R.E .

Ma r ks 2003

Lect u r e 1-1

S T R A T EGIC G AME T HEO R Y FO R M AN A GER S

Ou tlin e o f s u bje c t: L ectu re 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. Topic 1. S tra te g ic D e c is io n Ma k in g F ir m s Beh a vin g Ba dly. Du opoly Beh a viou r Mor e E xa m ples. 2. D e c is io n An a ly s is : Ga m e s Ag a in s t N a tu re E va lu a t ion . Ga in in g In sigh t . Ut ilit y. 6. U n p re d ic ta bility 7. B a rg a in in g 8. U s in g In fo rm a tio n S tra te g ic a lly Scr een in g, Sign a llin g.

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Lect u r e 1-2

13. 14. 15. 16. 17. 18. 19. 20.

9. B id d in g a n d Au c tio n D e s ig n Con clu ded. 10. Co n tra c tin g , o r th e Ru le s o f th e Ga m e E m ployin g, F in a n cin g, F r a n ch isin g. 13. Ch o o s in g th e Rig h t Ga m e : Co o p e titio n Con clu ded. S tu d e n t p re s e n ta tio n s Con clu ded.

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Lect u r e 1-3

Books Recom m en ded (bu t n ot r equ ir ed) t ext : Bier m a n H .S. & Fer n a n dez L., Gam e T h eory w ith E con om ic Application s, Rea din g: Addison -Wesley, 2n d ed., 1998. Dixit A., a n d Skea t h S., Gam es of S trategy, New Yor k: Nor t on , 1999. As well, t h e followin g books will be fou n d u sefu l: Gin t is H ., Gam e T h eory E volvin g: A Problem -Cen tered In trod u ction to M od elin g S trategic In teraction , P r in cet on : P.U.P., 2000. Wa t son J., S trategy: An In trod u ction to Gam e T h eory, N.Y.: Nor t on , 2002. Ra sm u sen E ., Gam es an d In form ation : An In trod u ction to Gam e T h eory, Oxfor d: B. Bla ckwell, 3r d edit ion , 2001. Ga r dn er R., Gam es for B u sin ess an d E con om ics, N.Y.: Wiley, 2n d. ed., 2003. Gh em a wa t P., Gam es B u sin esses Play: Cases an d M od els, Ca m b.: MIT P r ess, 1997. Pa c k a g e As s e s s m e n t

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Lect u r e 1-4

Qu o ta ble Qu o te s Ga m e t h eor y: t h e gr ea t est a u ct ion in h ist or y T h e N ew York T im es, Ma r ch 16, 1995, p.A17. Wh en gover n m en t a u ct ion eer s n eed wor ldly a dvice, wh er e ca n t h ey t u r n ? To m a t h em a t ica l econ om ist s, of cou r se ... As for t h e r m s t h a t wa n t t o get t h eir h a n ds on a sliver of t h e a ir wa ves, t h eir best bet is t o go ou t r st a n d h ir e t h em selves a good ga m e t h eor ist . T h e E con om ist, J u ly 23, 1994, p.70. t h e m ost dr a m a t ic exa m ple of ga m e t h eor ys n ew power ... It wa s a t r iu m ph , n ot on ly for t h e F CC a n d t h e t a xpa yer s, bu t a lso for ga m e t h eor y (a n d ga m e t h eor ist s). Fortu n e, Febr u a r y 6, 1995, p.36. Ga m e t h eor y, lon g a n in t ellect u a l pa st im e, ca m e in t o it s own a s a bu sin ess t ool. Forbes, J u ly 3, 1995, p.62. Ga m e t h eor y is h ot . T h e Wall S treet J ou rn al, Febr u a r y 13, 1995, p.A14.

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Lect u r e 1-5

On -lin e Re fe e n c e s . . . bu t ga m e t h eor y is n ot n ew! For a h ist or y of ga m e t h eor y, see www.econ.canterbury.ac.nz/hist.htm For m or e ga m e t h eor y on t h e Web, see www.economics.harvard.edu/aroth/alroth.html For a glossa r y of t er m s you sh ou ld be fa m ilia r wit h a ft er Ch on gwoos SE T in t r odu ct ion , see www.agsm.edu.au/bobm/teaching/SGTM/glossary.html

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Lect u r e 1-6

Ga m e Th e o ry

Con ven t ion a l econ om ics t a kes t h e st r u ct u r e of m a r ket s a s xed.

People a r e t h ou gh t of a s sim ple st im u lu s-r espon se m a ch in es. Seller s a n d bu yer s a ssu m e t h a t pr odu ct s a n d pr ices a r e xed, a n d t h ey opt im ize pr odu ct ion a n d con su m pt ion a ccor din gly. Con ven t ion a l econ om ics h a s it s pla ce in descr ibin g t h e oper a t ion of est a blish ed, m a t u r e m a r ket s, bu t it doesn t ca pt u r e peoples cr ea t ivit y in n din g n ew wa ys of in t er a ct in g wit h on e a n ot h er. Ga m e t h eor y is a differ en t wa y of lookin g a t t h e wor ld. In ga m e t h eor y, n ot h in g is xed. Th e econ om y is dyn a m ic a n d evolvin g. Th e pla yer s cr ea t e n ew m a r ket s a n d t a ke on m u lt iple r oles. Th ey in n ova t e. No on e t a kes pr odu ct s or pr ices a s given . If t h is sou n ds like t h e fr ee-for m a n d r a pidly t r a n sfor m in g m a r ket pla ce, t h a t s wh y ga m e t h eor y m a y be t h e ker n el of a n ew econ om ics for t h e n ew econ om y. Br a n den bu r ger & Na lebu ff For ewor d t o Co-opetition

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Lect u r e 1-7

1. Strategic Decision Making

B u s in e s s is w a r a n d p e a c e . Cooper a t ion in cr ea t in g va lu e. Com pet it ion in dividin g it u p. No cycles of Wa r, Pea ce, Wa r, .... bu t sim u lt a n eou sly wa r a n d pea ce. You h a ve t o com pet e a n d cooper a t e a t t h e sa m e t im e. Ra y Noor da of Novell.

