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Game Theory

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:

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Game Theory

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  1. Game Theory “Only the Paranoid Survive” - Andy Grove, Intel Co-founder Mike Shor Lecture 1

  2. 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

  3. 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

  4. 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

  5. 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

  6. 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

  7. 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

  8. 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

  9. Game Theory Administratrivia

  10. Course Information • Course web site • Check after each lecture • Course discussion • Questions, comments • Instructor • Office hours - none • Appointment • Drop by Game Theory - Mike Shor

  11. 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

  12. Disclaimer # 1

  13. 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

  14. Disclaimer # 2 Game Theory - Mike Shor

  15. 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

  16. 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

  17. 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

  18. 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

  19. 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

  20. Policies They have a lovely “No cell phone” policy here… Game Theory - Mike Shor

  21. 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

  22. The Golden Rule COMMANDMENT Never assume that your opponents’ behavior is fixed. Predict their reaction to your behavior. Game Theory - Mike Shor

  23. 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

  24. 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

  25. 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

  26. Issues • Are the threats by the parties credible? • Can cooperation be sustained? • Are there informational advantages? Game Theory - Mike Shor

  27. 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

  28. 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

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