so as to thwart managers ability to know 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 Predatory Pricing. Prohibitions against predatory pricing stem from big business conspiracy theories popularized in the late nineteenth century by journalists such as Ida Tarbell, author of an influential book titled History of the Standard Oil

454 Chapter 14

Company. In that book, Tarbell condemned Standard Oil's allegedly predatory price cutting. Business historians assert that Tarbell vilified John D. Rockefeller because of personal reasons, and not only because of an interest in 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 to predatory pricing theory, the predatory firm sets price below marginal cost, the relevant cost of production. Competitors must then lower their price below marginal cost, thereby losing money on each unit sold. If competitors failed to match the predatory firm’s price cuts, they would continue to lose market share until they were driven out of business. If competitors follow the lead of the predatory pricing firm and cut price below marginal cost, they will incur devastating losses, and eventually go bankrupt. Either way, the “deep pockets” of the predatory firm give it the financial muscle and staying power necessary to drive smaller, weaker competitors out of business. After competition has been eliminated from the market, the predatory firm raises prices to compensate for money lost during its price war against smaller competitors, and earns monopoly profits forever thereafter.

A. The ban against predatory pricing is one of the most controversial U. S. antitrust policies. Explain why this ban is risky from a public policy perspective, and why predatory pricing strategy can be criticized as irrational from a game theory perspective.

B. Explain why the prohibition against predatory pricing might be politically popular even if predatory pricing is implausible from an economic perspective.

P14.8 SOLUTION

DDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDD.The antitrust ban on predatory pricing is risky from a public policy perspective because, like any

limit on price competition, a ban on predatory pricing can retard beneficial price competition among firms. The theory of 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 an industry. Critics of antitrust policy point out that there has never been a single clear-cut example of monopoly created by predatory pricing. 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. Economist Harold Demsetz, among others, has charged that legal restrictions on price cutting in the name of combating “predation” are protectionist and anti-consumer.

From a game theory perspective, predatory pricing strategy seems irrational because it is based upon output and pricing assumptions that are not credible. For predatory pricing to constitute a profitable competitive strategy, smaller competitors


and prospective entrants must believe that the incumbent will maintain the same predatory pricing strategy for so long as potential competitors remain viable. At the same time, the firm embarking on a money-losing strategy of price predation must anticipate a significant post-price war period when higher prices and monopoly prices become possible. The “victims” of price predation must not be able to discern the long-term pricing and monopoly profit objectives of the price 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 is not credible.

EEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEE.Predatory pricing theory gets virtually no respect from economists, but is still a popular legal and

political theory for several reasons. Huge sums of money are involved in predatory pricing litigation and that fact guarantees that the antitrust bar will be fond of the theory of predatory pricing. For example, during the 1970s, AT&T estimated that it spent over $100 million per year defending itself against claims of predatory pricing. In addition, the idea of predatory pricing lends itself to political demagoguery. The idea that large, greedy corporations from the United States and abroad might conspire to drive out smaller, innocent competitors is extremely popular in folk myth. Union leaders, trade associations, and protectionist members of Congress frequently invoke the 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 control of industry and the economy. For example, when oil and gas prices go up, citizen groups denounce 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 constant, price-fixing is frequently asserted.

During recent years, charges of predatory pricing have become a convenient weapon for businesses that do not want to match competitor price cutting. Filing an antitrust lawsuit is an easy alternative to competing by cutting prices or improving product quality. Customers appear to like the low prices offered by Wal-Mart; competitors and union groups do not. Given the rapid growth that Wal-Mart has enjoyed for more than a generation, it is obvious that Wal-Mart enjoys a large and enthusiastic following 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 Non-price Competition. General Cereals, Inc. (GCI), produces and markets Sweeties!, a popular ready-to-eat breakfast cereal. In an effort to expand 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 for three box tops, as sent in by retail customers. A 25% boost in demand is anticipated, even though only 15% of all eligible customers are expected

456 Chapter 14

to redeem their coupons. Each redeemed coupon costs GCI $6, so the expected cost of this promotion is 30¢ (= 0.15 × $6 ÷ 3) per unit sold. Other marginal costs for cereal production and distribution are constant at $1 per unit.Current demand and marginal revenue relations for Sweeties! are

Q = 16,000 - 2,000P,

MR = ΔTR/ΔQ = $8 - $0.001Q.

