Lecture 2

CHP 10

Management Accounting 2022

Introduction Equilibrium? Haggling CHP 10.2 CHP 10.3 CHP 10.4 Remarks

Introduction

• CHP 8 - CHP 9: what is a decision-maker

• CHP 10: two decision-makers
• The value of the criterion/objective/pay-off (fx profit) of one
decision maker depends on what action is choose by the other
decision-maker as well
Nash equilibrium (informally):
A strategy profile is a Nash equilibrium if no player can do better
by unilaterally changing his or her strategy.

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Introduction Equilibrium? Haggling CHP 10.2 CHP 10.3 CHP 10.4 Remarks

Some Examples
• Consumers & firms
• Competing firms
• Cournot
• Bertrand
• First mover (dis)advantage
• Coordination
• Divisions
• Supply chain
• R&D
• Entry barrier
• Necessity
• Labor contracts
• Unions
• Individual performance contracts
• (Public) acquisitions & subcontracting
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Introduction Equilibrium? Haggling CHP 10.2 CHP 10.3 CHP 10.4 Remarks

Equilibrium Behavior

• Payoff for DM-1 depends on (i) what DM-1’s choice/action is;

(ii) what DM-2’s action/choice is; and (iii) what the state of
the world turns out to be
• Payoff for DM-2 depends on (i) what DM-2’s choice/action is;
(ii) what DM-1’s action/choice is; and (iii) what the state of
the world turns out to be
• Payoff: Profit, utility ↔
at the time of action choice: expected profit, expected
utility/CE

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Introduction Equilibrium? Haggling CHP 10.2 CHP 10.3 CHP 10.4 Remarks

Simultaneous Choice Bimatrix Game

• Two players: row and column

• Payoffs: (row ,column)

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Introduction Equilibrium? Haggling CHP 10.2 CHP 10.3 CHP 10.4 Remarks

Simultaneous Choice Bimatrix Game

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Introduction Equilibrium? Haggling CHP 10.2 CHP 10.3 CHP 10.4 Remarks

Simultaneous Choice Bimatrix Game

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Introduction Equilibrium? Haggling CHP 10.2 CHP 10.3 CHP 10.4 Remarks

Sequential Choice Bimatrix Game

• Now row starts and can commit to a choice

• What if column starts and can commit?

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Introduction Equilibrium? Haggling CHP 10.2 CHP 10.3 CHP 10.4 Remarks

• Game 1 has a unique equilibrium

• The equilibrium depends on the rules of the game:
simultaneous vs. sequential & who starts
• Game 2 has no equilibrium
• Game 3 has 2 equilibria
• Simultaneous: ?
• Sequential: depends on who starts
• Rules of the game matter

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Introduction Equilibrium? Haggling CHP 10.2 CHP 10.3 CHP 10.4 Remarks

Haggling with Private Information

• One seller & one buyer; risk neutral
• Value to buyer: V ; Seller’s cost ∆
• V = 3 and this is common knowledge
• ∆ = α ∗ x where α = 2 and x ∼ U[0, 1]
• The buyer should own the object as V > ∆max
• The buyer offers P to the supplier
maxP E [Π] = (V − P) ∗ prob(trade)
= (3 − P) ∗ prob(∆ ≤ P) =
(3 − P) ∗ P2
FOC: 1.5 − P = 0 ⇒ P = 1.5
• Rationing: a decision-maker is willing to sacrifice the
likelihood of trade in order to get more out of the trade when
it takes place.
Bidding

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Introduction Equilibrium? Haggling CHP 10.2 CHP 10.3 CHP 10.4 Remarks

Haggling with Private Information

• The trade SHOULD take place whenever V ≥ ∆max

• Should is not the same as “The trade will take place”
Will depend on the parties’ individual actions!
• With uniformly distributed cost in our set-up
• When V = 5 the buyer’s best strategy is to offer ∆max = 21
• When V = 3 the buyer’s best strategy is to offer P < ∆max
• If the supplier made the offer, he would say P = V (as long as
∆ ≤ V)

1
FOC is 2.5 − P = 0, a rational buyer then sets P = 2.
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Introduction Equilibrium? Haggling CHP 10.2 CHP 10.3 CHP 10.4 Remarks

Uniform distribution & Updating

Uniform Distributions: y ∼ U[a, b]

E [y ] = a+b
2
Probability updating: we pick z then
• prob(y ≤ z) = b−az−a

→ E [y |y ≤ z] = a+z
2
• prob(y > z) = b−z
b−a
→ E [y |y > z] = z+b
2
• This (the expected value of y, if...) is updating again, but
instead of “good” vs “bad” news, we now have “over” vs.
“under” some value

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Introduction Equilibrium? Haggling CHP 10.2 CHP 10.3 CHP 10.4 Remarks

Sharing a Market: A Simple Rational Expectations Model

• 2 firms, Cournot competition

• P̂(q1 + q2 ) = 340 − 2(q1 + q2 )
• C (qi ; P) = 100qi , i ∈ {1, 2}
• FOCs respectively for firm ONE and firm TWO are:

240 − 4q1 − 2q2∗ = 0

240 − 4q2 − 2q1∗ = 0

• Equilibrium condition: qi = qi∗

• → q1∗ = q2∗ = 40

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Introduction Equilibrium? Haggling CHP 10.2 CHP 10.3 CHP 10.4 Remarks

