Game Theory

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

3
Games We Play

• Group projects free-riding, reputation
• Flat tire coordination
• GPA trap prisoners dilemma
• Tennis / Baseball mixed strategies
• Mean professors commitment
• Traffic congestion
• Dating information manipulation

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

5
Why Study Game Theory?

• FCC Spectrum Auction
• 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

6
Why Study Game Theory?

• Strategy
• Commitment vs. flexibility
• Decision-making under uncertainty
• Looking forward reasoning back
• Market Design
• Auctions
• National Resident Matching Program
• Electric Power Exchanges
• Internet

7
Interactive Decision Theory

• Decision theory
• You are self-interested and selfish
• Game theory
• So is everyone else
• If its true that we are here to help others,
• then what exactly are the others here for?
• - George Carlin

8
The Golden Rule
COMMANDMENT Never assume that your opponents beh
avior is fixed. Predict their reaction to your be
havior.
9
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

10
History

• TRU had a lot of market power
• Toy stores did not compete on price
• Discounters couldnt 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
  

11
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

12
Issues

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

13
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

14
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?