Game Theory

1. Game Theory Topic 6Strategic Moves “The power to constrain an adversary depends upon the power to bind oneself.” - Thomas Schelling

2. Credibility • Review • Cooperation requires sacrificing immediate profits for a future relationship • The sacrifice is only made if the punishment is both severe enough and credible • But what is credibility?

3. Review • Credible commitments require • Severe enough punishment to change behavior • Irreversible and clear actions • Strategic Moves: • Changing the game for strategic advantage • Being credible • Overcoming the prisoner’s dilemma

4. The Winning Lottery Ticket “It won’t change me one bit!”

5. What is Credibility? “ The difference between genius and stupidity is that genius has its limits.” – Albert Einstein • Telling you I’m going to act in my best interest is not committing • To commit to a suboptimal action, I need to: • Change the game • Change perceptions

6. How to be Credible? • Reduce payoffs from those strategies that may tempt you • Make it costly to renege • Remove strategies from among those that may tempt you in the future • Destroy avenues of retreat • Replace players by eliminating strategic control • Remove “human meddling”

7. Commitment • Must commit to be credible! “ The difference between ‘involvement’ and ‘commitment’ is like an eggs-and-ham breakfast: the chicken was ‘involved’ – the pig was ‘committed.’ ”

8. Commitment vs. Involvement • Two firms considering market entry: • Market potential is $10 million NPV profits • Entry costs $7 million • It is in our best interest to stay out if we think that the other firm will enter Them

9. Involvement • We make an initial investment: • Invest first $1 million to deter entry • It is still in our best interest to stay out if we think that the other firm will enter Them

10. Commitment • We make an initial investment: • Invest first $3 million to deter entry • Now, it is our dominant strategy to enter regardless of what the other firm will do Them

11. Credible Commitment • By reducing our own payoffs from staying out, we have committed to entry • It is credible because it is now in our own best interest!

12. Commitment & Competition • Consumers want companies to compete • Companies prefer to cooperate • Credible commitment by companies: • Change payoffs to • Maximize joint gains • Promise higher prices • Threaten competitors that lower prices • Three practices consumers like but economists hate

13. Promises and Threats • Getting the promise or threat right • Making it credible • Firms want to • promise each other high prices • threaten rivals who lower prices

14. Getting the Threat Right Monty Python’s Piranha Brothers • The Operation • Select a victim • Threaten to beat him up if he pays the “protection” money • The Other Operation • Select a victim • Threaten not to beat him up if he pays the “protection” money • The Other Other Operation • Select a victim • Threaten to beat him up if he doesn’t pay the “protection” money

15. Making it Credible • Promises can sometimes be credible through a contract with the party to whom you are making the promise • Threats can never be credible through a contract with the party to whom you are making the threat • Must contract with third party

16. The Bocchicchio Family “ Once a particularly ferocious branch of the Mafia in Sicily, it had become an instrument of peace in America. ” • How can Michael invite Don Tessio for a meeting and guarantee that Don Tessio will not be harmed?

17. Customers as Hostages • Firms can contract with customers as a third party to make credible threats and promises

18. Customers as Hostages:Promises “I promise to keep prices high” • Most Favored Customer clause • If I ever offer a lower price to any other customer, I will offer it to you as well Firm 2

19. Most Favored Customer Clause • Say, in period 1, both firms charge high • In period 2, pricing low requires a $1 refund to 30 customers from last period Firm 1: 65 – 30 = 35

20. Most Favored Customer Clause Firm 2 Firm 2

21. Customers as Hostages:Threats “I will punish you if you lower prices” • Price Matching Guarantee • If any competitor offers a lower price, I will match it

22. Price Matching Guarantee Firm 2 Firm 2

23. Customers as Hostages • Price matching guarantees and most favored customer clauses exploit: • customer price sensitivity • customer price awareness • low customer switching costs • Exactly the factors that make price competition brutal!

24. Other Price Guarantees • What is the impact of: • “Drug companies should not be allowed to charge Americans more than Canadians” • China requests a “Most Favored Nation” clause with the United States • WalMart requires a price from suppliers that is no worse than its competitors

25. Increasing Search Costs:Theory • It costs a consumer a transportation cost, t, to “visit” another firm • If consumers expect prices of pe, how much should you charge? • Can charge up to pe + t • But, if you iterate this • If you charge pe+t, competitor can charge pe+t+t, but then you can charge pe+t+t+t

26. Increasing Search Costs:Implementation • Prevent price advertising • Government regulation (liquor stores) • Industry agreement (likely illegal) • Professional trade groups (doctors) • Limit store hours • Closing laws (florists) • Obfuscate price information (Dilbert “confusopolies”) • Make comparison difficult (mattresses, insurance) • Use multiple prices (banking, auto dealers)

27. Strategic Moves • A strategic move is an action taken prior to the play of the game • Transforms the original game into a two-stage game • Setting the Rules • Playing the Game "Victorious warriors win first and then go to war. Defeated warriors go to war first and then try to win.“ -- Sun Tzu

28. Strategic Moves • A credible strategic move must be • Observable • Irreversible • Incentive-changing • Incentive-changing • Change strategies, payoffs, or players • Be creative