Demand and marginal revenue relations that reflect the expected 25% boost in demand for Sweeties! are the following:

Q = 20,000 - 2,500P,

MR = ΔTR/ΔQ = $8 - $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 the expected 25% boost in demand.

P14.9 SOLUTION

A. The profit-maximizing price/output combination is found by setting MR = MC and solving for Q:

MR = MC

$8 - $0.001Q = $1

0.001Q = 7

Q = 7,000 boxes

and, because:

Q = 16,000 - 2,000P,

P = $8 - $0.0005Q

= $8 -$0.0005(7,000)

= $4.50 per 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

0.0008Q = 6.7

Q = 8,375 boxes

and, because:

Q = 20,000 - 2,500P,

P = $8 - $0.0004Q

= $8 -$0.0004(8,375)

= $4.65 per 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 Variability of Business Profits. Near the checkout stand, grocery stores and convenience stores prominently display low-price impulse items like candy, gum and soda that customers crave. Despite low prices, such products generate enviable profit margins for retailers and for the companies that produce them. For example, Hershey Foods Corp. is the largest U.S. producer of chocolate and nonchocolate confectionary (sugared) products. Major brands include Hershey’s, Reese’s, Kit Kat, Almond Joy, and Milk Duds. While Hershey’s faces increasing competition from other candy companies and snack-food producers of energy bars, the company is extremely profitable. Hershey’s rate of return on stockholder’s equity, or net income divided by book value per share, routinely exceeds 30% per year, or about three times the publicly-traded company average. Profit margins, or net income per dollar of sales revenue, generally exceed 13%, and earnings grow in a predictable fashion by more than 10 percent per year.

A. Explain how the failure to reflect intangible assets, like the value of brand names, might cause Hershey’s accounting profits to overstate Hershey’s economic profits.

458 Chapter 14

B. Explain why high economic profit rates are a necessary but not sufficient condition for the presence of monopoly profits.

P14.10 SOLUTION

FFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFF.Business profit is often measured in dollar terms or as a percentage of sales revenue, called profit

margin. The economist's concept of a normal rate of profit is typically assessed in terms of the realized rate of return on stockholders' equity (ROE). Return on stockholders' equity is defined as accounting net income divided by the book value of the firm. Average ROE for the typical publicly-traded corporation average about 10 percent per year, after the predictable adjustments for extraordinary items. ROE for the most successful publicly-traded companies falls in a broad range around 15 to 25 percent per year. 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 profit rates can overstate differences in economic profits if accounting error or bias causes investments with long-term benefits to be omitted from the balance sheet. For example, current accounting practice often fails to consider advertising or research and development expenditures as intangible investments with long-term benefits. Because advertising and research and development expenditures are immediately expensed rather than capitalized and written off over their useful lives, intangible assets can be grossly understated for 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 Joy, for example. Merck's balance sheet fails to reflect research dollars spent to develop important product names like Vasotec (for the treatment of high blood pressure), Zocor (an antiarthritic drug), and Singulair (asthma medication). As a result, business profit rates for both Hershey’s, Merck, and other advertising and research and development-intensive firms tend to overstate true economic performance.

GGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGG.In economic terms, monopoly profits are the unwarranted payoff received by firms for the raw

exercise of pricing power. Implicit in the concept of monopoly profits is the notion that the monopoly firm does not earn above-normal returns due to superior productivity, 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 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 capability. It is also important to remember that reported profits fluctuate widely. Some of the variation in ROE seen among publicly-traded companies 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. In the candy business, the economic value of brand name advertising is not reflected in accounting value of the firm. In an economic sense, advertisers like Hershey’s have a right to expect to earn a fair return on risky intangible assets derived from advertising and product promotion. Accounting rates of return for advertising-intensive firms should be higher than average to compensate brand name leaders for high-risk promotional strategies. A similar situation exists for firms with significant research and development activity. In the pharmaceuticals industry, for 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 adjustment.