Co-opet it ion

(See Lect u r es 17 a n d 18 la t er a n d Br a n den bu r ger & Na lebu ff in t h e Pa cka ge.)

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Lect u r e 1-8

Ma n u a l fo r Co -o p e titio n H ow t o: cooper a t e wit h ou t bein g a sa in t com pet e wit h ou t killin g t h e opposit ion .

Ga m e Th eor y

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Lect u r e 1-9

1.1 Business is a Game, of Sorts

Bu sin ess is a ga m e, bu t differ en t fr om st r u ct u r ed boa r d ga m es or a r ca de ga m es or com pu t er ga m es: it is n ot win -lose (n ot zer o-su m ): possible for a ll pla yer s t o win a pa r t fr om t h e la w, t h er e is n o r u le book ot h er s will ch a n ge t h e ga m e t o t h eir a dva n t a ge t h e ga m e is m a de u p of ve PARTS (see below) su ccess com es fr om playin g th e righ t gam e So ga m e t h eor y pr ovides a fr a m ewor k for a n ever-r a pidly ch a n gin g wor ld.

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Lect u r e 1-10

Wid e r is s u e s . In Lect u r es 17 a n d 18 we go beyon d t h e m or e m icr o issu es wider issu es: Wh ich gam e sh ou ld you r rm / organ isation be in ?

It s n o good st ickin g t o you r kn it t in g if t h er es n o dem a n d for ju m per s.

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Lect u r e 1-11

Qu e s tio n : Hig h o r lo w ? You ca n ch oose Left or Righ t : P r ot s: Left You Riva l $40 m $20 m Righ t $80 m $160 m

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Lect u r e 1-12

Th e PARTS o f th e Ga m e Players : cu st om er s, su pplier s, r iva ls, a llies; Ch a n ge a n y, in clu din g you r self. Ad d ed Valu es : wh a t ea ch pla yer a dds t o t h e ga m e (t a kin g t h e pla yer ou t wou ld su bt r a ct t h eir a dded va lu e). Wa ys t o r a ise you r s, or lower t h eir s. R u les : give st r u ct u r e t o t h e ga m e; in bu sin ess n o u n iver sa l set of r u les fr om la w, cu st om , pr a ct ica lit y, or con t r a ct s Ca n r evise exit in g r u les, or devise n ew on es Tactics : m oves t o sh a pe t h e wa y: pla yer s per ceive t h e ga m e, a n d h en ce h ow t h ey pla y Ta ct ics t o r edu ce m isper cept ion , or t o cr ea t e or m a in t a in m isper cept ion . S cope: t h e bou n ds of t h e ga m e: expa n d or sh r in k. PARTS gives m or e t h a n a fr a m ewor k, it pr ovides a com plet e set of lever s. PARTS pr ovides a m et h od t o pr om ot e n on -r ou t in e t h in kin g, see la t er.

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Lect u r e 1-13

A Ca s e : Th e N e w Yo rk Po s t v. th e N e w Yo rk N e w s

N.Y. Post J a n u a r y 1994 Febr u a r y 1994 Ma r ch 1994 J u ly 1994 40 50 25 (in St a t en Isla n d) 50

N.Y. N ew s 40 40 40 50

Un t il Feb 1994 bot h pa per s wer e sold a t 40. Th en t h e Post r a ised it s pr ice t o 50 bu t t h e N ew s h eld t o 40 (sin ce it wa s u sed t o bein g t h e r st m over ). So in Ma r ch t h e Post dr opped it s St a t en Isla n d pr ice t o 25 bu t kept it s pr ice elsewh er e a t 50, u n t il N ew s r a ised it s pr ice t o 50 in J u ly, h a vin g lost m a r ket sh a r e in St a t en Isla n d t o t h e Post a n d h a vin g a ccept ed t h a t t h e Post wou ld h en cefor t h be t h e lea der in a n y pr ice h ike. So bot h wer e n ow pr iced a t 50 ever ywh er e in NYC.

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Lect u r e 1-14

1.2 A gentle introduction

P iem a x In c. ba kes a n d sells desser t pies. It s decision : pr ice h igh or low for t oda ys pies? Th in gs t o be con sider ed: pr ices of r iva ls pies? pr ices of n on -pie su bst it u t es? A n a ve opt ion : sim ply opt im ise it s pr icin g policy given it s beliefs a bou t r iva ls pr ices, or

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Lect u r e 1-15

Th in k s tra te g ic a lly... Alt er n a t ive: t r y t o pr edict t h ose pr ices, u sin g P iem a x kn owledge of t h e in du st r y, in pa r t icu la r : it s kn owledge t h a t it s r iva ls will ch oose t h eir pr ices ba sed on t h eir own pr edict ion s of t h e m a r ket en vir on m en t , in clu din g P iem a x own pr ices. Ga m e Th eor y P iem a x sh ou ld bu ild a m od el of t h e beh a viou r of ea ch in dividu a l com pet it or, Wh ich beh a viou r wou ld be m ost r ea son a ble t o expect ? La t er : wh a t is a n equ ilibr iu m ? La t er : ou gh t P iem a x t o believe t h a t t h e m a r ket ou t com e equ ilibr iu m ? Now: wh a t kin d of m odel?

