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  1. 1. Game Theory “ Only the paranoid survive.” - Andy Grove, Co-founder of Intel Mike Shor Lecture 1
  2. 2. What is Game Theory? <ul><li>“ No man is an island” </li></ul><ul><li>Study of rational behavior </li></ul><ul><li>in interactive or interdependent situations </li></ul><ul><li>Bad news: </li></ul><ul><li>Knowing game theory does not guarantee winning </li></ul><ul><li>Good news: </li></ul><ul><li>Framework for thinking about strategic interaction </li></ul>
  3. 3. Games We Play <ul><li>Group projects free-riding, reputation </li></ul><ul><li>Flat tire coordination </li></ul><ul><li>Mean professors commitment </li></ul><ul><li>GPA trap prisoner’s dilemma </li></ul><ul><li>Tennis / Baseball mixed strategies </li></ul><ul><li>Poker credibility </li></ul><ul><li>Traffic congestion </li></ul><ul><li>Dating information manipulation </li></ul>
  4. 4. Games Businesses Play <ul><li>Market entry commitment </li></ul><ul><li>Drug testing mixed strategies </li></ul><ul><li>Supply chains auctions </li></ul><ul><li>Corporate takeovers winner’s curse </li></ul><ul><li>Fishing congestion </li></ul><ul><li>Patent races game of chicken </li></ul><ul><li>Stock options compensation schemes </li></ul><ul><li>OPEC output collusion & enforcement </li></ul>
  5. 5. Why Study Game Theory? <ul><li>Because the press tells us to … </li></ul><ul><li>“ Managers have much to learn from game theory — provided they use it to clarify their thinking, not as a substitute for business experience.” </li></ul><ul><ul><li> The Economist , 15 June 1996 </li></ul></ul><ul><li>“ Game Theory, long an intellectual pastime, came into its own as a business tool.” </li></ul><ul><ul><li> Forbes , 3 July 1995 </li></ul></ul><ul><ul><li>  </li></ul></ul><ul><li>“ Game theory is hot.” </li></ul><ul><ul><li> The Wall Street Journal , 13 February 1995 </li></ul></ul>
  6. 6. Why Study Game Theory? <ul><li>Because recruiters tell us to … </li></ul><ul><li>“ Game theory forces you to see a business situation over many periods from two perspectives: yours and your competitor’s.” </li></ul><ul><ul><li>Judy Lewent – CFO, Merck </li></ul></ul><ul><li>“ 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.” </li></ul><ul><ul><li>Tom Copeland – Director of Corporate Finance, McKinsey </li></ul></ul>
  7. 7. Game Theory Administratrivia
  8. 8. Course Information <ul><li>Course web site </li></ul><ul><ul><ul><li>Check after each lecture </li></ul></ul></ul><ul><li>Course discussion </li></ul><ul><ul><ul><li>Questions, comments </li></ul></ul></ul><ul><li>Instructor </li></ul><ul><ul><ul><li>Office hours - none </li></ul></ul></ul><ul><ul><ul><li>Appointment </li></ul></ul></ul><ul><ul><ul><li>Drop by </li></ul></ul></ul>
  9. 9. Course Outline Concepts <ul><li>Recognizing the game </li></ul><ul><ul><ul><li>Rules of the game </li></ul></ul></ul><ul><ul><ul><li>Simultaneous games </li></ul></ul></ul><ul><ul><ul><li>Anticipating rival’s moves </li></ul></ul></ul><ul><ul><ul><li>Sequential games </li></ul></ul></ul><ul><ul><ul><li>Looking forward – reasoning back </li></ul></ul></ul><ul><ul><ul><li>Mixed strategies </li></ul></ul></ul><ul><ul><ul><li>Sensibility of being unpredictable </li></ul></ul></ul><ul><ul><ul><li>Repeated games </li></ul></ul></ul><ul><ul><ul><li>Cooperation and agreeing to agree </li></ul></ul></ul>
  10. 10. Disclaimer #1
  11. 11. Disclaimer #1 A theory provides a way to organize our thinking. Theory is the science of business, not the art .