460 Chapter 14

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 of magazines such as Fortune, Time, People, and Sports Illustrated. The 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. Time Warner has the potential to profit whether people go to theaters, buy or rent videos, watch cable or broadcast TV, or listen to records.

Just as impressive as Time Warner’s commanding presence in the entertainment field is its potential for capitalizing on its recognized strengths during coming years. Time Warner is a leader in terms of embracing new entertainment-field technology. The company’s state-of-the-art cable systems allow subscribers to rent movies, purchase a wide array of goods and services, and participate in game shows and consumer surveys--all within the privacy of their own homes. Wide channel flexibility also gives the company the opportunity to expand pay-per-view TV offerings to meet demand from specialized market niches. In areas where cable systems have sufficient capacity, HBO subscribers are now offered a choice of programming on different channels. Time Warner also has specialized networks, like TVKO, to offer special events on a regular pay-per-view basis.

Time Warner is also famous for introducing common stockholders to the practical use of game theory concepts. In 1991, the company introduced a controversial plan to raise new equity capital through use of a complex “contingent” rights offering. After months of assuring Wall Street that it was close to raising new equity from other firms through strategic alliances, Time Warner instead asked its shareholders to ante up more cash. Under the plan, the company granted holders of its 57.8 million shares of common stock the rights to 34.5 million shares of new common, or 0.6 rights per share. Each right enabled a shareholder to pay Time Warner $105 for an unspecified number of new common shares. Because the number of new shares that might be purchased for $105 was unspecified, so too was the price per share. Time Warner’s Wall Street advisers structured the offer so that the new stock would be offered at cheaper prices if fewer shareholders chose to exercise their rights.

In an unusual arrangement, the rights from all participating shareholders were to be placed in a pool to determine their pro rata share of the 34.45 million shares to be distributed. If 100% of Time Warner shareholders chose to exercise their rights, the price per share would be $105, the number of shares owned by each shareholder would increase by 60%, and each shareholder would retain his or her same proportionate ownership in the company. In the event that less than 100% of the shareholders chose to participate, participating shareholders would receive a discount price and increase their proportionate 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, the price per share would be $63. These lower prices 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. Finally, to avoid the possibility of issuing equity at fire-sale


prices, Time Warner reserved the privilege to cancel the equity offering entirely if fewer than 60% of holders chose to exercise their rights.

The terms of the offer were designed to make Time Warner shareholders feel compelled to exercise their rights in hopes of getting cheap stock and avoiding seeing their holdings diluted. Although such contingent rights offerings are a common capital-raising technique in Britain, prior to the Time Warner offering they had never been proposed on such a large scale in the United States. Wall Street traders and investment bankers lauded the Time Warner offer as a brilliant coercive device--a view that might have been colored by the huge fees they stood to make on the offering. Advisory fees for Merrill Lynch and Time Warner’s seven other key advisers were projected at $41.5 million to $145 million, depending on the number of participating shareholders. An additional $20.7 million to $34.5 million was set aside to pay other investment bankers for soliciting shareholders to exercise their rights. Time Warner’s advisers argued that their huge fees totaling 5.22% of the proceeds to the company were justified because the offering entered uncharted ground in terms of Wall Street experience. Disgruntled shareholders noted that a similar contingent rights offering by Bass PLC of Britain involved a fee of only 2.125% of the proceeds to the company, despite the fact that the lead underwriter Schroders PLC agreed to buy and resell any new stock that wasn’t claimed by rights holders. This led to charges that Time Warner’s advisers were charging underwriters’ fees without risking any of their own capital.

