APPLIED GAMETHEORY AND

STRATEGICBEHAVIOR

ILHAN KUBILAY GECKILPATRICK L ANDERSON

CRC PressTaylor & Francis Group

Boca Raton London New York

CRC Press is an imprint of theTaylor & Francis Group an Informa business

A CHAPMAN & HALL BOOK

Figure List

Table List

Preface

Purpose of this BookOur ApproachOrganization of BookOur Appreciation

Chapter 1 A Brief History of Game Theory

Why Study Games? 1Rapid Discoveries in the Twentieth Century 2

Key Conceptual Developments in Early Years 2Pioneers of Game Theory and Advancement of the Field 3Game Theory's Evolution during the Last Three Decades 6

Recognition 7

Chapter 2 Strategy and Game Theory Concepts

Game Theory, Strategy, and Strategic Behavior 10More on Strategic Behavior and Strategy 10Game Theory and Strategic Behavior in Business 11

Consumer Behavior, Utility Theory, and Game Theory 12Cardinal Utility 13Choice Behavior and Game Theory 13Utility Functions and Game-Theoretic Models 13Utility Theory and Payoffs 14

Game-Theoretic Models and Illustration 14The Payoff Matrix and Tree Diagram 14

Strategic Thinking and Simultaneous- andSequential-Move Games 16

Rules of the Game 16Players 17Information 17

Perfect vs. Imperfect Information 18Complete vs. Incomplete Information 18Symmetric vs. Asymmetric Information 18

Set of Actions and Strategies ....18Payoffs '. 19

Strategy and Equilibrium 19Dominant and Dominated Strategies 19

Dominated Strategies 20Equilibrium 20Nash Equilibrium 22

Note on Dominant Strategy Equilibrium andNash Equilibrium 23

Subgame Perfect Nash Equilibrium 23Mixed Strategies; Repeated Games 23Maximin Strategy .....24

Sequential Games and Problem Solving 25Complex Games and Games by Categories 27

n-Person Games 27Different Categories of Games 29

Zero-Sum Games vs. Non-Zero-Sum Games 29Static vs. Dynamic Games; Repeated Games 30Cooperative vs. Non-Cooperative Games 30

Other Key Game Theory Concepts 31Threats and Rewards (Promises) 31

Credibility 31Sample Game with Threats 31The Threat as a Strategy 32

Games of Chance: Uncertainty and Risk 32

Chapter 3 Modeling Games with Computer Software andExperimenting Games

Prisoner's Dilemma 36Analysis 36Notes 37Modeling the Game with MATLAB 38Tit for Tat and the Repeated Game 40Famous Experiment 40Another Prisoner's Dilemma Experiment 41Even More Experiments 42

Battle of the Sexes -. 43Analysis 43

Mixed Strategy 44Modeling the Original Battle of the Sexes Game with MATLAB 45A Battle of the Sexes Experiment 47

Assumptions of the Researchers 48Additional Experiments 50

A Sample Game of Dominated Strategies with MATLAB 50

Chapter 4 A Theory of Strategic Value

Introduction: The Game of Business 57Strategic Value for a Business 58Important Concepts : 58

Advanced Topics 59Strategy and Value 60

Accounting Net Worth 60Current Income 60

Portfolio Investment 61Real Options 61

States of Nature and Strategy 61The State of Nature 62

A Short Revolutionary Example 62A Revolutionary Game: The State of Affairs in 1775 63State Variables in 1775 Colonial America 63

State Variables for Business; Control Variables 65How Many Ships in Your Navy? 65

The Event Tree and Dynamic Payoffs 67The Event Tree 67The Extensive Form and the Event Tree 68State and Control Variables in the Event Tree 68

Encoding History in the State 68Additional Examples 69

Payoffs and Business Value 69Static "Payoffs" vs. Strategic Value 69Value Changes 69Dynamic Payoffs : 70

The Firm 70Equity in a Firm 71

Note on Limited-Liability Companies 72Markets 72

Real Options and Management Flexibility 72The Ubiquity of Uncertainty 72The Inherent Value of Management Flexibility 73

The Investment Decision 74What is "Value" for a Firm? 75

Earnings and Capital Gains 75Strategy and the Pursuit of "Total Return" 75

Available Principles of Valuation 76Practical Models 78Example: Strategic Valuation for the Damaged Business 80

Appendix 4.A Stochastic Processes, Diffusions, and Expectations...82A. Introduction 82

Use of Stochastic Processes in Study of Strategic Behavior 82B. Brownian Motion and Random Events 82

The Markov Property 83C. Geometric Brownian Motion and Stock Prices 83D. Expected Value 84

Expected Value of a Strategy 84Appendix 4.B Dynamic Programming 85

A. Optimization over Time 85B. A Prototype "Bellman Equation" for a Private Firm 85C. Recursive Decisions 85D. Existence Theory 86

Chapter 5 A Dynamic Game of Asymmetric Information in theBeer Industry

A Game between a Global Brewer and a National Importer 87Background 87Motivation and Incentives of Companies: Maximizing Business