  12. 12. Course Outline Applications <ul><li>Winning the game </li></ul><ul><ul><ul><li>Commitment </li></ul></ul></ul><ul><ul><ul><li>Credibility, threats, and promises </li></ul></ul></ul><ul><ul><ul><li>Information </li></ul></ul></ul><ul><ul><ul><li>Strategic use of information </li></ul></ul></ul><ul><ul><ul><li>Bargaining </li></ul></ul></ul><ul><ul><ul><li>Gaining the upper hand in negotiation </li></ul></ul></ul><ul><ul><ul><li>Auctions </li></ul></ul></ul><ul><ul><ul><li>Design and Participation </li></ul></ul></ul>
  13. 13. Disclaimer #2
  14. 14. Disclaimer #2
  15. 15. Case Write Ups (Four) <ul><li>Self selected groups of four or five students </li></ul><ul><li>a word of caution </li></ul><ul><li>Apply game theory to real scenarios </li></ul><ul><li>real: messy, unclear, undirected </li></ul><ul><li>Make a proposal and explain it in English </li></ul><ul><li>no jargon! and there are wrong answers! </li></ul><ul><li>Length: about 750 words (one page), plus figures </li></ul><ul><li>Grading: </li></ul><ul><ul><li>Depth and logic of analysis </li></ul></ul><ul><ul><li>Value of advice </li></ul></ul><ul><ul><li>Professionalism, clarity of writing </li></ul></ul>
  16. 16. Experiments <ul><li>Participate by 9 pm the evening prior to each lecture </li></ul><ul><li>Timed – no research required </li></ul><ul><li>Scores are known </li></ul><ul><li>Opponents are not </li></ul><ul><li>Not graded (but required) </li></ul>
  17. 17. Honor Code <ul><li>Applies to: </li></ul><ul><ul><li>Experiments </li></ul></ul><ul><ul><li>Cases </li></ul></ul><ul><ul><li>Exam </li></ul></ul><ul><ul><li>Academic Integrity </li></ul></ul><ul><li>Questions? </li></ul><ul><li>ASK! </li></ul>
  18. 18. Grading <ul><li>Cases (15% each) 60% </li></ul><ul><li>Class Participation 15% </li></ul><ul><li>Final Exam 25% </li></ul><ul><li>Games (participation) –10% to 0% </li></ul>
  19. 19. Keys to Success <ul><li>After each lecture: </li></ul><ul><ul><ul><li>Visit course web site </li></ul></ul></ul><ul><ul><ul><li>Do assigned readings </li></ul></ul></ul><ul><ul><ul><li>Do sample problems </li></ul></ul></ul><ul><li>Ask questions </li></ul><ul><li>Don’t fall behind </li></ul>
  20. 20. Policies They have a lovely “ No cell phone” policy here…
  21. 21. Interactive Decision Theory <ul><li>Decision Theory </li></ul><ul><ul><li>You are self-interested and selfish </li></ul></ul><ul><li>Game Theory </li></ul><ul><ul><li>So is everyone else </li></ul></ul><ul><li>“ If it’s true that we are here to help others, </li></ul><ul><li>then what exactly are the others here for? ” </li></ul><ul><li>- George Carlin </li></ul>
  22. 22. The Golden Rule COMMANDMENT Never assume that your opponents’ behavior is fixed. Predict their reaction to your behavior.
  23. 23. Decision Theory vs. Game Theory <ul><li>Ten of you go to a restaurant </li></ul><ul><li>If each of you pays for your own meal… </li></ul><ul><ul><li>This is a decision problem </li></ul></ul><ul><li>If you all agree to split the bill... </li></ul><ul><ul><li>Now, this is a game </li></ul></ul>
  24. 24. Restaurant Decision-Making <ul><li>Check splitting policy changes incentives. </li></ul>May I recommend that with the Bleu Cheese for ten dollars more ? Sure! It is only a dollar more for me!
