Game Theory “In war the will is directed at an animate object that reacts.” - Karl Von Clausewitz, On War Mike Shor Lecture 2

Game Theory

“In war the will is directed at an animate object that reacts.”

- Karl Von Clausewitz, On War

Mike ShorLecture 2

Mike ShorGame Theory & Business Strategy

2

Defining the Game

Review Game theory is a description of strategic

interaction between mutually aware players You are self-interested and selfish So is everyone else

Outline: Defining the rules of the game Manipulating the rules if they are flexible Questioning game theory’s assumptions


3

Rules of the Game The strategic environment

Players Strategies Payoffs

The rules Timing of moves Nature of conflict and interaction Informational conditions Enforceability of agreements or contracts

The assumptions Rationality Common knowledge


4

The Strategic Environment

PlayersEveryone who has an effect on your earnings

StrategiesActions available to each playerDefine a plan of action for every contingency

PayoffsNumbers associated with each outcomeReflect the interests of the players


5

The Rules

Timing of movesAre moves simultaneous or sequential?

Nature of conflict and interactionAre players’ interests in conflict?Will players interact once or repeatedly?

Informational conditionsAre some players better informed?

Enforceability of agreementsCan contracts be enforced?


6

Example: Toys “R” Us Sequential timing

Threat Manufacturer’s decisionsHow will my opponents react?

Simultaneous timing Manufacturer’s decisions

What is my opponent doing right now? Information

Future profitability of warehouse clubsWhat can I infer from the actions of others?

Agreements Enforceability of contracts & agreements

What happens if someone breaks the agreement?


7

Changing the Rules

Are the rules of the game fixed?

COMMANDMENT

When the rules of the game are flexible manipulate them to your advantage.


8

Example:Agenda Setting

Gore v. Bush before the U.S. Supreme Court

Four judges prefer: Bush to Gore to Remand ( B > G > R )

Three judges prefer:Gore to Remand to Bush ( G > R > B )

Two judges prefer:Remand to Bush to Gore ( R > B > G )

Voting by Majority Rule


9

Agenda Setting (continued)

No majority in three way race Chief Justice selects voting rules:

First, Bush v. GoreThen, Bush/Gore winner versus Remand

First, Bush v. RemandThen, Bush/Remand winner versus Gore

First, Gore v. RemandThen, Gore/Remand winner versus Bush


10

Agenda Setting (continued) Recall member preferences:

4 (B>G>R) 3 (G>R>B) 2 (R>B>G)

Majority rule results: B beats G ; G beats R ; R beats B

Voting results: B beats G then winner versus R R B beats R then winner versus G G G beats R then winner versus B B


11

The 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.


12

Common Knowledge

Do people really behave as the theory predicts?

If not, what good is the theory?


13

Common Knowledge

Examples Intentional failure to coordinate

Financial and grade disclosure

Bluffing

Stock market


14

The Stock Market& Rationality

“I can calculate the motions of heavenly bodies, but not the madness of people”

- Sir Isaac Newton(upon losing £20,000 in the South Sea Bubble in 1720)

QUESTION:

When would a sell-off occur if we knew the exact date of a bubble’s burst?


15

Greater Fool Theory

He who panics first wins

You may be a fool to pay as much as you did, but you are betting that there’s a greater fool down the road.

And if you’re right, then of course you aren’t being foolish.


16

often is a good month for stocks” is typically a strong month for stocks” tends to be a good month for stocks” is usually a good month for stocks”

is typically a bad month for the stock market”

is usually the worst month for stocks” is traditionally a cruel month for stocks” is the worst month for stocks”

“_________ “_________ “_________ “_________

“_________ “_________ “_________ “_________

Which Month Am I?


17

Fun with Probabilities

If, in each month, the stock market is equally likely to go up or go down, then there is over an 80% chance that some month will be “bad” three years in a row!

Why is October so bad?


18

October 1987


19

– Wall Street Journal, quoting Mark Twain

The Worst Month for Stocks

“ October. This is one of the peculiarly dangerous months to speculate in stocks. ”


20

Wall Street JournalMay 1988

Front Page Story:

“Clear Road Ahead …”

“Will record gains through the fall” “October looms on the horizon …

the dreaded though inevitable slide.”


21

1988

01234

MAY


22

Excess Returns prior to IPO Lock-Up Expiration

Event Day

Cum

ulat

ive

Abn

orm

al R

etur

n

-20 -16 -12 -8 -4 0 4 8 12 16

0.005

0

-0.005

-0.010

-0.015

-0.020

-0.025

-0.030


23

What is a “Step”?

“Now keep in mind this is

just a ballpark figure”


24

Summary

You’re in a game The rules are likely to be flexible Think one step ahead The rule of three steps

Looking ahead: Equilibrium:

What are the outcome of games?

Documents

Game Theory “In war the will is directed at an animate object that reacts.” - Karl Von Clausewitz, On War Mike Shor Lecture 2