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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

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

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

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

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

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

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

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

Administratrivia

Course Information Course discussion Instructor

- Course web site
- Check after each lecture

- Questions, comments

- Office hours - none
- Appointment
- Drop by

Game Theory - Mike Shor

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

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

- Commitment

Game Theory - Mike Shor

Game Theory - Mike Shor

Group Deliverables Content Grading

- Self selected – four to five students
- A word of caution
- Length: about 750 words
- Exhibits: three or four slides

- Make a proposal
- Explain it in plain English

- Relevance, difficulty of undertaking
- Depth of analysis, value of advice
- Professionalism, clarity of writing

Game Theory - Mike Shor

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

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

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

Keys to Success After each lecture: Ask questions Submit drafts (3 days prior) Don’t fall behind

- Before each lecture:
- Review text

- Visit course web site
- Do sample problems

Game Theory - Mike Shor

Interactive Decision Theory Game theory

- Decision theory
- You are self-interested and selfish

- 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

The Golden Rule

COMMANDMENT

Never assume that your opponents’ behavior is fixed.

Predict their reaction to your behavior.

Game Theory - Mike Shor

Toys “R” Us Mark-ups: 9% to 50% High product differentiation

- Market share: 20% nationally
- Levels of toy stores:
- Toy & department stores
- Specialized discounter (only TRU)
- General discounter (Wal-Mart,Target)
- Warehouse clubs (Costco,Pace)

Game Theory - Mike Shor

History Advent of warehouse clubs TRU reaction:

- TRU had a lot of market power
- Toy stores did not compete on price
- Discounters couldn’t match variety

- By 1989: 200 items in competition

- Statement to manufacturers:
Cannot sell to warehouses without losing TRU as a customer

Game Theory - Mike Shor

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

Issues

- Are the threats by the parties credible?
- Can cooperation be sustained?
- Are there informational advantages?

Game Theory - Mike Shor

Resolution TRU brokered a cooperative agreement among the manufacturers

- Major manufacturers agreed to TRU deal
- Costco toy sales decreased
- Pre-agreement growth of 51% per year

- Served as the central clearinghouse for complaints about breaches in the agreement

Game Theory - Mike Shor

Definition of a Game Rules of the game

- Must consider the strategic environment
- Who are the PLAYERS? (Decision makers)
- What STRATEGIES are available? (Feasible actions)
- What are the PAYOFFS? (Objectives)

- 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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