Problem 1 Two projects have the following NPVs and standard deviations: Project A Project B NPV 200 300 Standard deviation 75 100 Which of the two projects is more risky? Problem 2 Your firm has an opportunity to make an investment of $50,000. Its cost of capital is 12 percent. It expects after-tax cash flows (including the tax shield from depreciation) for the next five years to be as follows: Year 1 $10,000 Year 2 $20,000 Year 3 $30,000 Year 4 $20,000 Year 5 $ 5,000 a. Calculate the NPV. b. Calculate the IRR (to the nearest percent) c. Would you accept this project? Chapter Eleven Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. * Chapter 11 Game Theory and Asymmetric Information Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. Chapter Eleven Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. * OverviewGame theoryGame theory and auctionsStrategy and game theory Asymmetric informationReputationStandardizationMarket signaling Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. Chapter Eleven Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. * Game theoryEconomic optimization has two shortcomings when applied to actual business situations assumes factors such as reaction of competitors or tastes and preferences of consumers remain constant managers sometimes make decisions when other parties have more information about market conditions Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. Chapter Eleven Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. * Game theory Game theory: is concerned with “how individuals make decisions when they are aware that their actions affect each other and when each individual takes this into account” Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. Chapter Eleven Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. * Game theoryFundamental aspects of game theoryplayers are interdependentuncertainty: other players’ actions are not entirely predictable Types of gameszero-sum or non-zero-sumcooperative or non-cooperativetwo-person or n-person Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. Chapter Eleven Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. * Games in economicsPrisoners’ Dilemmatwo-person, non-zero-sum, non-cooperativealways has a dominant strategyequilibrium is stable  confessing is dominant strategy for each player, no matter what other player chooses  each player has no incentive to unilaterally change his strategy Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. Chapter Eleven Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. * Games in economics Oligopoly pricing using prisoners’ dilemma (Low/Low) is a stable equilibrium … no incentive for either firm to deviate better off at (High/High) but it is not stable .

1. Problem 1
Two projects have the following NPVs and standard deviations:
Project A
Project B
NPV
200
300
Standard deviation
75
100
Which of the two projects is more risky?
Problem 2
Your firm has an opportunity to make an investment of $50,000.
Its cost of capital is 12 percent. It expects after-tax cash flows
(including the tax shield from depreciation) for the next five
years to be as follows:
Year 1
$10,000
Year 2
$20,000
Year 3

2. $30,000
Year 4
$20,000
Year 5
$ 5,000
a. Calculate the NPV.
b. Calculate the IRR (to the nearest percent)
c. Would you accept this project?
Chapter Eleven
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Hall.
*
Chapter 11
Game Theory
and
Asymmetric Information
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Hall.

3. Chapter Eleven
Copyright 2009 Pearson Education, Inc. Publishing as Prentice
Hall.
*
OverviewGame theoryGame theory and auctionsStrategy and
game theory
Asymmetric informationReputationStandardizationMarket
signaling
Copyright 2009 Pearson Education, Inc. Publishing as Prentice
Hall.
Chapter Eleven
Copyright 2009 Pearson Education, Inc. Publishing as Prentice
Hall.
*
Game theoryEconomic optimization has two shortcomings when
applied to actual business situations
assumes factors such as reaction of competitors or tastes and
preferences of consumers remain constant
managers sometimes make decisions when other parties have
more information about market conditions
Copyright 2009 Pearson Education, Inc. Publishing as Prentice
Hall.
Chapter Eleven
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Hall.
*
Game theory
Game theory: is concerned with “how individuals make

4. decisions when they are aware that their actions affect each
other and when each individual takes this into account”
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Hall.
Chapter Eleven
Copyright 2009 Pearson Education, Inc. Publishing as Prentice
Hall.
*
Game theoryFundamental aspects of game theoryplayers are
interdependentuncertainty: other players’ actions are not
entirely predictable
Types of gameszero-sum or non-zero-sumcooperative or non-
cooperativetwo-person or n-person
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Hall.
Chapter Eleven
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Hall.
*
Games in economicsPrisoners’ Dilemmatwo-person, non-zero-
sum, non-cooperativealways has a dominant strategyequilibrium
is stable
r
what other player chooses
strategy
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5. Hall.
Chapter Eleven
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Hall.
*
Games in economics
Oligopoly pricing using
prisoners’ dilemma
(Low/Low) is a stable equilibrium … no incentive for either
firm to deviate
better off at (High/High) but it is not stable … each firm has an
incentive to deviate
(High/High) would be an equilibrium … if the firms were
allowed to cooperate
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Hall.
Chapter Eleven
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*
Games in economicsExample: Beach Kiosk Game: a two-person,
zero-sum, non-cooperative game
Suppose two companies provide snacks and sunscreen on a
beach
beachgoers will spread themselves out evenly along the beach

