Introduction to practical Game Theory

and its corporate applications

Prepared by Manbo Li
May 8, 2002
Opening Experiment

• Each of you give me one buck;

• Each of you pick one number between 1 and 100.

Then we take the average of all the numbers you
pick, and multiple it by 60% and get number X;

• Whoever picks the number that is closest to this

number X will get all the money.

2
An example of irrationality in reality
• Rationality is a foundation assumption for Game Theory

• If one is rational, he would assume everyone start with 50,

the average between 1 and 100. So he will further reason that
the final number will be 30 - however, if every one is thinking
the same way, everyone will pick 30, so the final number
should be 18… then he continue to think in this way again
and again until he picks zero - the equilibrium point!

• However, that’s never the case in reality - in group

experiments, the final number that appears most often is
around 17, given a large enough sample size.

• Actual outcome depends on how smart the group is, or how

smart (stupid) the group thinks their peers are;

3
Agenda

• Game Theory in Definition

• Game Theory in Illustration

• Game Theory in Application

4
Agenda

• Game Theory in Definition

• Game Theory in Illustration

• Game Theory in Application

5
What is Game theory? - many definitions, but
you got the point

• Study of rational behavior in situations involving

interdependence. (McMillan, economist)

• A formal way to analyze interactions among a

group of rational agents who behave strategically
(Dutta, economist)

• In war the will is directed at an animate object that

reacts (Karl von Clausewitz, general)

6
Key elements of a game we will visit many
times in today’s discussion
• Assumption for players
– Rationality (not doing crazy things)
– Self-interested (to maximize own utilities)

• The strategic environment

– Who are the players? (decision makers)
– What actions are available? (strategic options)
– What are the payoffs? (objectives)

• Rules of the game

– What is the time frame? (Repeat game vs. one-shot
interaction)
– What is the nature of the interaction? (sequential vs.
simultaneous)
– What information are available? (symmetric vs. asymmetric)
– What’s the nature of the conflict? (seriousness and players’
posture)
7
Game theory is everywhere - Economics &
Business
• “Game theory is hot!” - Wall Street Journal, 13
February 1995, P. A14
– Auctioneer and bidders, such as in FCC Spectrum
auctions in 1993 where government employed a game
theory professor to design auction methods ;
– Labor union negotiation with employer & repeated game;
– Negotiation between buyer and seller;
– Airlines’ price wars & tacit collusion;
– Timing of launch of new products in IT industry;
– Evaluation in merger and acquisitions & winner’s curse;
– Insurance companies vs. the insured & asymmetric
information;
– Others ...
8
Game theory is everywhere - Beyond
Economics & Business

• Presidential election
• International relations
• Office politics
• Dating strategies
• War
• Sports games
• Recruiting
• Everything...

9
Game theory is everywhere - Even hot in Pop
Culture these days

• John Nash &

Nash equilibrium
• 2001 • Prisoner’s
dilemma
• 2002
• Game of
chicken
• 2000 10
Agenda

• Game Theory in Definition

• Game Theory in Illustration

• Game Theory in Application

11
Prisoner’s dilemma - the classic game as a
example throughout our discussion
A
Don’t Confess

Don’t 3, 3 5, -5
B

Confess
-5, 5 0, 0

• Player: A & B;
• Payoffs: (a, b);
• Strategies: (don’t confess, confess) 12
Nash Equilibrium
• Nash equilibrium
– For every game, there exists at least one set of
strategies, one for each player, such that each
player’s strategy is best for her given that all other
players are playing their equilibrium strategies

• key condition
– No incentive to unilaterally change my strategy
– The strategies employed can be mixed strategies

• A byproduct theorem by Nash in his proof using

Topology
– For every human head, there exists at least one
swirl.

13
Prisoner’s dilemma - the equilibrium is not
necessarily the best payoffs
Person A
Don’t Confess

Don’t 3, 3 5, -5
Person B

Confess
-5, 5 0, 0
Equilibria

14
Agenda

• Game Theory in Definition

• Game Theory in Illustration

• Game Theory in Application

15
Conventional business strategy focuses on
understanding the static environment

• Who are the players?

• What strategic options are available?
• Who are the payoffs and objectives?