Proceeds from the offering were earmarked to help pay down the $11.3 billion debt Time Inc. took on to buy Warner Communications Inc. Time Warner maintained that it was in intensive talks with potential strategic partners and that the rights offering would strengthen its hand in those negotiations by improving the company’s balance sheet. Time Warner said that the rights offering would enhance its ability to enter into strategic alliances or joint ventures with partners overseas. Such alliances would help the company penetrate markets in Japan, Europe, and elsewhere. Critics of the plan argued that the benefits from strategic alliances come in small increments and that Time Warner had failed to strike any such deals previously because it wants both management control and a premium price from potential partners. 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, Time Warner shares closed at $99.50, down $11.25, in New York Stock Exchange composite trading. This is in addition to a decline of $6 suffered the previous day on the basis of a report in The Wall Street Journal that some form of equity offering was being considered. After trading above $120 per share in the days prior to the first reports of a pending offer, Time Warner shares plummeted by more than 25% to $88 per share within a matter of days. This is yet one more disappointment for the company’s long-suffering common stockholders. During the summer of 1989, Time cited a wide range of synergistic benefits to be gained from a merger with Warner Communications and spurned a $200 per share buyout offer from Paramount Communications, Inc. This is despite the fact that the Paramount offer represented a fat 60% premium to the then prevailing market price of $125 for Time stock. During the succeeding two-year period, Time Warner stock failed to rise above this $125 level and traded as low as $66 per share during the fall of 1990. Meanwhile, the hoped-for Time Warner synergy has yet to emerge.

462 Chapter 14

A. Was Paramount’s above-market offer for Time, Inc. 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? Was management’s rejection of Paramount’s above-market offer for Time, Inc. consistent with the value-maximization concept?

B. Assume that a Time Warner shareholder could buy additional shares at a market price of $90 or participate in the company’s rights offering. Construct the 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 the secure game theory strategy for Time Warner shareholders. Was there a dominant strategy?

D. Explain why the price of Time Warner common stock fell following the announcement of the company’s 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 entity, the stock market estimated the discounted net present value of Time, Inc. at $125 per share. It is possible that advantages from combining Paramount and Time might have led to such a dramatic improvement in cash flows that a $200 versus $125 market price per share could be justified. However, subsequent events may call this interpretation into question. Paramount and Warner have many similarities, and Time Warner’s failure to generate such synergies makes the magnitude of such benefits 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. On the other hand, if the 1989 offer of $200 per share was above the fair value of Time, Inc., then perhaps hubris on the part of Paramount management is to blame. In light of Time Warner’s subsequent performance, the fact that 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 decision to participate in the rights offering in light of 100%, 80%, and 60%


participation by all Time Warner shareholders is:

Share Purchase Cost Payoff Matrix

Decision Alternatives

States of Nature

60% Participation 80% Participation 100% Participation

Market Purchase

$90 $90 $90

Rights Offering Participation

$63 $84 $105

Note that investors wish to minimize the cost of additional share purchases. 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. In this case, the worst possible scenario for current shareholders would occur if they chose to participate and all other shareholders also decided to participate in the rights offering. In that case, everybody would pay $105 per share. To avoid that outcome, the secure strategy for current shareholders is not to participate in the rights offering, and to instead buy additional shares in the marketplace for $90. Because the best possible outcome cannot be 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 cash flows. Thus, the contingent nature of the rights offering has the predictable effect of reducing the market price of Time Warner 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 that management views this price as “high,” and indicates some lack of confidence in the company’s future prospects. And 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.Interestingly, in light of the furor caused by its contingent rights offering, 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 the right to purchase up to 34.45 million new shares at a fixed price of $80 per share. The company’s investment bankers also took a haircut on commissions, reducing their take to a total

464 Chapter 14

of 3% of the amount raised and agreed to purchase for their own account any unsold shares. Obviously, the initial contingent rights offering was a bad idea. Both large and small investors heralded the company’s change in the offering as a victory for shareholders.

economic instructor manual

Documents

public policy

multiple nash

discounted

future cash

day free financing

marginal revenue

predatory

maximizing