6. both companies ultimately locate at the midpoint of the beach,
otherwise the other company has an advantage (closer to more
beachgoers
Real life example: location of gas stations
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Chapter Eleven
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*
Games in economicsRepeated Game: game is played repeatedly
over a period of time
in a perpetual repeated game, equilibria that are not stable may
become stable due to the threat of retaliation
however, if number of periods is fixed, players will have
incentive to ‘cheat’ in the last period due to lack of threat of
retaliation, which will then allow them to cheat in all periods
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Chapter Eleven
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Games in economics
Example: assume (High, High) equilibrium reached and both
firms start off charging the high price

7. in the next period, if one firm cheats (charges low price), it
receives 600 in that period
other firm will change to low prices in the next period to
‘retaliate’ and both will end up at (Low, Low) equilibrium
thus, incentive exists not to cheat in a perpetual repeated game
and (High, High) is a viable equilibrium (unlike in the short
game)
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Chapter Eleven
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Games in economicsSimultaneous games are games in which
players make their strategy choices at the same time
Sequential games are games in which players make their
decisions sequentially
In sequential games, the first mover may have an advantage
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Chapter Eleven
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Games in economicsConsider the following payoff matrix in
which firms choose their capacity, either high or low. Suppose
firm C has the ability to move first

8. Copyright 2009 Pearson Education, Inc. Publishing as Prentice
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Chapter Eleven
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Game theory and auctionsDutch auction (a non-cooperative,
non-zero-sum game):each buyer describes the quantity
demanded and price to paystarting at highest price, sum
quantity demanded up to the supply availableall product is sold
at the highest price that clears the market
Seller wants to sell at highest price, buyer wants to buy at
lowest price
Solution
: every player’s dominant strategy is to bid as late as possible
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Chapter Eleven
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9. Hall.
*
Strategy and game theoryProblem: in Prisoners’ Dilemma,
players have a dominant strategy that leads to suboptimal
results
Commitment, explicit or implicit, can be used to achieve
preferred outcomes. It must be credible:burn bridges behind
youestablish and use a reputationwrite contracts
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Chapter Eleven
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Strategy and game theory
Incentives also can be used to change the game to achieve
preferred outcomes
Illustration: GM card. GM came up with a strategy where

10. customers could apply 5% of their purchases to a GM vehicle
Illustration: Health insurance. Firms provide a menu of care
levels.
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Chapter Eleven
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Strategy and game theory
PARTS: paradigm for studying a situation, predicting players’
actions, making strategic decisionsPlayers: Who are players and
what are their goals?Added Value: What do the different players
contribute to the pie?Rules: What is the form of competition?
Time structure of the game?Tactics: What options are open to
the players? Commitments? Incentives?Scope: What are the
boundaries of the game?
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11. Chapter Eleven
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Asymmetric informationAsymmetric information: market
situation in which one party in a transaction has more
information than the other party. Leads to many problems in
markets:too much or too little productiondifficult
contractingpossible fraudmarket may disappear
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Chapter Eleven
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Asymmetric informationAdverse selection: prior to transaction,
one party may know more about the value of a good than the
other
Example: ‘lemons’ (bad used cars)… seller knows the
vehicle well, but buyer does not, yet market does not divide in

12. two
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Chapter Eleven
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Asymmetric informationMoral Hazard: transaction changes the
incentives of a party because it cannot be monitored after the
transaction
Example: insurance industry ... poor information takes
place after the sale, not before
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Chapter Eleven
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*

