Game Theory “The difference between genius and stupidity is that genius has its limits.” - Albert Einstein Mike Shor Lecture 7

Game Theory

“The difference between genius and stupidity is that genius has its limits.”

- Albert Einstein

Mike ShorLecture 7

Punishment and Credibility

Review Cooperation requires sacrificing immediate profits

for a future relationship

The sacrifice is only made if the punishment is severe enough

Punishment that is too severe is not credible

Outline: What is credibility? Payoffs, strategies, irrationality A credibility check list

Mike ShorGame Theory & Business Strategy

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The Winning Lottery Ticket

“It won’t change me one bit!”


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What is Credibility?

“The difference between genius and stupidity is that genius has its limits.”

– Albert Einstein

Telling you I’m going to act in my best interest is not committing

To commit to a suboptimal action, I need to: Change the game Change perceptions


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How to be Credible?

Reduce payoffs from those strategies that may tempt you

Make it costly to renege

Remove strategiesfrom among those that may tempt you in the future

Destroy avenues of retreat

Become irrationalby eliminating strategic control

Remove “human meddling”Mike Shor

Game Theory & Business Strategy5

Talk is Cheap

“ Continental Airlines said yesterday that it would raise airfares on about two-thirds of its routes … to take effect September 5.” - The New York Times August 29, 1992


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Commitment

Must commit to be credible!

“The difference between ‘involvement’ and ‘commitment’ is like an eggs-and-ham breakfast:

the chicken was ‘involved’ – the pig was ‘committed.’ ”


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Commitment vs. Involvement

Two firms considering market entry: Market potential is $10 million NPV profits Entry costs $7 million

It is in our best interest to stay out if we think that the other firm will enter


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In Out

UsIn -2 , -2 3 , 0

Out 0 , 3 0 , 0

Them

Involvement

We make an initial investment: Invest first $1 million to deter entry

It is still in our best interest to stay out if we think that the other firm will enter


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In Out

UsIn -2 , -2 3 , 0

Out -1 , 3 -1 , 0

Them

Commitment

We make an initial investment: Invest first $3 million to deter entry

Now, it is our dominant strategy to enter regardless of what the other firm will do


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In Out

UsIn -2 , -2 3 , 0

Out -3 , 3 -3 , 0

Them

Credible Commitment

By reducing our own payoffs from staying out, we have committed to entry

Other examples: Financing of takeovers


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Reducing Payoffs: Contracting

Takeover offer:$200 million You can “afford” $20 million / year Finance takeover for 20 years at 7%

Add penalty: if amount greater than $200 million, +1.5 points on interest rate

Annual Payments:$200 million: $18.6 million / year$210 million: $19.6 million / yearwith penalty: $21.9 million / year


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Credible Threats

Targeted threats are generally more credible than blanket threats

But what if a blanket threat is exactly what we need? Assign responsibility to alter incentives


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From Incredible to Credible

Ten suppliers each have two options: Deliver on time at a cost of $70,000 Deliver a week late at a cost of $20,000

Delivery results in $100,000 payment

I need at least nine suppliers and the suppliers know this


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A Non-Credible Threat

I threaten not to deal with any supplier who delivers late But, suppliers know that I can punish at most one

Two equilibria: All deliver on time All deliver late (the likely equilibrium) Even if I think that only one other supplier will

deliver late, it is in my best interest to do so: ½ (80) > 30


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A Credible Threat

I number the suppliers arbitrarily: 1…10 I refuse delivery from the lowest numbered

supplier among those who are late

Result: Supplier 1 delivers on time

(better than getting nothing) Thus, supplier 2 delivers on time …


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Removing Strategies I

You are not always better off with more options.

DelegationIn contract negotiation, can “squabble” over

many detailsInstead, send an agent with power of attorney

to “sign as is” or “walk away”Haggling over prices in a department store

Learn from government bureaucracy: “The rules won’t allow me to do what you ask!”


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Delegation Examples

Human resource departments Shield from requests for higher salaries HR execs not compensated based on employer

value

Collection agencies shield from pleas or threats of the debtor reinforce repayment to protect reputation

Accounting firms overseeing contests Accountant’s payment not tied to outcome Concerned with reputation for fairness


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Removing Strategies II

Sometimes, you should burn bridges.

Burning Bridges Power comes from not being able to retreat Allow opponent to retreat (Sun Tzu)

The nicotine patch Hunt for Red October Cortes upon arriving in Mexico


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Burning Bridges Example

Semiconductor patent sharing

“Mosaid Technologies, a designer and licensor of semiconductor chips and technologies, just announced a patent sharing deal with Mitsubishi Electric”

Share patent with another competing firmCommit to chip supply to production plantsCommit to no opportunistic behavior


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Building Bridges

Build bridges for your opponents.

“When you surround an enemy, you must leave an outlet for him to go free.” – Sun-Tzu

Jimmy Hoffa’s negotiation lesson:

What is the single most important thing for a negotiator to know?


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Commitment Is Counterintuitive


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COMMANDMENTCOMMANDMENT

Reduce your strategy space and decrease your own payoffs to commit.

(Hurt yourself to help yourself)

Increase your opponent’s strategy space

to preclude the rival from committing.(Help your rival to help yourself)

Irrationality

U.S. / U.S.S.R. nuclear deterrence Mutually Assured Destruction (MAD)

like Grim Trigger Strategy

Proportional Response like Tit-for-Tat

Want a lot of deterrence Want irrationality to be credible Dr. Strangelove & the Doomsday device


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Irrationality

A takeover defense tactic: “I will burn the factories down!”

If threatening the irrational – take it out of your control, permanently

Reversible commitment is akin to no commitment at all


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Dr. Strangelove The Credibility Checklist

Severity “Create fear in the mind of the enemy”

Irreversibility “It is essential”

Irrationality “Not something a sane man would do”

Practicality “It wasn’t a practical deterrent”

Clarity “Tell the world”


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Changing the Rules

Question the clichés: Less options may be better Sometimes, burn bridges

Commitments change the game. Which game is best for you to play?

Looking ahead: How commitments can resolve

the prisoner’s dilemma


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Documents

Game Theory “The difference between genius and stupidity is that genius has its limits.” - Albert Einstein Mike Shor Lecture 7