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Game Theory

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									                 Game Theory
                                        Mike Shor
                                        Lecture 1




“Only the paranoid survive.”
    - Andy Grove, Co-founder of Intel
             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


Mike Shor
                                                                                2
Game Theory & Business Strategy
             Games We Play

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



Mike Shor
                                                                 3
Game Theory & Business Strategy
             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



Mike Shor
                                                                  4
Game Theory & Business Strategy
             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
Mike Shor
                                                                              5
Game Theory & Business Strategy
             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

Mike Shor
                                                                                  6
Game Theory & Business Strategy
      Game Theory




Administratrivia
             Course Information

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


Mike Shor
                                                          8
Game Theory & Business Strategy
             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
Mike Shor
                                                                  9
Game Theory & Business Strategy
             Disclaimer #1




Mike Shor
                                  10
Game Theory & Business Strategy
             Disclaimer #1




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

Mike Shor
                                                                11
Game Theory & Business Strategy
             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

Mike Shor
                                                                     12
Game Theory & Business Strategy
             Disclaimer #2




Mike Shor
                                  13
Game Theory & Business Strategy
             Disclaimer #2




Mike Shor
                                  14
Game Theory & Business Strategy
             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
Mike Shor
                                                                     15
Game Theory & Business Strategy
             Experiments

                 Participate by 6:00 pm each Sunday
                     First       and last game have different due date
              Timed – no research required
              Scores are known
              Opponents are not
              Not graded (but required)



Mike Shor
                                                                          16
Game Theory & Business Strategy
             Honor Code

                 Applies to:
                     Experiments

                     Cases

                     Exam

                     Academic    Integrity


                 Questions?
                  ASK!
Mike Shor
                                              17
Game Theory & Business Strategy
             Grading


                 Cases (15% each)           60%

                 Class Participation        15%

                 Final Exam                 25%

                 Games (participation) –10% to 0%

Mike Shor
                                                     18
Game Theory & Business Strategy
             Keys to Success

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


                 Ask questions

                 Don’t fall behind
Mike Shor
                                                     19
Game Theory & Business Strategy
             Policies




Mike Shor
                                  20
Game Theory & Business Strategy
             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

Mike Shor
                                                               21
Game Theory & Business Strategy
             The Golden Rule



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




Mike Shor
                                                               22
Game Theory & Business Strategy
             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

Mike Shor
                                                           23
Game Theory & Business Strategy
             Restaurant Decision-Making
                                  May I recommend that with the Bleu
                                    Cheese for ten dollars more?

                                                                 Sure!


                                                                   It is only
                                                                a dollar more
                                                                    for me!


                 Check splitting policy changes incentives.
Mike Shor
                                                                                24
Game Theory & Business Strategy
             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?

Mike Shor
                                                                 25
Game Theory & Business Strategy
             Decision Theory

              Free money!
              Pick an option:


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



Mike Shor
                                        26
Game Theory & Business Strategy
             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



Mike Shor
                                               27
Game Theory & Business Strategy
             Is Game Theory Moral?


                                  ‘Game Theory’ Excuse for Anything
                                    A student cheats on his exam. A corporation fudges its        Game theory goes on to say that you should expect
                                  accounts to boost its stock price. A professor lies about     people to lie, and so you also might want to lie. Isn't this
                                  his past. A politician sends out a newsletter with one        a wonderful concept to be teaching our college students?
                                  opinion to one group of constituents, another newsletter        Here's a quote from one of the textbooks used in game
                                  with an opposing opinion to another group. A store            theory courses, ''Thinking Strategically,'' by Avinash
                                  chain uses underhanded methods to gain locations. Are         Dixit and Barry Nalebuff: ''Individuals' incentive to
                                  these all independent actions, or part of a larger attitude   cheat on any agreement should be recognized and made
             Teddy Milne          that's eating away at ethics in this country?
                                    To me, they seem part of the ''realist'' approach to
                                                                                                a part of their strategy choice.'' In a roundabout way, this
                                                                                                teaches that cheating is not only acceptable, but to your
                                  politics, especially as exemplified by ''game theory.''       advantage.
                                    Game theory starts out by saying forget about                 Further, game theory suggests that in order to get a
             October 22,          morality, feelings and emotions; we are going to assume       competitive edge, you might want to pretend to be
             2002                 that a rational person is going to always act in his own
                                  best interests.
                                                                                                insane, so that your opponent won't be able to judge
                                                                                                which way you're going to jump.
                                    In other words, self-interest is king, a theory as old as     Well, we've seen that in politics, haven't we? Perhaps
                                  man. Thucydides noted it in 400 B.C. Machiavelli              Dr. Strangelove was only pretending. However, this
                                  described it in the 16th Century, and perhaps every           seems in reality a pretty insane course to take, and
                                  generation has come up with theories, explanations and        might easily have unintended consequences.
                                  justifications for acting selfishly.                                                 (see “Mindless Commentary”, p. 3)




Mike Shor
                                                                                                                                                               28
Game Theory & Business Strategy
             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!
Mike Shor
                                                                                    29
Game Theory & Business Strategy
             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)

Mike Shor
                                                                                          30
Game Theory & Business Strategy
             Toys “R” Us (continued)

                 Issues:




Mike Shor
                                       31
Game Theory & Business Strategy
             Toys “R” Us (continued)

                 What would you do?




Mike Shor
                                       32
Game Theory & Business Strategy
             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



Mike Shor
                                                                            33
Game Theory & Business Strategy
             Toys “R” Us (continued)
                 Manufacturers agreed to TRU deal

                 Warehouse club toy sales decreased
                             Pre-agreement  growth of 51% per year
                             Overall growth of clubs of over 10% per year



                 But …


Mike Shor
                                                                             34
Game Theory & Business Strategy
             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?)

Mike Shor
                                                                35
Game Theory & Business Strategy
             Summary
             Defining 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?

Mike Shor
                                                                                36
Game Theory & Business Strategy

								
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