Racing to Capture a Market: R&D

• Value of being the first-mover: P̂

• R&D investments: z1 , z2
• Likelihood of first-mover advantage:
1+zi
pi (z1 , z2 ) = 2+z 1 +z2
• Expected profit:
E [Πi (z1 , z2 )] = P̂ ∗ pi − zi
• The respective FOCs are:
1+z2∗ 1+z1∗
P̂ ∗ ∗ 2 = 1 and P̂ ∗ 2 = 1
(2+z1 +z2 ) (2+z2 +z1∗ )
• When P̂ = 1, 000, then z1∗ = z2∗ = 249

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Introduction Equilibrium? Haggling CHP 10.2 CHP 10.3 CHP 10.4 Remarks

Bidding for a Prize: Set-Up

• 2 potential risk neutral suppliers that bid b1 , b2

• 1 risk neutral client ⇒ a lowest bid auction
• If b1 = b2 , flip a coin
• Cost structure: ∆ = αx + βy + γz
where
α, β, γ > 0
and
x, y , z ∼ U[0, 1]

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Introduction Equilibrium? Haggling CHP 10.2 CHP 10.3 CHP 10.4 Remarks

Bidding for a Prize: No Private Information

Prize = get the opportunity to do the construction & thus a profit

• Cost unknown: b1∗ = b2∗ = E [∆] → E [Πi ] = 0.5 ∗ 0
• Equally capable of doing the construction & equally
un-knowledgeable about the future cost of construction
• Cost is known: b1∗ = b2∗ = ∆ → Πi = 0.5 ∗ 0
• No capability advantages are present in this example!
If no private information is present, then the suppliers simply
“compete the profit away”

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Introduction Equilibrium? Haggling CHP 10.2 CHP 10.3 CHP 10.4 Remarks

Competing for a Prize: Private Cost Information

• Firm ONE knows y i.e. is the cable specialist

whereas firm TWO knows z i.e. is the underwater construction
specialist
specialist enough to know the cost, but not enough to affect
the potential cost
• x is common knowledge i.e. both can build a road-deck
• The distributions of y and z are common knowledge
• Winning (the bidding round) carries information!
• If firm i’s bid wins the auction, it update its beliefs about the
cost component that it does not know
• Bayesian updating if supplier 1 wins the auction:
Before winning: z ∼ U[0, 1]
After winning: z ∼ U[g (b1 , b2 ), 1]

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Introduction Equilibrium? Haggling CHP 10.2 CHP 10.3 CHP 10.4 Remarks

Winner’s Curse (Table 10.1)

• Expected cost before the winner is revealed:
1
Supplier 1: E [∆|x, y ] = αx + βy + γ
2
1
Suppler 2: E [∆|x, z] = αx + β + γz
2
• Suppliers’ bidding strategies (i.e. equilibrium bids) are:
β+γ (β + γ) ∗ y
b1∗ (x, y ) = αx + +
2 2
β + γ (β + γ) ∗ z
b2∗ (x, z) = αx + +
2 2
(β+γ)
• Supplier 1 wins only if b1∗ − b2∗ = 2 ∗ (y − z) < 0
As the bids are confidential, supplier 1 does not learn z exactly, but if it
wins and is allotted the construction contract, it knows that z > y and
thus E [z|y < z] = y +1
2 > 2
1

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Introduction Equilibrium? Haggling CHP 10.2 CHP 10.3 CHP 10.4 Remarks

Winner’s Curse (Table 10.1)

• Of course a strategic supplier would anticipate that if it wins
the auction, it has underestimated the unknown cost
component!
(1 + y )
Suppler 1: E [∆|x, y , b1 < b2 ] = αx + βy + γ
2
(1 + z)
Suppler 2: E [∆|x, z, b2 < b1 ] = αx + β + γz
2
• This implies that the mistake in the initial cost estimate was:
y
Suppler 1: E [∆|x, y , b1 < b2 ] − E [∆|x, y ] = γ
2
z
Suppler 2: E [∆|x, z, b2 < b1 ] − E [∆|x, z] = β
2

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Introduction Equilibrium? Haggling CHP 10.2 CHP 10.3 CHP 10.4 Remarks

Winner’s Curse (Table 10.1): Back to the Equilibrium Bids

(β + γ) ∗ (1 + y )
b1∗ (x, y ) =αx + =
2
y (1 − y )
E [∆|x, y ] + γ + β
2 2
and

(β + γ) ∗ (1 + z)
b2∗ (x, z) =αx + =
2
z (1 − z)
E [∆|x, z] + β + γ
2 2

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Introduction Equilibrium? Haggling CHP 10.2 CHP 10.3 CHP 10.4 Remarks

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Introduction Equilibrium? Haggling CHP 10.2 CHP 10.3 CHP 10.4 Remarks

Bidding for a Prize with Private Information

• E [Πi ] > 0
• Adjust cost estimate
• Trade-off between probability of winning & expected profit if
bid is won
• Depends on own private information: Table 10.2
• Depends on importance of both firms’ private information

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Introduction Equilibrium? Haggling CHP 10.2 CHP 10.3 CHP 10.4 Remarks

Internal Control

• Set the rules of the game

• Allocation of decision rights
• The firm: who has access to/decides what?
• The accounting library: what is to be found in the accounting
library
• Redundancy
• Do it again: auditors
• Use of incentives
• Bonus contracts and options plans

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Introduction Equilibrium? Haggling CHP 10.2 CHP 10.3 CHP 10.4 Remarks

Summary

• Nash equilibrium (informally):

A strategy profile is a Nash equilibrium if no player can do
better by unilaterally changing his or her strategy.
• Rules of the game matter
• Simultaneous vs. sequential choices
• Private information
• Importance
• Who makes the “take-it-or-leave-it” offer
• Information updating

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