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Lect u r e 1-16

Th e s im p le s t k in d o f m o d e l. All ba ker s oper a t e for on e d ay on ly (a so-ca lled on e-sh ot m odel) All ba ker s kn ow t h e pr odu ct ion t ech n ologies a n d object ives of t h e ot h er s St u dy wit h t h e t ools of: p a y o ff m a trix ga m es a n d N a s h e qu ilibriu m N ash E qu ilibriu m : n o pla yer h a s a n y in cen t ive t o ch a n ge h is or h er a ct ion , a ssu m in g t h a t t h e ot h er pla yer (s) h a ve ch osen t h eir best a ct ion s for t h em selves. Na sh equ ilibr ia a r e self-rein forcin g . In t wo-pla yer ga m es, a Na sh equ ilibr iu m pr escr ibes st r a t egies t h a t a r e m u t u a lly best r espon se (n ot u n iver sa lly best r espon ses, a s wit h dom in a n t st r a t egies).

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Lect u r e 1-17

Re p e a te d in te ra c tio n s . If m ore th an on e d ay (a r epea t ed ga m e or in t er a ct ion ): t h en P iem a xs object ives? e.g. (m or e t h a n m a xim isin g t oda ys pr ot s) low pr ice t oda y m a y: cu st om er s swit ch fr om a r iva l br a n d in cr ea se P iem a x m a r ket sh a r e in t h e fu t u r e ba kin g a la r ge ba t ch of pies m a y a llow lea r n in g by doin g by t h e st a ff lower pr odu ct ion cost s in t h e fu t u r e

e.g. &

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Lect u r e 1-18

B u t th e re a re d a n g e rs ! It s r iva ls m a y be in u en ced by P iem a xs pr ice t oda y a low P iem a x pr ice m a y t r igger a price w ar. Su ch dyn a m ic ga m es ca n be dea lt wit h u sin g ext en sive-for m ga m e t r ees a n d t h e solu t ion con cept of su bgam e perfection S u bgam e Perfect E qu ilibriu m : a Na sh equ ilibr iu m t h a t does n ot r ely on n on -cr edible t h r ea t s (t h a t sa t ises ba ckwa r ds in du ct ion ).

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Lect u r e 1-19

Ho w a bo u t in fo rm a tio n ?
Wh a t if P iem a x is u n certain of t h e cost fu n ct ion s or t h e lon g-t er m

object ives of it s r iva ls? H a s Cu pca ke P t y Lt d ju st m a de a br ea kt h r ou gh in la r ge-ba t ch pr odu ct ion ? Does Sweet st u ff plc ca r e m or e a bou t m a r ket sh a r e t h a n a bou t cu r r en t pr ot s? An d h ow m u ch do t h ese r iva ls kn ow a bou t P iem a x? In com plete in form ation ga m es. Act in g in a fog: per cept ion s r u le!

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Lect u r e 1-20

An d le a rn in g ? If t h e in du st r y con t in u es for sever a l per iods, t h en P iem a x ou gh t t o learn a bou t Cu pca kes a n d Sweet st u ffs pr iva t e in for m a t ion from th eir cu rren t pricin g beh aviou r a n d u se t h is in for m a t ion t o im pr ove it s fu t u r e st r a t egy. In a n t icipa t ion , Cu pca ke a n d Sweet st u ff m a y be loa t h t o let t h eir pr ices r evea l in for m a t ion t h a t en h a n ces P iem a xs com pet it ive posit ion : Th ey m a y a t t em pt t o m an ipu late Piem axs in form ation .

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Lect u r e 1-21

In a n u ts h e ll ... Ga m e t h eor y is t h e st u dy of r a t ion a l beh a viou r in sit u a t ion s in volvin g in t er depen den ce: Ma y in volve com m on in t er est s: coord in ation Ma y in volve com pet in g in t er est s: rivalry R ation al beh aviou r : pla yer s do t h e best t h ey ca n , in t h eir eyes; Beca u se of t h e pla yer s in t er depen den ce, a r a t ion a l decision in a ga m e m u st be ba sed on a pr edict ion of ot h er s r espon ses. Pu t you rself in th e oth ers sh oes a n d pr edict in g wh a t a ct ion t h e ot h er per son will ch oose, you ca n decide you r own best a ct ion .

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Lect u r e 1-22

1.3 Strategic Interaction

Ga m e t h eor y a ga m e pla n , a specica t ion of a ct ion s cover in g a ll

possible even t u a lit ies in st r a t egic in t er a ct ion s. S trategic situ ation s : in volvin g t wo or m or e pa r t icipa n t s, ea ch t r yin g t o in u en ce, t o ou t gu ess, or t o a da pt t o t h e decision s or lin es of beh a viou r t h a t ot h er s h a ve ju st a dopt ed or a r e expect ed t o a dopt (Tom Sch ellin g). L ook forw ard an d reason back w ard s!

