Game Theory

Only the paranoid survive.

Andy Grove, Cofounder of Intel

What is Game Theory?

Introduction
Game theory is a description of strategic interaction between mutually aware players You are self-interested and selfish So is everyone else

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

The Strategic Environment

Who are the players?
Everyone who has an effect on your earnings - Decision makers

What strategies are available?

Actions available to each player - Feasible actions Define a plan of action for every contingency

What are the payoffs?

Numbers associated with each outcome - Objectives Reflect the interests of the players

Rules of the Game

What is the time-frame for decisions?
Timing of moves
Are moves simultaneous or sequential?

What is the nature of the conflict?

Nature of conflict and interaction
Are players interests in conflict? Will players interact once or repeatedly?

What is the nature of interaction?

Enforceability of agreements or contracts
Can contracts be enforced?

What information is available?

Informational conditions
Are some players better informed?

Assumptions
Rationality
Players aim to maximize their payoffs Players are perfect calculators

Common Knowledge
Each player knows the rules of the game Each player knows that each player knows the rules
Each player knows that each player knows that each player knows the rules
Each player knows that each player knows that each player knows that each player knows the rules
Each player knows that each player knows that each player knows that each player knows that each player knows the rules

Etc. Etc. Etc. I can calculate the motions of heavenly bodies, but not the madness of people -Sir Isaac Newton on losing 20,000 in the South Sea Bubble in 1720)

Equilibrium
The likely outcome of a game when rational, strategic agents interact
Each player is playing his or her best strategy given the strategy choices of all other players No player has incentive to change his or her action unilaterally

Equilibrium sometimes is not the optimal solution.

Prisoners Dilemma
Two suspects, A and B, are arrested by the police. The police have insufficient evidence for a conviction, and, having separated both prisoners, visit each of them to offer the same deal. If one testifies for the prosecution against the other and the other remains silent, the betrayer goes free and the silent accomplice receives the full 10-year sentence. If both stay silent, both prisoners are sentenced to only six months in jail for a minor charge. If each betrays the other, each receives a two-year sentence. Each prisoner must make the choice of whether to betray the other or to remain silent. However, neither prisoner knows for sure what choice the other prisoner will make. So this dilemma poses the question: How should the prisoners act?

Prisoners Dilemma

Prisoner B
Betrays Betrays Stays Silent
2 Years 2 Years Free 10 Years 6 Months Free 6 Months

Stays Silent
10 Years

Prisoner A

Prisoners Dilemma
Game in which two players can "cooperate" with or "defect" (i.e. betray) the other player. The only concern of each individual player is maximizing his/her own payoff, without any concern for the other player's payoff. No matter what the other player does, one player will always gain a greater payoff by playing defect. The unique equilibrium for this game is a Pareto-suboptimal solutionthat is, rational choice leads the two players to both play defect even though each player's individual reward would be greater if they both played cooperate.

In equilibrium, each prisoner chooses to cooperate even though both individually would be better off by defecting, hence the dilemma.

Prisoners Dilemma

Prisoner B
Defect Defect Cooperate
Lose Lose Win Much Lose Much Win Win Much Win

Cooperate
Lose Much

Prisoner A

Cigarette Advertising on TV

All US tobacco companies advertised heavily on TV

1964

Surgeon General issues official warning

Cigarette smoking may be hazardous

Cigarette companies fear lawsuits

Government may recover healthcare costs 1970

Companies strike agreement

Carry the warning label and cease TV advertising in exchange for immunity from federal lawsuits.

Strategic Interaction
Players: Strategies: Payoffs:
Reynolds and Philip Morris Advertise or Not Advertise Companies Profits

Strategic Landscape:
Each firm earns $50 million from its customers Advertising costs a firm $20 million Advertising captures $30 million from competitor

How to represent this game?

Representing a Game

Players
Philip Morris
No Ad No Ad 50 , 50 60 , 20 Ad 20 , 60 30 , 30

Reynolds
Ad

Strategies
Payoffs

What to Do?

Philip Morris No Ad Ad

Reynolds

No Ad 50 , 50 60 , 20

Ad 20 , 60 30 , 30

If you are advising Reynolds, what strategy do you recommend?

Solving the Game

Philip Morris No Ad Ad

Reynolds

No Ad 50 , 50 60 , 20

Ad 20 , 60 30 , 30

Best reply for Reynolds:

If Philip Morris advertises: If Philip Morris does not advertise:

Chicken Game

Two hooligans with something to prove drive at each other on a narrow road. The first to swerve loses faces among his peers. If neither swerves, however, a terminal fate plagues both.

Chicken Game
Loss" of swerving is trivial compared to the crash if nobody swerves, the reasonable strategy would seem to be to swerve before a crash is likely. If one believes one's opponent to be reasonable, one may well decide not to swerve at all. One tactic in the game is for one party to signal their intentions convincingly before the game begins. For example, if one party were to ostentatiously disable their steering wheel just before the match, the other party would be compelled to swerve. This shows that, in some circumstances, reducing one's own options can be a good strategy. This model also assumes that, if both parties swerve, they will not swerve in the same direction.

Chicken Game

Cuban Missile Crisis

Brinkmanship is the policy or practice of pushing a dangerous situation to the brink of disaster in order to achieve the most advantageous outcome. J. F. Kennedy, in 1961, revealed that the Soviet Union, despite rhetoric, had far fewer ICBMs than it claimed. In response, Nikita Khrushchev ordered nuclear missiles with shorter ranges installed in Cuba. Based on Kennedy's failure to back up the Bay of Pigs invasion, they believed the U.S. wouldn't respond harshly. Kennedy and his advisors evaluated a number of options, ranging from doing nothing to a full invasion of Cuba. A blockade of Cuba was chosen because it wouldn't necessarily escalate into war, and because it forced the Soviets to make the next move. Because of mutually assured destruction by a nuclear war, the Soviets had no choice but to bow to U.S. demands and remove the weapons.

Business Applications
A procurement manager trying to induce a subcontractor to search for costreducing innovations An entrepreneur negotiating a royalty arrangement with a manufacturing firm to license the use of a new technology A sales manager devising a commission payments scheme to motivate salespeople A production manager deciding between piece-rate and wage payments to workers designing a managerial incentive system How low to bid for a government procurement contract How high to bid in an auction A takeover raiders decision on what price to offer for a firm A negotiation between a multinational and a foreign government over the setting up of a manufacturing plant The haggling between a buyer and seller of a used car Collective bargaining between a trade union/employees and an employer

Why Study Game Theory?

Because the press tells us to Managers have much to learn from game theory provided they use it to clarify their thinking, not as a substitute for business experience.
- The Economist, 15 June 1996

Game Theory, long an intellectual pastime, came into its own as a business tool.
- Forbes, 3 July 1995

Game theory is hot.

- The Wall Street Journal, 13 February 1995

Why Study Game Theory?

Because recruiters tell us to Game theory forces you to see a business situation over many periods from two perspectives: yours and your competitors.
Judy Lewent CFO, Merck

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.
Tom Copeland Director of Corporate Finance, McKinsey

Q&A