0:03

Great, so, thanks for staying on. In this video, we'll draw a slightly more

complex game matrix than the one we did in the previous video.

And we'll use the concept of dominated strategies to figure out the best

strategy in a complex competitive situation.

But for that let me give you a concrete example.

So please now follow me on the streets around the university here in Munich.

So here we are just a few yards from the university and we're thinking about

getting something for lunch. So right now there's a couple of places

we can choose from and one of those is called Rosso Pizza.

Obviously they sell pizza which is very popular with students around here.

But the issue is that just a few yards down the road there's another place

called Piccola Osteria. So these two are in close competition,

they're tight competitors and they're thinking about setting

prices. So for now, let me just get a pizza, and

I'll see you back in the office in a second.

Okay, so let's see what we have, a pizza obviously.

Okay, that's some sort of veg, got to keep healthy, very nice.

And we've got a Margherita, also very nice.

Sorry about that, just a second. So, having seen these two firms, having

seen these two restaurants it all looked very harmonious, all looked

straightforward. But, the issue is actually, I mean these

two firms, these two restaurants are of course in competition with each

other. It matters what the prices are, it

matters what the relative prices are. If you are more expensive, you're cheaper

than the other then that's going to make a difference to your profits.

And let's now try to structure and then analyze the situation in a

bit more detail using game theory. So we've got these two players, Piccola

Osteria and Rosso Pizza selling pizza. And they can charge one of three prices.

They can charge a high price of 12 euros they can charge a medium price of

10 or a low price of 5 euros. Let's assume there are 1,000 students

around school interested in pizza. And 300 of those will only ever buy at

Piccola Osteria, right? They swear on Piccola Osteria being

the better pizza place. 300 of those will only ever buy at Rosso

Pizza because they like that type of pizza more.

3:28

Let's now look at payoffs as an example. We just assume that there's no cost of

producing pizza so the 10 Euros or 12 Euros are basically gross profit margins.

So if Piccola Osteria charges a medium price and Rosso Pizza charges a high

price, then the payoffs are for Piccola Osteria,

that they sell to their 300 loyal students plus the 400 students that are

price-sensitive. Because they will go for the lower price,

and they do that at a price of 10 euros per pizza, okay?

So that's going to be 300 plus 400 times 10 euros.

That's going to be 7000 Euros, okay? What about Rosso Pizza?

Rosso Pizza is going to sell only to their 300 loyal students.

But they sell it at a higher profit margin.

So they're going to sell 300 pizzas at 12 euros.

That's going to be, 3,600, okay, 3,600 euros.

And from that we can basically just construct the entire payoff matrix.

Like we did in the previous example on toothpaste.

Let's have a look here. Well we've got Pizza Rosso, we've got

Piccolo Osteria, we've got the three strategies, high, medium, low for both

players. Now, the thing we just discussed, Pizza

Rosso charging a medium price and Piccola Osteria charging a high price gives 7,000

euros for Pizza Rosso and gives 3,600 for Piccola Osteria, and

we can construct the entire pay off matrix, and complete it. Of course, these

are in 1,000 euros. So from that we can try to find out what

outcome is likely to happen. All right, and what I want to do to help

this along is, I want to look at two particular concepts.

One is a dominant strategy. A dominant strategy is a strategy that

always does better than any other strategy regardless of what the other

firms, what the other players do. A rational player will always choose a

dominant strategy. Now this is easy for yourself right?

If something always does better, then that's what you're going to choose.

What's actually more interesting is that if your rival, if the other player in the

market has a dominant strategy, you can rely on that player playing a

dominant strategy, okay? So you can anticipate that

the other player will choose a dominant strategy as a consequence.

6:30

There's a flip side to that. There's a what's called a

dominated strategy. A dominated strategy is a strategy that

never does better than another one. So we compare two different strategies,

and if one always does worse than the other, this strategy is dominated.

So of course a rational player would never opt for that strategy.

And again, it's easy for yourself. If you're trying to maximize your own

profit, why would you choose a dominated strategy?

But what's more interesting, and what takes more thinking, is

that a rational rival will never play a dominated strategy, right?

So even if a dominated strategy by your rival would give

you massive profits you should never count on the other

player choosing a dominated strategy if he's interested in maximizing profits,

okay? So if we want to solve the pizza war, and

basically try to predict what's going to come out, what the prices are going

to be, we can try to to eliminate the dominated

strategies in this case, okay? So if we just have a look we can

eliminate the dominated strategies one by one.

Okay, let's go back and see how we can do that.

So if Piccola Osteria would charge a high price, okay we're here, Pizza Rosso can

choose high price and get 6, a medium price and get 7

and a low price and get 3 and a half. So the best strategy here would be a

medium price. If Piccola Osteria chooses a medium price

then the best response, the best strategy that Pizza Rosso can choose

is to choose a medium price again. If the Piccola Osteria chooses a low

price, the best strategy by Pizza Rosso is actually to choose a high price,

right, 3.6 versus 3 versus 2 and a half. Why do they do it?

They've basically given up the market for the price sensitive consumers and they

only sell to their loyal consumers at a high margin.

Now, if you look at this, what's interesting is that if you compare a low

price, and a medium price. It's always better for Pizza Rosso to

choose a medium price rather than a low price.

And what that means is that there is no circumstance, no strategy by

Piccola Osteria, under which Pizza Rosso would want to choose a low price.

Now what we can do with this strategy is basically just eliminate it.

It's not going to happen, right? There's never going to be a low price set

by Pizza Rosso. We can do it exactly the other way

around, and given this is a symmetric problem, we'll find that also for Piccola

Osteria charging a low price is never going to be

a viable strategy, okay? So, we eliminate these dominated

strategies. We can eliminate them one by one, and we

will continue with that until we can find a solution to the game or you just can't

eliminate more. And let's go back to the game

here. Once we've simplified this game, let's

have a look again. If Piccola Osteria charges a high price

we've already figured out that it's better for Pizza Rosso to charge a medium

price than a high price. Because 6 is less than 7.

If Piccola Osteria charges a medium price, then it's better for Pizza Rosso

to charge a medium price than high. Which means that here charging a high

price is dominated again. And by the same token, we can do the same

thing for this simplified game and eliminate the high price for Piccola

Osteria as well. And this is going to let us solve this

game, make a prediction of what the outcome of this game is.

Namely, both Pizza Rosso and Piccola Osteria charging a medium price

and both making profits of 5000 euros. In this video we analyzed very briefly

the strategic problem of choosing the right price

and we structured this problem with the help of a matrix that was slightly more

complicated than the first one we saw. We used the process of iterated

elimination of dominated strategies, so we kept on cutting up the game to make it

simpler and simpler. To eventually find the optimal strategies

for Piccola Osteria and Pizza Rosso respectively.

So in the next video we'll go on and demonstrate to you a more formal and a

more precise way of thinking about optimal strategies.

So please stay on to, to go on to the next video.

But first, let's have a look at the exercise and figure out all the dominated

strategies in these exercises. Again, any case you'll find help in our

forum. Thanks very much and see you in the next video.