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Lect u r e 1-23

Th e a t ty re a n d m y o p ia ... Two college st u den t s, ver y con den t a bou t t h eir m id-t er m exa m per for m a n ce in a su bject , decided t o a t t en d a pa r t y t h e weeken d befor e t h e n a l exa m . Th e pa r t y wa s so good t h a t t h ey over slept t h e wh ole Su n da y. In st ea d of t a kin g t h e exa m u n pr epa r ed on Mon da y, t h ey plea ded t o t h e pr ofessor t o give t h em a m a ke-u p exa m . Th eir excu se wa s a a t t yr e wit h ou t a spa r e a n d a n y h elp. Th e pr ofessor a gr eed. On Tu esda y m or n in g, t h e pr ofessor pla ced t h em in sepa r a t e r oom s a n d h a n ded t h em t h e t est . Th e t est h a d ju st on e qu est ion : Wh ich tyre?

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Lect u r e 1-24

An d th e a p p lic a tio n s ... a procu rem en t m an ager t r yin g t o in du ce a su bcon t r a ct or t o sea r ch for cost r edu cin g in n ova t ion s a n en trepren eu r n egot ia t in g a r oya lt y a r r a n gem en t wit h a m a n u fa ct u r in g r m t o licen se t h e u se of a n ew t ech n ology a sales m an ager devisin g a com m ission pa ym en t s sch em e t o m ot iva t e sa lespeople a prod u ction m an ager decidin g bet ween piece-r a t e a n d wa ge pa ym en t s t o wor ker s design in g a m an agerial in cen tive system h ow low to bid for a gover n m en t pr ocu r em en t con t r a ct h ow h igh to bid in a n a u ct ion a tak eover raid ers decision on wh a t pr ice t o offer for a r m a n egotiation bet ween a m u lt in a t ion a l a n d a for eign gover n m en t over t h e set t in g u p of a m a n u fa ct u r in g pla n t t h e h agglin g bet ween a bu yer a n d seller of a u sed ca r collective bargain in g bet ween a t r a de u n ion /em ployees a n d a n em ployer

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Lect u r e 1-25

1.4 Some Interactions

1.4.1 Auctioning a Five-Dollar Note Ru les: F ir st bid: 20 Lowest st ep in biddin g: 20 (or m u lt iples of 20) Au ct ion la st s u n t il t h e clock st a r t s r in gin g. H igh est bidder pa ys bid a n d get s $5 in r et u r n . Secon d-h igh est bidder a lso pa ys, bu t get s n ot h in g. Wr it e down t h e sit u a t ion a s seen by 1. t h e h igh bidder, a n d 2. t h e secon d h igh est bidder. Wh a t h a ppen ed? E sca la t ion a n d en t r a pm en t E xa m ples? (See ONea ls pa per in t h e pa cka ge.)

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Lect u r e 1-26

1.4.2 Schellings Game Ru les: Sin gle pla y, $4 t o pla y: by wr it in g you r n a m e on t h e slip Vot e C (Coo per a t e) or D (Defect ). Sign you r ba llot . (a n d com m it t o pa y t h e en t r y fee.) If x % vot e C a n d (100 x )% vot e D: x t h en Cs pa yoff = ( $6) $4 100 t h en Ds pa yoff = C pa yoff + $2 Or : You n eedn t pla y a t a ll.

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Lect u r e 1-27

S c h e llin g s Ga m e

6 $ per pa r t icipa n t

0 0 25 50 75 100 Per cen t a ge of pa r t icipa n t s vot in g C Not e: t h e ga m e cost s $4 t o join .

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Lect u r e 1-28

S c h e llin g s Ga m e
WH AT H AP P E NE D ?

n u m ber s & pa yoffs. pr eviou s yea r s? coo per a t e for t h e com m on good or Dilem m a : defect for on eself P u blic/pr iva t e in for m a t ion E xa m ples?

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Lect u r e 1-29

1.4.3 The Ice-Cream Sellers (See Ma r ks in t h e Pa cka ge)

L Dem on st r a t ion Pa yoff m a t r ix In cen t ives for m ovem en t ? E xa m ples?

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Lect u r e 1-30

Mo d e llin g th e ic e -c re a m s e lle rs . We ca n m odel t h is in t er a ct ion wit h a sim plica t ion : ea ch seller ca n eit h er : m ove t o t h e cen t r e of t h e bea ch (M), or n ot m ove (st a y pu t ) (NM). Th e sh a r e of ice-cr ea m s ea ch sells (t o t h e t ot a l popu la t ion of 80 su n ba t h er s) depen ds on it s m ove a n d t h a t of it s r iva l. Sin ce ea ch h a s t wo ch oices for it s loca t ion , t h er e a r e 2 2 = 4 possibilit ies. We u se arrow s a n d a p a y o ff m a trix , wh ich clea r ly ou t lin es t h e possible a ct ion s of ea ch a n d t h e r esu lt in g ou t com es. Wh a t a r e t h e sa les if n eit h er m oves (or bot h NM)? E a ch sells t o h a lf t h e bea ch . Wh a t a r e t h e sa les if You m ove t o t h e cen t r e (M) a n d you r r iva l st a ys pu t a t t h e t h r ee-qu a r t er poin t ? Wh a t if you bot h m ove? Given t h e a n a lysis, wh a t sh ou ld you do?

