lecture1

Game Theory

- Andy Grove, Co-founder of Intel

Mike ShorLecture 1

“Only the paranoid survive.”

Mike ShorGame Theory & Business Strategy

2

What is Game Theory?

“No man is an island”

Study of rational behaviorin interactive or interdependent situations

Bad news:Knowing game theory does not guarantee winning

Good news:Framework for thinking about strategic interaction


3

Games We Play

Group projects free-riding, reputation Flat tire coordination Mean professors commitment GPA trap prisoner’s dilemma Tennis / Baseball mixed strategies Poker credibility Traffic congestion Dating information manipulation


4

Games Businesses Play

Market entry commitment Drug testing mixed strategies Supply chains auctions Corporate takeovers winner’s curse Fishing congestion Patent races game of chicken Stock options compensation schemes OPEC output collusion & enforcement


5

Why Study Game Theory?

Because the press tells us to …

“Managers have much to learn from game theory —provided they use it to clarify their thinking, not as a substitute for business experience.”

The Economist, 15 June 1996

“Game Theory, long an intellectual pastime, came into its own as a business tool.”

Forbes, 3 July 1995

“Game theory is hot.” The Wall Street Journal, 13 February 1995


6

Why Study Game Theory?

Because recruiters tell us to … “Game theory forces you to see a business situation

over many periods from two perspectives: yours and your competitor’s.” Judy Lewent – CFO, Merck

“Game theory can explain why oligopolies tend to be unprofitable, the cycle of over capacity and overbuilding, and the tendency to execute real options earlier than optimal.” Tom Copeland – Director of Corporate Finance, McKinsey

Game Theory

Administratrivia


8

Course Information

Course web siteCheck after each lecture

Course discussionQuestions, comments

InstructorOffice hours - noneAppointmentDrop by


9

Course OutlineConcepts

Recognizing the gameRules of the gameSimultaneous games

Anticipating rival’s movesSequential games

Looking forward – reasoning backMixed strategies

Sensibility of being unpredictableRepeated games

Cooperation and agreeing to agree


10

Disclaimer #1


11

Disclaimer #1

A theory provides a way to organize our thinking. Theory is the science of business, not the art.


12

Course OutlineApplications

Winning the gameCommitment

Credibility, threats, and promisesInformation

Strategic use of informationBargaining

Gaining the upper hand in negotiationAuctions

Design and Participation


13

Disclaimer #2


14

Disclaimer #2


15

Case Write Ups (Four) Self selected groups of four or five students

a word of caution Apply game theory to real scenarios

real: messy, unclear, undirected Make a proposal and explain it in English

no jargon! and there are wrong answers! Length: about 750 words (one page), plus figures Grading:

Depth and logic of analysis Value of advice Professionalism, clarity of writing


16

Experiments

Participate by 9 pm the evening prior to each lecture

Timed – no research required Scores are known Opponents are not Not graded (but required)


17

Honor Code

Applies to: Experiments Cases Exam Academic Integrity

Questions?

ASK!


18

Grading

Cases (15% each) 60%

Class Participation 15%

Final Exam 25%

Games (participation) –10% to 0%


19

Keys to Success

After each lecture: Visit course web site Do assigned readings Do sample problems

Ask questions

Don’t fall behind


20

Policies

They have a lovely “No cell phone”

policy here…

They have a lovely “No cell phone”

policy here…


21

Interactive Decision TheoryDecision Theory

You are self-interested and selfish

Game Theory So is everyone else

“ If it’s true that we are here to help others,

then what exactly are the others here for? ”

- George Carlin


22

The Golden Rule

COMMANDMENT

Never assume that your opponents’ behavior is fixed.

Predict their reaction to your behavior.


23

Decision Theory vs. Game Theory

Ten of you go to a restaurant

If each of you pays for your own meal… This is a decision problem

If you all agree to split the bill... Now, this is a game


24

Restaurant Decision-Making

Check splitting policy changes incentives.

May I recommend that with the Bleu Cheese for ten dollars more?

Sure!

It is only a dollar more for

me!


