UNIT I: Overview & History

1. UNIT I: Overview & History • Introduction: What is Game Theory? • Von Neumann and the Bomb • The Science of International Strategy • Logic of Indeterminate Situations 7/1

2. The Science of International Strategy Last time, we considered the application of game theory to problems of military strategy (e.g., Battle of Bismarck Sea; “Dr. Strangelove”). We also looked at the Prisoner’s Dilemma, which gives rise to the problem of inefficient equilibria. Today, we will consider game theory’s role in analyzing the US-Soviet conflict, in particular the move from zero- to nonzero-sum game theory: from a theory of war to a theory of bargaining and negotiation.

3. The Science of International Strategy • Schelling’s Reorientation of Game Theory • Securing Insecure Agreements • Post War Economic Regimes • Bargaining and Negotiation

4. Schelling’s Reorientation Realism • The actor (nation-state) is rational: goal-directed, concerned with maximizing power or security. • The environment is anarchic: there is no supervening authority that can enforce agreements. • The solution is an equilibrium or balanceofpower, enforced by the interests of those involved w/o the need for external enforcement mechanisms.

5. Schelling’s Reorientation • In the 1940s and ’50s, game theory lent itself to the analysis of military strategy, casting Realist principles and assumptions at an abstract level of analysis. • Von Neumann’s minimax theorem and the doctrine of military decision both recommend prudence: maximize the minimum payoff available. • Given Realist assumption, conflict is inevitable. The Security Dilemma arises because one nation’s attempt to increase it’s security decreases the security of others. • Arm Races(e.g., WWI). Is security zero-sum?

6. Schelling’s Reorientation The Reciprocal Fear of Surprise Attack The technology of nuclear warfare created a fundamentally new kind of arms race – the speed and devastation of the new generation of weapons meant that “[f]or the first time in the history of the world, it became possible to contemplate a surprise attack that would wipe the enemy off the face of the earth ... . Equally important, each nation would fear being the victim of the other’s surprise attack” (Poundstone, 1992, p. 4).

7. Schelling’s Reorientation So why didn’t the US preemptively attack the USSR?

8. Securing Insecure Agreements Prisoner’s DilemmaAssurance Game Don’t Preempt 3, 3 0, 5 5, 0 1, 1 Don’t Preempt

9. Securing Insecure Agreements Prisoner’s DilemmaAssurance Game Don’t Build weapons 3, 3 0, 5 5, 0 1, 1 Don’t Build weapons

10. Securing Insecure Agreements Prisoner’s Dilemma Assurance Game A credible second-strike capability can change the payoffs … 3, 3 0, 5 5, 0 1, 1 3, 3 0, 2 2, 0 1, 1

11. Securing Insecure Agreements Prisoner’s Dilemma Assurance Game 3, 3 0, 5 5, 0 1, 1 3, 3 0, 2 2, 0 1, 1 In the PD, the pareto efficient outcome is individually inaccessible and collectively unstable. in the AG, it is individually inaccessible but collectively stable, I.e., self-enforcing.

12. Securing Insecure Agreements Prisoner’s Dilemma Assurance Game 3, 3 0, 5 5, 0 1, 1 6, 6 0, 5 5, 0 1, 1 In the PD, the pareto efficient outcome is individually inaccessible and collectively unstable. in the AG, it is individually inaccessible but collectively stable, I.e., self-enforcing.

13. Securing Insecure Agreements The Balance of Terror: MAD There is a difference between a balance of terror in which either side can obliterate the other and one in which both sides can do it no matter who strikes first. It is not the “balance” – the sheer equality or symmetry of the situation – that constitutes mutual deterrence; it is the [self-enforcing] stability of the balance. The balance is stable when neither, in striking first, can destroy the other’s ability to strike back (Schelling, 1960: 232). If both have a credible second-strike capability: An equilibrium

14. Postwar Economic Regimes We learned to live with MAD. Both sides built and targeted missiles, and neither attacked. The stability that emerged between East and West made it possible for each side to turn its attention inward, on its own sphere of influence. In the West, focus shifted from (zero-sum and bipolar) security problems to (multipolar and nonzero-sum)problems of reorganizing and reviving the national economies that had been battered by the war. Accordingly, game theory turned from a theory of war to a theory of exchange.

15. Postwar Economic Regimes Bretton Woods (1944) • World Bank • International Monetary Fund (IMF) • General Agreement on Tariffs & Trade (GATT) (1947)

16. Postwar Economic Regimes World Trade Organization (WTO) (1994) • Multilateral trade liberalization • International business negotiations • Trade and environment • North/South conflict

17. Mixed Motives: The Bargain Buyer and seller try to agree on a price. Buyer is better off at a price less than b, Seller at a price above s. If b > s, we say there is a positive zone of agreement, or Surplus: S(urplus) = b(uyer’s reservation price) – s(eller’s reservation price) b 0 50 100 150 200 250 s i) b - s > 0 Surplus How to divide?

18. Bargaining Games Buyer and seller try to agree on a price. Buyer is better off at a price less than b, Seller at a price above s. If b > s, we say there is a positive zone of agreement, orSurplus: S(urplus) = b(uyer’s reservation price) – s(eller’s reservation price) b 0 50 100 150 200 250 s i) b > s If b and s are known to both players: How should the surplus be divided? Surplus = 50

19. Mixed Motives: The Bargain Buyer and seller try to agree on a price. Buyer is better off at a price less than b, Seller at a price above s. If b = s, we say the price is fully determined, and there is no room for negotiation. S(urplus) = b(uyer’s reservation price) – s(eller’s reservation price) b 0 50 100 150 200 250 s ii) b = s

20. Mixed Motives: The Bargain Buyer and seller try to agree on a price. Buyer is better off at a price less than b, Seller at a price above s. If b < s, there is nothing to gained from the exchange. S(urplus) = b(uyer’s reservation price) – s(eller’s reservation price) b 0 50 100 150 200 250 s (iii) b < s No “zone of agreement” What happens if information is incomplete?