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Lect u r e 1-31

Th e Ic e -Cre a m S e lle rs T h e oth er seller M M You NM 30, 50 40, 40 40, 40 NM 50, 30

TAB LE 1. Th e pa yoff m a t r ix (You , Ot h er ) A n on -cooper a t ive, zer o-su m ga m e, wit h a d o m in a n t s tra te g y , or dom in a n t m ove.

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Lect u r e 1-32

Re a l-Wo rld Ic e -Cre a m S e lle rs Th in k of t h e bea ch a s a pr odu ct spect r u m , ea ch en d r epr esen t in g a pa r t icu la r n ich e, a n d t h e cen t r e r epr esen t a t in g t h e m ost popu la r pr odu ct . Dem a n d is la r gest for t h e m ost popu la r pr odu ct , bu t so is com pet it ion . Th is sim ple m odel: a t en den cy t o a void ext r em es, especia lly wit h ba r r ier s t o en t r y for n ew pla yer s. E xa m ples: t h e con ver gen ce of fa sh ion s? t h e sim ila r it y of com m er cia l TV a n d r a dio pr ogr a m m in g? t h e copy-ca t policies of polit ica l pa r t ies? t h e pa r a llel sch edu lin g of An set t (a n d per h a ps Vir gin ) a n d Qa n t a s?

A t wist : Wh a t if t h e cen t r e is t oo fa r for som e ba t h er s (a t t h e en ds of t h e bea ch ) t o wa lk? Th en t h e t en den cy for t h e seller s t o offer t h e sa m e pr odu ct (a t t h e cen t r e) is r edu ced, a n d t h ey m igh t differ en t ia t e t h eir pr odu ct s.

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Lect u r e 1-33

1.4.4 The Prisoners Dilemma (See Ma r ks in t h e Pa cka ge) Ca s e : Te ls tra a n d Op tu s a n d a d v e rtis in g . Da vid Ogilvy: H alf th e m on ey spen t on ad vertisin g is w asted ; th e problem is id en tifyin g w h ich h alf. Telst r a a n d Opt u s in depen den t ly m u st decide h ow h ea vily t o a dver t ise. Adver t isin g is expen sive, bu t if on e t elco ch ooses t o a dver t ise m oder a t ely wh ile t h e ot h er a dver t ises h ea vily, t h en t h e r st loses ou t wh ile t h e secon d does well. Let s a ssu m e if bot h Adver t ise H ea vily t h en Telst r a n et s $70,000, wh ile Opt u s n et s $50,000. Bu t if Telst r a Adver t ises H ea vily wh ile Opt u s Adver t ises Moder a t ely on ly, t h en Telst r a n et s $140,000 wh ile Opt u s n et s on ly $25,000, a n d vice ver sa . If bot h Adver t ise Moder a t ely, t h en Telst r a n et s $120,000 a n d Opt u s n et s $90,000. Wh a t t o do?

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Lect u r e 1-34

Th e Ad v e rtis in g Ga m e Optu s H ea vy Telstra H ea vy Moder a t e 70, 50 25, 140 Moder a t e 140, 25 120, 90

TAB LE 2. Th e pa yoff m a t r ix (Telst r a , Opt u s) Ra n kin g ou t com es is OK: 4 = best 1 = wor st .

Telstra

H ea vy Moder a t e

Optu s H ea vy Moder a t e 2, 2 4, 1 1, 4 3, 3

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Lect u r e 1-35

Th e Tra d itio n a l, S y m m e tric Pa y o ffs fo r th e P ris o n e rs D ile m m a : Th e Pa yoff Ma t r ix: Th e Ch ea t er s Rewa r d = 5 Th e Su cker s Pa yoff = 0 Mu t u a l defect ion = 2 Mu t u a l coo per a t ion = 4 Th ese a r e ch osen so t h a t : 5 + 0 < 4 + 4 so t h a t C,C is e f c ie n t in a r epea t ed ga m e.

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Lect u r e 1-36

Th e P ris o n e rs D ile m m a A n eed for : com m u n ica t ion coo r din a t ion t r u st o r? Ef c ie n t Ou tc o m e : t h er e is n o ot h er com bin a t ion of a ct ion s or st r a t egies t h a t wou ld m a ke a t lea st on e pla yer bet t er off wit h ou t m a kin g a n y ot h er pla yer wor se off.

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Lect u r e 1-37

Th e P ris o n e rs D ile m m a T h e oth er player C You C D 4, 4 5, 0 D 0, 5 2, 2

TAB LE 3. Th e pa yoff m a t r ix (You , Ot h er ) A n on -cooper a t ive, posit ive-su m ga m e, wit h a dom in a n t st r a t egy. E fcien t a t _____ Na sh E qu ilibr iu m a t _____

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Lect u r e 1-38

1.4.5 The Capacity Game Ca s e : D u Po n ts Tita n iu m d o x id e c a p a c ity. Tit a n iu m dioxide is a wh it en er for pa in t , pa per, a n d pla st ics. In 1972 du Pon t , wit h 34% of t h e U.S. m a r ket for t it a n iu m dioxide, a n n ou n ced a ddit ion a l ca pa cit y wh ich wou ld a ft er six yea r s r esu lt in it s sh a r e r isin g t o 65%. Du Pon t r esist ed ot h er s pr ice r ises, bu t sla cken in g dem a n d gr owt h m ea n t it s pla n s wer e r edu ced in size a n d dela yed. Bu t it s pr eem pt ive st r a t egy h a s been ver y pr ot a ble: it is n ow t h e globa l lea der in t it a n iu m dioxide su pply a n d it s exclu sive ilm en it e pr odu ct ion is t h e lowest cost t ech n ology. A S im p le r Mo d e l: Two r m s ea ch pr odu ce iden t ica l pr odu ct s a n d ea ch m u st decide wh et h er t o E xpa n d (E ) it s ca pa cit y in t h e n ext yea r or n ot (DNE ). A la r ger ca pa cit y will in cr ea se it s sh a r e of t h e m a r ket , bu t a t a lower pr ice. Th e sim u lt a n eou s ca pa cit y ga m e bet ween Alph a a n d Bet a ca n be wr it t en a s a pa yoff m a t r ix.