25

Understanding Incentives Do bicycle helmets cause less injuries? Should airplanes require children to

be in their own seats?

Why shut down a plant operating at capacity? Why cannibalize your own sales? Why offer price guarantees to consumers?


26

Decision Theory

Free money! Pick an option:

Option 1: $50 Option 2: $40 Option 3: $20


27

Now What Do You Do?

Free money! Pick an option:

Option 1: $50 or $60 Option 2: $40 or $80 Option 3: $20 or $90


28

Is Game Theory Moral?

A student cheats on his exam. A corporation fudges its accounts to boost its stock price. A professor lies about his past. A politician sends out a newsletter with one opinion to one group of constituents, another newsletter with an opposing opinion to another group. A store chain uses underhanded methods to gain locations. Are these all independent actions, or part of a larger attitude that's eating away at ethics in this country?

To me, they seem part of the ''realist'' approach to politics, especially as exemplified by ''game theory.''

Game theory starts out by saying forget about morality, feelings and emotions; we are going to assume that a rational person is going to always act in his own best interests.

In other words, self-interest is king, a theory as old as man. Thucydides noted it in 400 B.C. Machiavelli described it in the 16th Century, and perhaps every generation has come up with theories, explanations and justifications for acting selfishly.

Game theory goes on to say that you should expect people to lie, and so you also might want to lie. Isn't this a wonderful concept to be teaching our college students?

Here's a quote from one of the textbooks used in game theory courses, ''Thinking Strategically,'' by Avinash Dixit and Barry Nalebuff: ''Individuals' incentive to cheat on any agreement should be recognized and made a part of their strategy choice.'' In a roundabout way, this teaches that cheating is not only acceptable, but to your advantage.

Further, game theory suggests that in order to get a competitive edge, you might want to pretend to be insane, so that your opponent won't be able to judge which way you're going to jump.

Well, we've seen that in politics, haven't we? Perhaps Dr. Strangelove was only pretending. However, this seems in reality a pretty insane course to take, and might easily have unintended consequences.

(see “Mindless Commentary”, p. 3)

Teddy Milne

October 22, 2002

‘Game Theory’ Excuse for Anything


29

Toys “R” Us Competitive Landscape

Toy & department stores Do not compete with TRU on price (50% markups)

General discounters (Wal-Mart, Target)

Cannot compete with TRU on selection (9% markups) Toys exhibit high product differentiation

Specialized discounters (only TRU) Enjoyed 20% market share nationally

Warehouse clubs (Costco, Pace) Introduced in the 1980s By 1989, about 200 items in competition

Cause of concern for Toys “R” Us!


30

Toys “R” Us (continued) Market research into the future of warehouse clubs

Manufacturers estimated 3-5% annual growth rate Toys “R” Us conducted comprehensive but proprietary study Manufacturers were aware of the study, but not its results Toys “R” Us expected warehouse clubs to grow quite fast

Idea! Issue statement to manufacturers: You may not sell to warehouse clubs

without losing Toys “R” Us as a customer Effectively, choose between a $5 billion market (TRU)

and a less than $500M market (warehouse clubs)


31

Toys “R” Us (continued)

Issues:


32


What would you do?


33

Toys “R” Us (continued) Toys R Us strived to change the game:

Broker a cooperative agreement among the toy manufacturers

Serve as a clearinghouse for complaints

Utilize consumer expectations to alter payoffs Annual industry convention & product launch Safety advisories & recalls Availability of compatible products


34


Manufacturers agreed to TRU deal

Warehouse club toy sales decreasedPre-agreement growth of 51% per yearOverall growth of clubs of over 10% per year

But …


35

Defining the Game

CAVEAT

Predict opponents’ reaction to your behavior.

BUT

Be sure you understand who your opponents are.

(Do you know everyone who may react to your decisions?)


36

SummaryDefining the Game

The strategic environment Who are the players? (Decision makers) What strategies are available? (Feasible actions) What are the payoffs? (Objectives)

Rules of the game What is the time-frame for decisions? What is the nature of the conflict? What is the nature of interaction? What information is available?

Economy & Finance

lecture1