13. Asymmetric InformationMarket responses:
obtaining information from third parties
relying on reputation of the seller
standardization of products
market signaling: demonstrated success in one activity provides
information about success/quality in another
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Chapter Eleven
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Asymmetric Information
Example: education as a signal
attending college demonstrates certain traitsemployers see this a
screening device
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14. Chapter Eleven
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*
Asymmetric Information
Example: warranties
more costly on low quality goods than high quality
goodsconsumers see them as a screening device
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Asymmetric Information
Example: banking systems
banks know less about the borrower’s ability to repay than the
customerarms length banking: USrelationship banking: Japan
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15. Hall.
Chapter Ten
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Chapter 10
Special Pricing Policies
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Chapter Ten
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*
OverviewCartel arrangementsPrice leadershipRevenue
maximizationPrice discriminationNonmarginal
pricingMultiproduct pricingTransfer pricing

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Chapter Ten
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Cartel arrangementsA cartel is an arrangement where firms in
an industry cooperate and act together as if they were a
monopoly
cartel arrangements may be tacit or formal
illegal in the US: Sherman Antitrust Act, 1890
examples: OPEC
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17. Cartel arrangementsConditions that influence the formation of
cartelssmall number of large firms in the industrygeographical
proximity of the firmshomogeneous products that do not allow
differentiationstage of the business cycledifficult entry into
industryuniform cost conditions, usually defined by product
homogeneity
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Chapter Ten
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Cartel arrangementsIn order to maximize profits, the cartel as a
whole should behave as a ‘monopolist’
the cartel as a whole
of the members’ marginal cost curves

18. monopoly way, by determining
quantity demanded where MC=MR and deriving P from the
demand curve at that Q
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Cartel arrangements
MCT is the horizontal sum of MCI and MCII
QT is found at the intersection of MRT and MCT
price that maximizes total industry profits
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19. Chapter Ten
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Cartel arrangements
horizontal line back from the MRT/MCT intersection
this line intersects each individual firm’s MC
determines that firm’s output, QI and QII. Note that the firms
may produce different outputs
Key point: the MC of the last unit produced is equated across
both firms
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Chapter Ten
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20. *
Cartel arrangements
Profits for each firm are shown as rectangles in blue
Firms may earn different levels of profit, though combined
profits are maximized
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Cartel arrangementsProblem: incentive for firms to cheat on
agreement, thus cartels are unstable
Additional costs facing the cartelformation costsmonitoring
costsenforcement costscost of punishment by authorities

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Cartel arrangementsExamples: price fixing by cartels
GE, WestinghouseArcher Daniels Midland CompanySotheby’s,
Christie’sRoche Holding AG, BASF AG
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Chapter Ten
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*

22. Price leadershipBarometric price leadership
one firm in an industry will initiate a price change in response
to economic conditions the other firms may or may not follow
this leaderleader may vary
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Chapter Ten
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Price leadershipDominant price leadership
one firm is the industry leaderdominant firm sets price with the
realization that the smaller firms will follow and charge the
same pricecan force competitors out of business or buy them out
under favorable termscould result in investigation under
Sherman Anti-Trust Act
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23. Chapter Ten
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*
Price leadership
DT = demand curve for entire industry
MCD = marginal cost of the dominant firm
MCR = summation of MC of follower firms
supplied by all firms
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24. *
Price leadership
Demand curve facing the dominant firm is found by
subtracting MCR from DT
demand curve’ DD
A units and the rest of the demand
(QT – A) is supplied by the follower firms
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Chapter Ten
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Revenue maximizationBaumol model: firms maximize revenue
(not profit) subject to maintaining a specific level of profits

25. Rationalea firm will become more competitive when it
achieves a large sizemanagement remuneration may be related
to revenue not profits
Implication: unlike the profit maximization case, a change in
fixed costs will alter price and output (by raising the cost curve
and lowering the profit line)
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Chapter Ten
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Price discriminationPrice discrimination: products with
identical costs are sold in different markets at different prices
products
Conditions for price discriminationthe markets in which the
products are sold must by separated (no resale between
markets)the demand curves in the market must have different

