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Game Theory
- Andy Grove, Co-founder of Intel
Mike ShorLecture 1
“Only the paranoid survive.”
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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
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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
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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
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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
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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
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Game Theory
Administratrivia
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Course Information
Course web siteCheck after each lecture
Course discussionQuestions, comments
InstructorOffice hours - noneAppointmentDrop by
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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
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Disclaimer #1
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Disclaimer #1
A theory provides a way to organize our thinking. Theory is the science of business, not the art.
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Course OutlineApplications
Winning the gameCommitment
Credibility, threats, and promisesInformation
Strategic use of informationBargaining
Gaining the upper hand in negotiationAuctions
Design and Participation
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Disclaimer #2
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Disclaimer #2
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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
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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)
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Honor Code
Applies to: Experiments Cases Exam Academic Integrity
Questions?
ASK!
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Grading
Cases (15% each) 60%
Class Participation 15%
Final Exam 25%
Games (participation) –10% to 0%
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Keys to Success
After each lecture: Visit course web site Do assigned readings Do sample problems
Ask questions
Don’t fall behind
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Policies
They have a lovely “No cell phone”
policy here…
They have a lovely “No cell phone”
policy here…
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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
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The Golden Rule
COMMANDMENT
Never assume that your opponents’ behavior is fixed.
Predict their reaction to your behavior.
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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
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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!
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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?
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Decision Theory
Free money! Pick an option:
Option 1: $50 Option 2: $40 Option 3: $20
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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
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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
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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!
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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)
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Toys “R” Us (continued)
Issues:
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Toys “R” Us (continued)
What would you do?
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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
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Toys “R” Us (continued)
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 …
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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?)
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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?