29. The Prisoner’s Dilemma Equilibrium: $40 K Cooperation: $60 K

30. Firm 2: (4/5) 65 + (1/5) 35 = 59 Firm 1: (4/5) 35 + (1/5) 65 = 41 Joint Ventures & Cross-Shareholding • If each firm acquires 20% of the other:

31. Joint Ventures & Cross-Shareholding Firm 2 Firm 2

32. Reducing Payoffs: Contracting • Takeover offer: $200 million • You can “afford” $20 million / year • Finance takeover for 20 years at 7% • Add penalty: if amount greater than $200 million, +1.5 points on interest rate • Annual Payments: • $200 million: $18.6 million / year • $210 million: $19.6 million / year • with penalty: $21.9 million / year

33. Credible Threats • Targeted threats are generally more credible than blanket threats • But what if a blanket threat is exactly what we need? • Assign responsibility to alter incentives

34. From Incredible to Credible • Ten suppliers each have two options: • Deliver on time at a cost of $70,000 • Deliver a week late at a cost of $20,000 • Delivery results in $100,000 payment • I need at least nine suppliers and the suppliers know this

35. A Non-Credible Threat • I threaten not to deal with any supplier who delivers late • But, suppliers know that I can punish at most one • Two equilibria: • All deliver on time • All deliver late (the likely equilibrium) • Even if I think that only one other supplier will deliver late, it is in my best interest to do so: ½ (80) > 30

36. A Credible Threat • I number the suppliers arbitrarily: 1…10 • I refuse delivery from the lowest numbered supplier among those who are late • Result: • Supplier 1 delivers on time (better than getting nothing) • Thus, supplier 2 delivers on time …

37. Removing Strategies I You are not always better off with more options. • Delegation • Delegate decision to a disinterested third party • In contract negotiation, can “squabble” over many details • Instead, send an agent with power of attorney to “sign as is” or “walk away” Learn from government bureaucracy: “The rules won’t allow me to do what you ask!”

38. Delegation Examples • Human resource departments • Shield from requests for higher salaries • HR execs not compensated based on employer value • Collection agencies • Shield from pleas or threats of the debtor • Reinforce repayment to protect reputation • Accounting firms overseeing contests • Accountant’s payment not tied to outcome • Concerned with reputation for fairness

39. Removing Strategies II Sometimes, you should burn bridges. • Burning Bridges • Power comes from not being able to retreat • Allow opponent to retreat (Sun Tzu) • The nicotine patch • Hunt for Red October • Cortes upon arriving in Mexico

40. Burning Bridges • Reputation • “I burn all cities about to be conquered” • “We do not negotiate with terrorists” • Takeover defenses • Irreversibility • Pressing the “send” button • Turning off the phone • Extreme form: Last Will and Testament

41. Burning Bridges Example • Semiconductor patent sharing “Mosaid Technologies, a designer and licensor of semiconductor chips and technologies, just announced a patent sharing deal with Mitsubishi Electric” • Share patent with another competing firm • Commit to chip supply to production plants • Commit to no opportunistic behavior

42. Building Bridges Build bridges for your opponents. “When you surround an enemy, you must leave an outlet for him to go free.” –Sun-Tzu • Jimmy Hoffa’s negotiation lesson: • What is the single most important thing for a negotiator to know?

43. Commitment Is Counterintuitive Reduce your strategy space and decrease your own payoffs to commit. (Hurt yourself to help yourself) Increase your opponent’s strategy space to preclude the rival from committing. (Help your rival to help yourself)

44. Irrationality • U.S. / U.S.S.R. nuclear deterrence • Mutually Assured Destruction (MAD) • like Grim Trigger Strategy • Proportional Response • like Tit-for-Tat • Want a lot of deterrence • Want irrationality to be credible • Dr. Strangelove & the Doomsday device

45. Dr. Strangelove The Credibility Checklist • Severity “Create fear in the mind of the enemy” • Irreversibility “It is essential” • Irrationality “Not something a sane man would do” • Practicality “It wasn’t a practical deterrent” • Clarity “Tell the world”

46. Commitment Under Uncertainty • An offer you can’t refuse • After a seemingly successful interview, the interviewer asks where the firm ranks on your list of potential employees • Before answering, you are told: • The firm only hires applicants who rank it first • If the firm is in fact your first choice, then you must accept a job offer in advance, should one be made

47. Commitment Under Uncertainty • Why make such proposals? • Take advantage of your uncertainty • Take advantage of your risk-aversion • Make you commit before they do! • Binding early-decision college applications

48. Flexibility vs. Commitment • Must balance: Value of commitment • Change in others’ behavior from your committing to some course of action generates value Value of flexibility • Keeping your options open and remaining flexible allows you to react to changing situations (option value)

49. Philips, N.V. • Commitment in CD introduction • Philips: innovator’s advantage • Initiate construction of plant ahead of competitors • Decision problem of Philips in 1982: • Build a disk-pressing plant in the U.S. and invest in a substantial amount of capacity to deter potentially entry (Sony, etc.) • Delay decision until commercial appeal of CDs can be determined. Import CDs to the U.S. To “test the waters.”

50. Calculating Option Value The science • Option Value: • Added profit from flexibility (can’t lose) The art • Countervailing forces: By waiting, the firm risks: • Failing to capitalize fully on an opportunity. • Having the opportunity preempted by competitors. • What to do?