21. Acquiring a Company BUYER represents Company A (the Acquirer), which is currently considering make a tender offer to acquire Company T (the Target) from SELLER. BUYER and SELLER are going to be meeting to negotiate a price. Company T is privately held, so its true value is known only to SELLER. Whatever the value, Company T is worth 50% more in the hands of the acquiring company, due to improved management and corporate synergies. BUYER only knows that its value is somewhere between 0 and 100 ($/share), with all values equally likely. Source: M. Bazerman

22. Acquiring a Company What offer should Buyer make?

23. Acquiring a Company 45 123 BU MBA Students Similar results from MIT Master’s Candidates CPA; CEOs. Source: Bazerman, 1992 27 18 9 7 4 5 4 1 0 $0 10-15 20-25 30-35 40-45 50-55 60-65 70-75 80-85 90-95 Offers

24. Acquiring a Company Buyer There are many ways to depict the decision tree for this game. Buyer moves first and can make any Offer from 0 to 100 + e. Let’s say Buyer offers $60. O(ffer) = 0 60 100 Seller Accept Reject The expected payoff of a $60 offer is a net loss of - $15. O – s = -60 30 EP(O) = - 15

25. Acquiring a Company Buyer There are many ways to depict the decision tree for this game. Buyer moves first and can make any Offer from 0 to 100 + e. Seller accepts if O > s. O(ffer) = 0 60 100 Seller Accept Reject s < 60 s > 60 Chance s = 0 60 The expected payoff of a $60 offer is a net loss of - $15. O – s = -60 30 EP(O) = - 15

26. Acquiring a Company Buyer There are many ways to depict the decision tree for this game. Buyer moves first and can make any Offer from 0 to 100 + e. Let’s say Buyer offers $60. O(ffer) = 0 60 100 Seller Accept Reject s < 60 s > 60 Chance s = 0 60 The expected payoff of a $60 offer is a net loss of - $15. s – O = -60 30 EP(O) = - 15

27. Acquiring a Company OFFER VALUE ACCEPT OR VALUE GAIN OR TO SELLER REJECT TO BUYER LOSS (O) (s) (3/2 s = b) (b - O) $60 $0 A $0 $-60 10 A 15 -45 20 A 30 -30 30 A 45 -15 40 A 60 0 50 A 75 15 60 R - - 70 R - -

28. Acquiring a Company The key to the problem is the asymmetric information structure of the game. SELLER knows the true value of the company (s). BUYER knows only the upper and lower limits (0 < s < 100). Therefore, buyer must form an expectation on s (s'). BUYER also knows that the company is worth 50% more under the new management, i.e., b' = 3/2 s'. BUYER makes an offer (O). The expected payoff of the offer, EP(O), is the difference between the offer and the expected value of the company in the hands of BUYER: EP(O) = b‘ – O = 3/2s‘ – O.

29. Acquiring a Company BUYER wants to maximize her payoff by offering the smallest amount (O) she expects will be accepted: EP(O) = b‘ – O = 3/2s‘ – O. O = s' + e. Seller accepts if O > s. Now consider this: Buyer has formed her expectation based on very little information. If Buyer offers O and Seller accepts, this considerably increases Buyer’s information, so she can now update her expectation on s. How should Buyer update her expectation, conditioned on the new information that s < O?

30. Acquiring a Company BUYER wants to maximize her payoff by offering the smallest amount (O) she expects will be accepted: EP(O) = b‘ – O = 3/2s‘ – O. O = s' + e. Seller accepts if O > s. Let’s say BUYER offers $50. If SELLER accepts, BUYER knows that s cannot be greater than (or equal to) 50, that is: 0 < s < 50. Since all values are equally likely, s''/(s < O) = 25. The expected value of the company to BUYER (b'' = 3/2s'' = 37.50), which is less than the 50 she just offered to pay. (EP(O) = - 12.5.) When SELLER accepts, BUYER gets a sinking feeling in the pit of her stomach. THE WINNER’S CURSE!

31. Acquiring a Company BUYER wants to maximize her payoff by offering the smallest amount (O) she expects will be accepted: EP(O) = b‘ – O = 3/2s‘ – O. O = s' + e. Seller accepts if O > s. Generally: EP(O) = O - ¼s' (-e). EP is negative for all values of O. THE WINNER’S CURSE!

32. Acquiring a Company • The high level of uncertainty swamps the potential gains available, such that value is often left on the table, i.e., on average the outcome is inefficient. • Under these particular conditions, BUYER should not make an offer. • SELLER has an incentive to reveal some information to BUYER, because if BUYER can reduce the uncertainty, she may make an offer that leaves both players better off.

33. Summary Schelling’s Reorientation • Game theory had its earliest successes as a theory of war. • Schelling (and others) argued that the advent of nuclear warfare fundamentally changed the game; most interesting international conflicts are mixed-motive or nonzero-sum games. • In this context, game theory becomes a tool for conflict resolution as an alternative to war (bargaining & negotiation). • Today, game theory has applications to international trade liberalization, environmental negotiations, arms control, and the shift from East/West to North/South conflict.

34. Next Time 7/8 Zerosum Games Rapoport, Ch 1-7, pp: 13-93. Nonzerosum Games Gibbons, Ch 1, pp 1-51.