26. elasticities
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Chapter Ten
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Price discriminationFirst degree price discrimination
seller can identify where each consumer lies on the demand
curve and charges each consumer the highest price the consumer
is willing to payallows the seller to extract the greatest amount
of profitsrequires a considerable amount of information
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27. *
Price discriminationSecond degree price discrimination
differential prices charged by blocks of servicesrequires
metering of services consumed by buyers
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Chapter Ten
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Price discriminationThird degree price discriminationcustomers
are segregated into different markets and charged different
prices in eachsegmentation can be based on any characteristic
such as age, location, gender, income, etc
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28. Chapter Ten
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Price discrimination
Third degree discrimination:
assume the firm operates in two markets, A and B
the demand in market A is less elastic than the demand in
market B
the entire market faced by the firm is described by the
horizontal sum of the demand and marginal revenue curves …
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Chapter Ten
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29. Price discrimination
the firm finds the total amount to produce by equating the
marginal revenue and marginal cost in the market as a whole:
QT
if the firm were forced to charge a uniform price, it would find
the price by examining the aggregate demand DT at the output
level QT
the firm can increase its profits by charging a different price in
each market …
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Chapter Ten
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Price discrimination

30. in order to find the optimum price to charge in each market,
draw a horizontal line back from the MRT/MCT intersection
where this line intersects each submarket’s MR curve
determines the amount that should be sold in each market: QA
and QB
these quantities are then used to determine the price in each
market using the demand curves DA and DB
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Chapter Ten
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Price discrimination
Examples of price discrimination
doctors

31. telephone calls
theaters
hotel industry
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Price discriminationTying arrangement: a buyer of one product
is obligated to also buy a related product from the same supplier
illegal in some casesone explanation: a device to ‘meter’
demand for tied productother explanations of tyingquality
controlefficiencies in distributionevasion of price controls
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32. Chapter Ten
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Nonmarginal pricingCost-plus pricing: price is set by first
calculating the variable cost, adding an allocation for fixed
costs, and then adding a profit percentage or markup
Problems with cost-plus pricingcalculation of average
variable costallocation of fixed costsize of the markup
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Nonmarginal pricingIncremental pricing (and costing) analysis:

33. deals with changes in total revenue and total cost resulting from
a decision to change prices or product
Features:
incremental, similar to marginal analysis
only revenues and costs that will change due to the decision are
considered
examples of product change: new product, discontinue old
product, improve a product, capital equipment
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Multiproduct pricingWhen the firm produces two or more
products
increase in the quantity sold of one will bring about an increase
in the quantity sold of the other

34. increase in the quantity sold of one will bring about a decrease
in the quantity sold of the other
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Multiproduct pricingWhen the firm produces two or more
products
products produced from one set of inputs
Case 4: pr
produce one product takes those resources away from producing
other products
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35. Hall.
Chapter Ten
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Transfer pricingInternal pricing: as the product moves through
these divisions on the way to the consumer it is ‘sold’ or
transferred from one division to another at a ‘transfer price’
Rationale:
firm subdivided into divisions, each may be charged with a
profit objective
without any coordination, the final price of the product to
consumers may not maximize profits for the firm as a whole
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Transfer pricingDesign of the optimal transfer pricing
mechanism is complicated by the fact that
each division may be able to sell its product in external markets
as well as internallyeach division may be able to procure inputs
from external markets as well as internally
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Chapter Ten
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Transfer pricingCase A: no external marketsno division can buy
from or sell to an external marketthe selling division will
produce exactly the number of components that will be used by
the purchasing divisionone demand curve and two MC

37. curvesMC curves are summed verticallyset production where
MR = Total MC
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Transfer pricingCase B: external marketsdivisions have the
opportunity to buy or sell in outside competitive marketsif
selling division prices above the external market price, the
buying division will buy from outsideif selling division cannot
produce enough to satisfy buying division demand, the buying
division will buy additional units from the external market
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Chapter Ten

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Other pricing practicesPrice skimmingthe first firm to introduce
a product may have a temporary monopoly and may be able to
charge high prices and obtain high profits until competition
enters
Penetration pricingselling at a low price in order to obtain
market share
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Other pricing practicesPrestige pricingdemand for a product
may be higher at a higher price because of the prestige that
ownership bestows on the owner

39. Psychological pricingdemand for a product may be quite
inelastic over a certain range but will become rather elastic at
one specific higher or lower price
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