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Lect u r e 1-39

Th e Ca p a c ity Ga m e B eta DNE Alph a DNE E xpa n d $18, $18 $20, $15 E xpa n d $15, $20 $16, $16

TAB LE 4. Th e pa yoff m a t r ix (Alph a , Bet a ) A n on -cooper a t ive, posit ive-su m ga m e, wit h a dom in a n t st r a t egy. E fcien t a t _____ Na sh E qu ilibr iu m a t _____

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Lect u r e 1-40

Equ ilibriu m . At a N a s h e qu ilibriu m , ea ch pla yer is doin g t h e best it ca n , given t h e st r a t egies of t h e ot h er pla yer s. We ca n u se arrow s in t h e pa yoff m a t r ix t o see wh a t ea ch pla yer sh ou ld do, given t h e ot h er pla yer s a ct ion . Th e Na sh equ ilibr iu m is a self-r ein for cin g foca l poin t , a n d expect a t ion s of t h e ot h er s beh a viou r a r e fu llled. Th e Na sh equ ilibr iu m is n ot n ecessa r ily efcien t . Th e ga m e a bove is a n exa m ple of t h e P r ison er s Dilem m a : in it s on e-sh ot ver sion t h er e is a con ict bet ween collect ive in t er est a n d self-in t er est .

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Lect u r e 1-41

1.5 Modelling Players Preferences

Wit h ou t u n cer t a in t y or a n y dice-r ollin g, we n eed on ly ran k t h e fou r com bin a t ion s: best, good , bad , w orst: pa yoffs of 4, 3, 2, a n d 1, r espect ively, in a 2 2 in t er a ct ion .

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Lect u r e 1-42

Co m p lic a tio n s La r ger n u m ber s of possible a ct ion s: h a r der t o r a n k t h e la r ger n u m ber of ou t com es (wit h t h r ee a ct ion s t h er e a r e 3 3 = 9), bu t r a n kin g su fcien t . (i.e. ord in al preferen ces , in st ea d of a skin g by h ow m u ch is on e ou t com e pr efer r ed t o a n ot h er ?) La t er, wit h m ix e d s tra te g ie s (pr oba bilist ic or dice-t h r owin g) a n d u n pr edict a bilit y: u se probabilities over a ct ion s a n d t h e expected valu es of t h e possible ou t com e u se card in al m easu res over t h e a m ou n t s, u su a lly dolla r a m ou n t s, wh ich a r e u n a m bigu ou s, an d th e n u m bers m atter !

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Lect u r e 1-43

1.6 More Interactions

1.6.1 Battle of the Bismark Sea It s 1943: Actors : Adm ir a l Im a m u r a : or der ed t o t r a n spor t J a pa n ese t r oops a cr oss t h e Bism a r k Sea t o New Gu in ea , a n d Adm ir a l Ken n ey: wish es t o bom b Im a m u r a s t r oop t r a n spor t s. Decision s/ Action s : Im a m u r a : a sh or t er Nor t h er n r ou t e (2 da ys) or a lon ger Sou t h er n r ou t e (3 da ys) Ken n ey: wh er e t o sen d h is pla n es t o look for Im a m u r a s sh ips; h e ca n r eca ll h is pla n es if t h e r st decision wa s wr on g, bu t t h en loses on e da y of bom bin g. Som e sh ips a r e bom bed in a ll fou r com bin a t ion s. Ken n ey a n d Im a m u r a ea ch h a ve t h e sa m e a ct ion set {N orth , S ou th } bu t t h eir pa yoffs a r e n ever t h e sa m e. Im a m u r a s losses a r e Ken n eys ga in s: a ze ro sum game.

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Lect u r e 1-44

Th e B a ttle o f th e B is m a rk S e a Does a n y pla yer h a ve a dom in a n t st r a t egy? Wh a t is t h e m ost obviou s wa y t h e ga m e sh ou ld be pla yed?

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Lect u r e 1-45

Th e B a ttle o f th e B is m a rk S e a

Im am u ra Nor t h Ken n ey Nor t h Sou t h 2, 2 1, 1 Sou t h 2, 2 3, 3

TAB LE 5. Th e pa yoff m a t r ix (Ken n ey, Im a m u r a ) A n on -cooper a t ive, zer o-su m ga m e, wit h a n it er a t ed dom in a n t st r a t egy equ ilibr iu m . Th er e is n o ot h er equ ilibr iu m com bin a t ion : wit h a ll ot h er com bin a t ion s, a t lea st on e of t h e pla yer s st a n ds t o ga in by ch a n gin g h is a ct ion , given t h e ot h er s a ct ion . For Im a m u r a . goin g N wea kly dom in a t es goin g S. Neit h er pla yer h a s a d om in an t strategy .

