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									                  Game Theory




“Only the Paranoid Survive”
  - Andy Grove, Intel Co-founder



                                   Mike Shor
                                   Lecture 1
What is Game Theory?
   “No man is an island”

   Study of rational behavior
    in interactive or interdependent situations

   Bad news:
       Knowing game theory does not guarantee winning

   Good news:
       Framework for thinking about strategic interaction


                      Game Theory - Mike Shor               2
Games We Play
   Group projects         free-riding, reputation
   Flat tire              coordination
   GPA trap               prisoner’s dilemma
   Tennis / Baseball      mixed strategies
   Mean professors        commitment
   Traffic                congestion
   Dating                 information manipulation




                    Game Theory - Mike Shor           3
Games Businesses Play
   Patent races          game of chicken
   Drug testing          mixed strategies
   FCC spectrum          auctions
   Market entry          commitment
   OPEC output choice    collusion & enforcement
   Stock options         compensation schemes
   Internet pricing      market design




                   Game Theory - Mike Shor          4
Why Study Game Theory?
          Because the press tells us to…
“As for the firms that want to get their hands on a sliver of
  the airwaves, their best bet is to go out first and hire
  themselves a good game theorist.”
          The Economist, July 23,1994 p. 70

“Game Theory, long an intellectual pastime, came into its
  own as a business tool.”
        Forbes, July 3, 1995, p. 62.

“Game theory is hot.”
        The Wall Street Journal, 13 February 1995, p. A14

                       Game Theory - Mike Shor                  5
Why Study Game Theory?

    Because we can formulate effective strategy…

    Because we can predict the outcome of
     strategic situations…

    Because we can select or design the best game
     for us to be playing…



                   Game Theory - Mike Shor          6
Why Study Game Theory?
McKinsey:
 John Stuckey & David White -               Sydney
       “To help predict competitor behavior and
        determine optimal strategy, our consulting
        teams use techniques such as pay-off
        matrices and competitive games.”

   Tom Copeland - Director of Corporate Finance
       “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.”
                      Game Theory - Mike Shor            7
Understanding Incentives
   Do safer cars cause more accidents?

   Does Canadian football have less punting
    than the NFL?

   Are you getting a good deal if the store
    matches competitors’ prices?

   What is the optimal time to execute an
    option (or sell stock during a bubble)?

                  Game Theory - Mike Shor      8
       Game Theory




Administratrivia
Course Information
   Course web site
      • Check after each lecture
   Course discussion
      • Questions, comments
   Instructor
      • Office hours - none
      • Appointment
      • Drop by


                   Game Theory - Mike Shor   10
Course Outline
Concepts
   Recognizing the game
      • Rules of the game
      • Simultaneous games
        Anticipating rival’s moves
      • Sequential games
        Looking forward – reasoning back
      • Mixed strategies
        Sensibility of being unpredictable
      • Repeated games
        Cooperation and agreeing to agree

                  Game Theory - Mike Shor    11
Disclaimer # 1




                 12
Course Outline
Applications
   Winning the game
      • Commitment
        Credibility, threats, and promises
      • Information
        Strategic use of information
      • Bargaining
        Gaining the upper hand in negotiation
      • Auctions
        Design and Participation

                  Game Theory - Mike Shor       13
Disclaimer # 2




   Game Theory - Mike Shor   14
Group Deliverables
      • Self selected – four to five students
      • A word of caution
      • Length: about 750 words
      • Exhibits: three or four slides
   Content
      • Make a proposal
      • Explain it in plain English
   Grading
      • Relevance, difficulty of undertaking
      • Depth of analysis, value of advice
      • Professionalism, clarity of writing
                    Game Theory - Mike Shor     15
Individual Assignments
 Apply game theory to real scenarios
 Real:
       messy, unclear, undirected
   Short, concise (about 500 words)

   There are wrong answers!


                  Game Theory - Mike Shor   16
Experiments
 Participate by midnight
  day prior to next lecture
 Timed – no research required
 Scores are known
 Opponents are not
 Honor code
 Not graded (but required)


              Game Theory - Mike Shor   17
Grading
 Group Homework #1                    10%
 Group Homework #2                    15%
 Group Homework #3                    15%
 Individual Assignments               25%

 Class Participation          10%
 Final Exam                   25%
 Games (participation) –10 to  0

             Game Theory - Mike Shor     18
Keys to Success
   Before each lecture:
      •Review text

   After each lecture:
      •Visit course web site
      •Do sample problems

 Ask questions
 Submit drafts (3 days prior)
 Don’t fall behind
                 Game Theory - Mike Shor   19
Policies
They have a lovely
 “No cell phone”
  policy here…




                     Game Theory - Mike Shor   20
Interactive Decision Theory
   Decision 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

                 Game Theory - Mike Shor     21
The Golden Rule


            COMMANDMENT
  Never assume that your opponents’
          behavior is fixed.
 Predict their reaction to your behavior.




               Game Theory - Mike Shor      22
Toys “R” Us
 Market share: 20% nationally
 Levels of toy stores:
    •Toy & department stores
    •Specialized discounter (only TRU)
    •General discounter (Wal-Mart,Target)
    •Warehouse clubs (Costco,Pace)
 Mark-ups: 9% to 50%
 High product differentiation


              Game Theory - Mike Shor   23
History
   TRU had a lot of market power
       • Toy stores did not compete on price
       • Discounters couldn’t match variety
   Advent of warehouse clubs
       • By 1989: 200 items in competition
   TRU reaction:
       • Statement to manufacturers:
         Cannot sell to warehouses without losing
         TRU as a customer

                    Game Theory - Mike Shor         24
    The “Game”
   Toys R Us
      analyzed market potential for warehouse clubs

      concluded that they will do well

   Manufacturers
      unaware of the future of warehouse clubs

      enthusiastic about the new market

      concerned that rivals who broke ranks and sold
       to the clubs might gain sales at their expense
   Warehouse clubs
      Consider not carrying a line of toys if few of the
       toys have any value
                       Game Theory - Mike Shor         25
Issues

   Are the threats by the parties credible?

   Can cooperation be sustained?

   Are there informational advantages?




                  Game Theory - Mike Shor      26
Resolution
   Major manufacturers agreed to TRU deal

   Costco toy sales decreased
      •Pre-agreement growth of 51% per year


   TRU brokered a cooperative agreement
    among the manufacturers
      •Served as the central clearinghouse for
       complaints about breaches in the agreement

                  Game Theory - Mike Shor      27
Definition of a Game
   Must consider 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?


                           Game Theory - Mike Shor      28

								
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