“3 Cs”
“Porter’s
5 forces”
“Core
Competence”
Others...
16
Game theory driven strategy formulation
focuses on Dynamics and Change the Rules
– What’s the nature of the conflict? – Game of Chicken
(seriousness and players’ posture)

– What is the nature of the interaction? – Game of Assurance

(sequential vs. simultaneous)

– What is the time frame? – Game of Collusion

(Repeat game vs. one-shot interaction)

– What information are available? – Winner’s Curse

(symmetric vs. asymmetric)

Good news: all of these rules can be changed,

manipulated or influenced to our advantage
17
I. Change the nature of the conflict - Game of
Chicken
Incumbent
Accommodate Fight

Don’t Enter 10, 0 10, 0

Equilibria
Potential
entrant
Enter
5, 5 -5, -5
Equilibria

18
Commitment and posture matters –
Perception Is Reality

• Two Equilibria exist - but incumbent wants the

equilibrium of (10, 0)

• To achieve this Equilibria, incumbent needs to

convince that he will fight to death if entrant enters

• Ways of convincing the rival:

– Serious commitment such as preemptively building
extra capacity in manufacturing and airline industry;
– Perception of being “tough” - bluff, PR, advertising,
and etc;
– Historical behaves to make credible threats

19
A real event...
Radio conversation released by the Chief of Naval Operations, 10-10-95.

#1: Please divert your course 15 degrees to the North to avoid a

collision.

#2: Recommend you divert YOUR course 15 degrees to South to avoid a

collision.

#1: This is the Captain of a US Navy ship. I say again, divert YOUR
course.

#2: No. I say again, you divert YOUR course.

#1: THIS IS THE AIRCRAFT CARRIER ENTERPRISE, WE ARE A LARGE

WARSHIP OF THE US NAVY. DIVERT YOUR COURSE NOW!

#2: This is a lighthouse. Your call.

20
II. Change the timing of the conflict - Game of
Assurance
Firm A
(Market Leader)
Don’t Promote/Invest new standard/product

Don’t 5, 5 0, 5
Equilibria
Firm B

Promote
5, 0 10, 10
Equilibria

21
Leadership and first move matters – snowball
effect in industry standardization
• Two Equilibria exist – “Invest & promote” is best
for all but very risky

• Ways of getting to the ideal equilibrium (10,10):

– Market leader must commit first and make the initial
move, rather than waiting for everything to happen
at the same time;
– Turn simultaneous game into sequential game, and
minimize uncertainty

Example: IP over voice, Java based banking and etc –

all are new standards and risky today given still
premature technology and services;
Do you have the right to influence the equilibrium?
22
Game in extensive form to demonstrate a
sequential move
(10, 10)
Invest
B
Invest Don’t

A (0, 5)
Leader Don’t
(5, 0)
Invest
B
Don’t

(5, 5)
23
III. Change the interaction of the conflict -
Game of Collusion
Airline A
don’t cut price Repeated learning and
cooperation process
don’t (5,5) (10,-5)
Airline Equilibria
B
cut (-5,10) (0,0)
price

Airline A
don’t cut price

don’t (5,5) (10,-5)

Stable
Point Airline
B
cut (-5,10) (0,0)
price
24
Repeatability and punishment matters – tacit
collusion in industry “co-petition”
• A variation of prisoner’s dilemma
• One mutually damaging Equilibria exists
• How to avoid it?

• Ways of getting to the optimal equilibrium (5,5):

– Signaling: announce commitment of price level through
press and advertising;
– Punishment: if A cuts price in period 1, B will cut prices
in the next 3 periods in a row no matter what A does;

Example: card issuers undercut each other

though 0% APR, fee waiving and other
measures - are there any ways that you can
slow down this path to non-profitability??
25
IV. Change information flow of the game -
Winner’s Curse

• What is winner’s curse?

– Lack of information or asymmetry of existing
information on the bidder or buyer side make the
winner actually a loser

• Examples
– Auction
– Merge & Acquisition
– LBO
– Others

26
Winner’s Curse in action - one example in
bidding
• In dotcom heydays, brick & mortar A, as one of the bidders,
wants to acquire Internet startup B of the same industry, with
assumed 50% added synergy generation;
• You know, accurate evaluation is almost impossible here: in
A’s assessment, the highest potential value is $100MM and
the actual outcome could be evenly spread between 0 and
$100MM;
• So A bid $50MM and won -- a perceived total value of
$50MM*(1+50%)=$75MM;
• But in fact B wouldn’t sell itself unless offer is equal to the
highest potential it feel it can reach; So the highest actual
value of the acquisition is $25MM*(1+50%)=$37.5MM, far
below the prices A pays for!

27
An example of how to avoid Winner’s Curse
• Before 1960s, American oil companies who won the
drilling right in certain area always later found themselves
in the business of losing money;

• After 1960s, American oil companies who participated in

bidding:
– always only offer a fraction (0.65 ~ 0.75) of their estimated
value in bidding for overseas drilling rights
– spend money in testing in adjacent fields;
– those who see critical strategic benefit in certain fields took
out full-page ads to signal their intention so others stayed
out;

Example: how should we gather and benchmark

information to make right decision in acquisition
and vendor selection? 28
Q&A

29