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Lect u r e 1-46

P la y e rs c h o ic e s . Neit h er pla yer h a s a d o m in a n t s tra te g y : Ken n ey wou ld ch oose N orth if h e t h ou gh t Im a m u r a wou ld ch oose N orth , bu t S ou th if h e t h ou gh t Im a m u r a wou ld ch oose S ou th . So Ken n eys best r espon se is a fu n ct ion of wh a t Im a m u r a does. Im a m u r a wou ld ch oose N orth if h e t h ou gh t Ken n ey wou ld ch oose S ou th , bu t eith er if h e t h ou gh t Ken n ey wou ld ch oose N orth . For Im a m u r a , N orth is w e a k ly d o m in a n t. An d Ken n ey kn ows it a n d ch ooses N orth t oo.

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Lect u r e 1-47

Equ ilibriu m . Th e st r a t egy com bin a t ion (N orth , N orth ) is a n ite ra te d d o m in a n t s tra te g y e qu ilibriu m . (It wa s t h e ou t com e in 1943.) (N orth , N orth ) is a (Na sh ) equ ilibr iu m , beca u se: Ken n ey h a s n o in cen t ive t o a lt er h is a ct ion fr om N orth t o S ou th so lon g a s Im a m u r a ch ooses N orth , a n d Im a m u r a ga in s n ot h in g by ch a n gin g h is a ct ion fr om N orth t o S ou th so lon g a s Ken n ey ch ooses N orth . An d n eit h er pla yer h a s a (st r ict ly) dom in a n t st r a t egy. S ou th is a (wea kly) dom in a t ed st r a t egy for Im a m u r a .

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Lect u r e 1-48

A m a rk e t a n a lo g u e ? Two com pa n ies, K a n d I, t r yin g t o m a xim ise t h eir sh a r es of a m a r ket of con st a n t size by ch oosin g bet ween t wo pr odu ct design s N a n d S . K h a s a m a r ket in g a dva n t a ge, a n d wou ld like t o com pet e h ea d-t o-h ea d wit h I, wh ile I wou ld r a t h er ca r ve ou t it s own n ich e in st ea d of h ea d-t o-h ea d com pet it ion .

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Lect u r e 1-49

1.6.2 The Battle of the Sexes (A coor din a t ion ga m e: video VH S v. Son ys Bet a m a x; n ow t h e com pet in g st a n da r ds for digit a l a u dio disks: SACD (Son y & P h ilips) v. DVD-A (Tosh iba , Ma t su sh it a , P ion eer et c.) a n d DVD r ecor din g: DVD+R, DVD-R, DVD-RAM.)) T h e Players & Action s: a m a n (H a l) wh o wa n t s t o go t o t h e Th ea t r e a n d a wom a n (Sh ir l) wh o wa n t s t o go t o a Con cer t . Wh ile selsh , t h ey a r e deeply in love, a n d wou ld, if n ecessa r y, sa cr ice t h eir pr efer en ces t o be wit h ea ch ot h er. Th e pa yoff m a t r ix (m ea su r in g t h e sca le of h a ppin ess) is below. Wh a t a r e a ll equ ilibr ia ? (Wh ich pa ir s of a ct ion s a r e m u t u a lly best r espon se?)

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Lect u r e 1-50

Th e B a ttle o f th e S e x e s

S h irl Th ea t r e Th ea t r e H al Con cer t 1, 1 1, 2 TAB LE 6. Th e pa yoff m a t r ix (H a l, Sh ir l) A n on -cooper a t ive, posit ive-su m ga m e, wit h t wo Na sh equ ilibr ia . 2, 1 Con cer t 1, 1

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Lect u r e 1-51

Th e B a ttle o f th e S e x e s Th er e is n o it er a t ed dom in a n t st r a t egy equ ilibr iu m . Th er e a r e t wo N ash equ ilibria : (T h eatre, T h eatre): given t h a t H a l ch ooses T h eatre, so does Sh ir l. (Con cert, Con cert ), by t h e sa m e r ea son in g. H ow do t h e pla yer s kn ow wh ich t o ch oose? (A coor din a t ion ga m e.)

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Lect u r e 1-52

P la y e rs c h o ic e s . If t h ey do n ot t a lk befor eh a n d, H a l m igh t go t o t h e Con cer t a n d Sh ir l t o t h e Th ea t r e, ea ch m ist a ken a bou t t h e ot h er s beliefs. Foca l poin t s? Repet it ion ? E a ch of t h e Na sh equ ilibr ia is collect ively r a t ion a l (efcien t ): n o ot h er st r a t egy com bin a t ion in cr ea ses t h e pa yoff of on e pla yer wit h ou t r edu cin g t h a t of t h e ot h er. Th er e is a rs t-m o v e r a d v a n ta g e in t h is sequ en t ia l-m ove ga m e.

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Lect u r e 1-53

Ma rk e t a n a lo g u e ? An in du st r y-wide st a n da r d wh en t wo dom in a n t r m s h a ve differ en t pr efer en ces bu t bot h wa n t a com m on st a n da r d. Th e ch oice of la n gu a ge u sed in a con t r a ct wh en t wo r m s wa n t t o for m a lise a sa les a gr eem en t bu t pr efer differ en t t er m s. Bou gh t a DVD pla yer r ecen t ly? DVD, CDV, MP 3, CD, DVD-V, DVD+, et c. E m er gin g st a n da r ds m ea n ch oice a n d decision s for ea r ly a dopt er s.