Value 88Examples 89

Business Value Depends on a Strategic Course of Action 89Implications of Value, Risk, and Strategic Decisionsto the Game 89

Regulated Alcoholic Beverages Industry and Three-TierSystem in the U.S 90

Sales Performance of Gambrinus; General Import Market 91Incentives at the Time of the 1996 Decision 91

Incentives for Grupo Modelo 92Objectives of Gambrinus 92Matching and Conflicting Objectives ' 93

Matching Objectives 93Conflicting Objectives 93

Concluding Remarks on Incentives 94Strategic Options Available in 1996 and the Game 94

Introduction of Strategic Options 94Strategic Options at Two Stages '. 95Potential Outcomes 95

Game-Theoretic Model 96Description 96

Information 96Analysis of the Game ./. 99

Stage I (1996) 99Stage I (1996-2001) 101Stage II ; 102

Outcomes of the Game and Conclusion 103Appendix 5.A 104

Chapter 6 Consolidation in the Wine and Spirits Industry

Introduction 109Economic Structure of the Industry 110

Distribution Arrangements in the Industry 110The Wine and Spirits Industry and Consolidation I l l

Consolidation at Wholesaler Level 112Recent M&As and Business Ventures in Major Marketsat Wholesaler Level 113

A Hypothetical Consolidation 114

Description of the Consolidation Game 116Market Share and Power 116The New Market and Strategic Issues 117Players' Strategies and Information 119Analysis of the Game 120

Simultaneous-Move Game between Wholesalers iii and iv 122Sequential Move Game between Supplier III andWholesalers iii and iv 122

Conclusion 124Appendix 6.A 125

Chapter 7 A Regulatory Game: CAFE Standards and CompetingAutomakers

Introduction 129Lobbying and Game Theory 130

Lobbying as Part of the Game 130History of Corporate Average Fuel Economy (CAFE) 131

Future Standards: Energy Independence and Security Act of2007,2011-2015 Targets 135

Current Debates 137Strategic and Game Theoretical Motivation behind CAFE 138Building the Game and Players, Strategies, Payoffs,

and Solution 140Game Stage 1 140Game Stage 2 141Outcomes of GameStages 1 and 2 142Game Stage 3 143Solving the Problem and Nash Equilibrium 144Conclusion 146

Appendix 7.A 147

Chapter 8 Business Strategy and Crisis: The U.S. Auto Industry

Introduction and Cause of the 2008 Auto Industry Crisis 149Likely Scenarios for the Automotive Industry 150Economic and Industry Conditions 152

Sales Trends by Automaker 153Car Sales 153Truck Sales 154Long-Term Sales Trends 154

Investor Confidence in Domestic Automakers and Suppliers 155Key Events to Date (December 2, 2008) 155Discussion of Potential Scenarios 158

The Most-Likely Scenario 159Scenario 1: A GM-Chrysler Merger with Federal Financial Aid ...159

Other Likely Scenarios 160Scenario 2: Federal Financial Aid and Radical Restructuringoutside of Bankruptcy 160Scenario 3: Federal Financial Aid and Radical Restructuringoutside of Bankruptcy; Chrysler Assets Purchased byCompetitors 160Scenario 4: Chrysler Files for Chapter 11 Bankruptcy;GM and Ford Restructure outside Bankruptcy 160Scenario 5: Both GM and Chrysler File for Chapter 11Bankruptcy 161

Strategic Approach to a Potential Merger: Strategiesof Key Players 161Players and Incentives 162

Incentives of the Players 162Strategies 163Sample Tree Diagrams Illustrating Players' Moves

and Their Strategies 164Strategic Analysis and Conclusion 167

Chapter 9 Game Theory and the Law

Introduction 169Classic Game Theory Applications in Litigation 170

Incentives to Settle 170Example: Litigation or Settlement in a CommercialDamages Case 170

" Optimal Sanctions 172Example: "Punitive" Damages 172

Properly Constructing the Payoff Matrix 173Examples: The Actual Payoff Elements 173

Commercial Damages : 174Overview of Commercial Damages 174

Events in a Typical Commercial Damages Case ..: 175Evaluating Commercial Damages Using Game Theory 175

The Value of Investments under Uncertainty 176Game Theory and Real Options v. :...177

Extensive Form Modeling of an Investment Outcome 177A Simulation Model for Real Options and Game Theory

Valuation 178Results of Experiment Using Simulation Model 179

Game Theory and Antitrust Law 181Market Entry and Collusion 181

Example 181Antitrust Case Study: United States of America,

et al., v. Microsoft Corporation 182History of Investigations Leading up to the Antitrust Suit 183Market Power: Windows and Internet Explorer 184

Major Competitors 184A Game-Theoretic Model of the Microsoft Antitrust Case 185

Key Incentives 186Analysis of Microsoft's Decision Tree 186The Trial and Conclusions of Law 187The Appeal 188The Settlement , 188

Appendix 9.A 190Bibliography ...193Index 199