  25. 25. Understanding Incentives <ul><li>Do bicycle helmets cause less injuries? </li></ul><ul><li>Should airplanes require children to be in their own seats? </li></ul><ul><li>Why shut down a plant operating at capacity? </li></ul><ul><li>Why cannibalize your own sales? </li></ul><ul><li>Why offer price guarantees to consumers? </li></ul>
  26. 26. Decision Theory <ul><li>Free money! </li></ul><ul><li>Pick an option: </li></ul><ul><ul><li>Option 1: $50 </li></ul></ul><ul><ul><li>Option 2: $40 </li></ul></ul><ul><ul><li>Option 3: $20 </li></ul></ul>
  27. 27. Now What Do You Do? <ul><li>Free money! </li></ul><ul><li>Pick an option: </li></ul><ul><ul><li>Option 1: $50 or $60 </li></ul></ul><ul><ul><li>Option 2: $40 or $80 </li></ul></ul><ul><ul><li>Option 3: $20 or $90 </li></ul></ul>
  28. 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. 29. Toys “R” Us <ul><li>Competitive Landscape </li></ul><ul><ul><li>Toy & department stores </li></ul></ul><ul><ul><ul><li>Do not compete with TRU on price (50% markups) </li></ul></ul></ul><ul><ul><li>General discounters (Wal-Mart, Target) </li></ul></ul><ul><ul><ul><li>Cannot compete with TRU on selection (9% markups) </li></ul></ul></ul><ul><ul><ul><li>Toys exhibit high product differentiation </li></ul></ul></ul><ul><ul><li>Specialized discounters (only TRU) </li></ul></ul><ul><ul><ul><li>Enjoyed 20% market share nationally </li></ul></ul></ul><ul><ul><li>Warehouse clubs (Costco, Pace) </li></ul></ul><ul><ul><ul><li>Introduced in the 1980s </li></ul></ul></ul><ul><ul><ul><li>By 1989 , about 200 items in competition </li></ul></ul></ul><ul><ul><ul><li>Cause of concern for Toys “R” Us! </li></ul></ul></ul>
  30. 30. Toys “R” Us (continued) <ul><li>Market research into the future of warehouse clubs </li></ul><ul><ul><li>Manufacturers estimated 3-5% annual growth rate </li></ul></ul><ul><ul><li>Toys “R” Us conducted comprehensive but proprietary study </li></ul></ul><ul><ul><li>Manufacturers were aware of the study, but not its results </li></ul></ul><ul><ul><li>Toys “R” Us expected warehouse clubs to grow quite fast </li></ul></ul><ul><li>Idea! Issue statement to manufacturers: </li></ul><ul><ul><li>You may not sell to warehouse clubs without losing Toys “R” Us as a customer </li></ul></ul><ul><ul><ul><li>Effectively, choose between a $5 billion market (TRU) and a less than $500M market (warehouse clubs) </li></ul></ul></ul>
  31. 31. Toys “R” Us (continued) <ul><li>Issues: </li></ul>
  32. 32. Toys “R” Us (continued) <ul><li>What would you do? </li></ul>
  33. 33. Toys “R” Us (continued) <ul><li>Toys R Us strived to change the game: </li></ul><ul><ul><li>Broker a cooperative agreement among the toy manufacturers </li></ul></ul><ul><ul><ul><li>Serve as a clearinghouse for complaints </li></ul></ul></ul><ul><ul><li>Utilize consumer expectations to alter payoffs </li></ul></ul><ul><ul><ul><li>Annual industry convention & product launch </li></ul></ul></ul><ul><ul><ul><li>Safety advisories & recalls </li></ul></ul></ul><ul><ul><ul><li>Availability of compatible products </li></ul></ul></ul>
  34. 34. Toys “R” Us (continued) <ul><li>Manufacturers agreed to TRU deal </li></ul><ul><li>Warehouse club toy sales decreased </li></ul><ul><ul><ul><li>Pre-agreement growth of 51% per year </li></ul></ul></ul><ul><ul><ul><li>Overall growth of clubs of over 10% per year </li></ul></ul></ul><ul><li>But … </li></ul>
  35. 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. 36. Summary Defining the Game <ul><li>The strategic environment </li></ul><ul><ul><li>Who are the players ? (Decision makers) </li></ul></ul><ul><ul><li>What strategies are available? (Feasible actions) </li></ul></ul><ul><ul><li>What are the payoffs ? (Objectives) </li></ul></ul><ul><li>Rules of the game </li></ul><ul><ul><li>What is the time-frame for decisions? </li></ul></ul><ul><ul><li>What is the nature of the conflict? </li></ul></ul><ul><ul><li>What is the nature of interaction? </li></ul></ul><ul><ul><li>What information is available? </li></ul></ul>