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Lect u r e 1-54

1.6.3 The Ultimatum Game You r da u gh t er, Ma ggie, a sks for you r sa ge a dvice. Sh e h a s a gr eed t o pa r t icipa t e in a la b exper im en t . Th e exper im en t is t wo-pla yer ba r ga in in g, wit h Ma ggie a s P la yer 1. Sh e is t o be given $10, a n d will be a sked t o divide it bet ween h er self a n d P la yer 2, wh ose iden t it y is u n kn own t o h er. Ma ggie m u st m a ke P la yer 2 a n offer, Th en P la yer 2 ca n eit h er : a ccept t h e offer, in wh ich ca se h e will r eceive wh a t ever Ma ggie offer ed h im , or h e ca n r eject , in wh ich ca se n eit h er pla yer r eceives a n yt h in g. H ow m u ch sh ou ld Ma ggie offer ?

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Lect u r e 1-55

Ma g g ie s c h o ic e s . Dist in gu ish : th e ration alists an sw er fr om th e lik ely agreem en t in pr a ct ice fr om th e ju st agreem en t. Th e r a t ion a list : P la yer 1 sh ou ld offer P la yer 2 5 (t h e sm a llest coin ). P la yer 2 will a ccept , sin ce 5 is bet t er t h a n n ot h in g. Bu t offer in g on ly 5 seem s r isky, sin ce, if P la yer 2 is in su lt ed, it wou ld cost h im on ly 5 t o r eject it . Ma ybe Ma ggie sh ou ld offer m or e. Bu t h ow m u ch m or e? In -cla ss exer cise.

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Lect u r e 1-56

1.6.4 The Inheritance Game T h e players : E liza bet h , a n a ged m ot h er, wish es t o give a n h eir loom t o on e of h er sever a l da u gh t er s. T h e gam e: E . wa n t s t o ben et t h e da u gh t er wh o va lu es it m ost . Bu t t h e da u gh t er s m a y be dish on est : ea ch h a s a n in cen t ive t o exa gger a t e it s wor t h t o h er.

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Lect u r e 1-57

A s e c o n d -p ric e a u c tio n . so E . devises t h e followin g sch em e: a sks t h e da u gh t er s t o t ell h er con den t ia lly (i.e. a sea led bid) t h eir va lu es, a n d pr om ises t o give it t o t h e on e wh o r epor t s t h e h igh est va lu e t h e h igh est bidder get s t h e h eir loom , bu t on ly pa ys t h e secon d-h igh est r epor t ed va lu a t ion . Will E liza bet h s sch em e (a Vickr ey 1 a u ct ion , or secon d -price a u ct ion ) m a ke h on est y t h e best policy? Yes.

1. Th e la t e Bill Vickr ey sh a r ed t h e Nobel pr ize in econ om ics in 1996.

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Lect u r e 1-58

Wh y ? Th in k in g th ro u g h th e o p tio n s . Con sider you r r ea son in g a s on e of t h e da u gh t er s: t h r ee opt ion s: tru th fu ln ess, exaggeration , or u n d erstatem en t. Th e a m ou n t you pa y is in depen den t of wh a t you sa y it s wor t h , so t h e on ly effect of you r r epor t is t o det er m in e wh et h er or n ot you win t h e h eir loom , a n d h en ce wh a t you m u st pa y. E xaggeration : t h e possibilit y t h a t you m a ke t h e h igh est r epor t wh en you wou ld n ot ot h er wise h a ve, h a d you been h on est . i.e., t h a t t h e secon d-h igh est r epor t , t h e on e you n ow exceed, is h igh er t h a n you r t r u e va lu a t ion . Bu t t h a t wh a t you m u st pa y (t h e secon d-h igh est r epor t ) is m or e t h a n wh a t you t h in k t h e h eir loom is wor t h . E xa gger a t ion n ot in you r in t er est . Un d erstatin g ch a n ges t h e ou t com e on ly wh en you wou ld h a ve won wit h a n h on est r epor t ; bu t n ow you r epor t a va lu e lower t h a n t h a t of on e of you r sist er s, so you do n ot win t h e h eir loom . Not in you r in t er est eit h er.

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Lect u r e 1-59

It w o rk s . So t h e m ot h er s sch em e wor ks, a n d t h e t r u t h is obt a in edbu t a t a pr ice, t o E liza bet h , t h e Mu m . E . r eceives a pa ym en t less t h a n t h e su ccessfu l da u gh t er s va lu a t ion , so t h is da u gh t er ea r n s a pr ot : = h er va lu a t ion t h e 2n d-h igh est va lu a t ion . = t h e pr em iu m t h e m ot h er for goes t o in du ce h on est y

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Lect u r e 1-60

Ma rk e t An a lo g u e ? Th in k: h ow ca n t h e n eigh bou r s wh o pr opose bu ildin g a pa r k over com e ea ch h ou seh olds t em pt a t ion t o free-rid e on t h e ot h er s effor t s by cla im in g n ot t o ca r e a bou t t h e pa r k, wh en con t r ibu t ion s sh ou ld r eect t h e h ou seh olds va lu a t ion of t h e pa r k? H ow ca n t h e u ser s of a sa t ellit e be in du ced t o r evea l t h eir pr ot s so t h a t t h e oper a t in g cost of t h e sa t ellit e ca n be divided a ccor din g t o t h e pr ot ea ch u ser ea r n s? \ &