Game Theory

The Power to Constrain

an Adversary Depends Upon
the Power to Bind Oneself.
- Thomas Schelling
Mike Shor
Lectures 7&8

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
Game Theory - Mik

Finite Repetition

Unraveling prevents cooperation if the

number of periods is fixed and known
Probabilistic termination

The game continues another round

with some probability p:

Equivalent to infinite game

1
$1 next period is worth 1 r p today
Value of future = { value if there is a future }
{ probability of a future }
Effective interest rate: r = (1+r)/p 1
Game Theory - Mik

Lessons

Be careful of finite games

Always a chance of another encounter

Balance severity of punishment!

Mild punishment may not
deter cheating
Severe punishments may not
be credible
Game Theory - Mik

Credibility & Commitment

The difference between genius and
stupidity is that genius has its limits.
- Albert Einstein
The difference between 'involvement'
and 'commitment' is like an eggs-andham breakfast: the chicken was
'involved' - the pig 'committed'.
- Unknown
Game Theory - Mik

Talk is Cheap

Promises
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
Continental Airlines has dropped its plan to raise
domestic airfares by 5%.
- USA Today September 4, 1992
Game Theory - Mik

Talk is Cheap

Threats
On January 5, Boeing, the worlds top aircraft
maker, announced it was building a plane with
600 to 800 seats, the biggest and most
expensive airliner ever. Some in the industry
suggest Boeings move is a bluff to preempt
Airbus from going ahead with a similar plane.
- Business Week, 1993

Game Theory - Mik

 And Getting Cheaper

Airbus announces commercial launch of
the A3XX, the largest civil aircraft ever
built.
Boeing has said that there is no market
for such a large plane and has decided to
modernize its trustworthy 747 family of
planes rather than build its own
megaseater.
- Associated Press June 23, 2000
Game Theory - Mik

Conventional Wisdom
Dont burn bridges.
Decrease downside risk.
It is nice to have more options.
While you may have money to
burn, you shouldnt burn money

Game Theory - Mik

Strategic Commitment

You are not credible if you propose

to take suboptimal actions.

Specifically, if a rational actor

proposes to play a strategy which
earns less than maximal profit.

How to be credible?
Game Theory - Mik

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Credibility

Remove strategies

Reduce payoffs

from your own set of future choices the

strategies that may tempt you in the future
Giving away your patent?
from those strategies that may tempt you
Customers as hostages.

Become irrational

Remove human meddling

Game Theory - Mik

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A Non-credible Threat

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

Game Theory - Mik

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A Non-credible Threat

I threaten not to deal with a late supplier

(at most one)

Two equilibria:
All deliver on time
All deliver late (the likely equilibrium)
Even if only one other supplier delivers
late, it is in my best interest to do so:
(80) > 30
Game Theory - Mik

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A Credible Threat
I number suppliers (110) and
refuse delivery from the lowest
numbered one among those who are
late.
Supplier 1 delivers on time (better
than getting nothing)
Thus, supplier 2 delivers on time

Game Theory - Mik

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Removing Strategies I

Delegation
In contract negotiation, can squabble over
many details
Instead, 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 wont allow me to do what you ask
Game Theory - Mik

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Delegation Examples

Human resource departments

Collection agencies

Shield from requests for higher salaries

HR execs not compensated based on employer
value
shield from pleas or threats of the debtor
reinforce repayment to protect reputation

Accounting firms overseeing contests

Accountants payment not tied to outcome

Concerned with reputation for fairness

Game Theory - Mik

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Removing Strategies II

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

The Patch
Hunt for Red October
Cortes upon arriving in Mexico

Game Theory - Mik

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Burning Bridges
(Example 1)
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 firm
Commit to chip supply to production plants
Commit to no opportunistic behavior

Game Theory - Mik

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Burning Bridges
(Example 2)

Capacity constraints
New entrant commits to low production
The puppy-dog ploy

Puppy Dog Ploy

Stay weak to avoid an aggressive response

Apple v. Microsoft
Game Theory - Mik

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Removing Strategies III

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
Game Theory - Mik

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Dr. Strangelove

Severity
Create fear in the mind of the enemy

Irreversibility
Must be irreversible

Irrationality
Not something a sane man would do

Practicality
Punishment shouldnt be too harsh

Clarity
Tell the world

Game Theory - Mik

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Use of Contracts

Promises vs. Threats

Promises can sometimes be credible
through a contract with the party to whom
you are making the promise
Not always: Mario Puzos The Godfather
Threats can never become credible by use
of a contract with the party you are
threatening
Must contract with third party

Game Theory - Mik

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Reducing Payoffs

Contracting with customers to

commit to competitors
Price-matching
Most Favored Customer clauses

Contracting with lenders to commit

to a take-over
Interest-rate rise if loan amount increases

Game Theory - Mik

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Example From Long Ago

Two firms: Firm 1 and Firm 2

Two prices: low ($4) or high ($5 )
3000 captive consumers per firm
4000 floating go to firm with lowest price
Firm 2
Firm 1

Low
High

Low
20 , 20
15 , 28
Game Theory - Mik

High
28 , 15
25 , 25
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Contracting with Customers

The game is a prisoners dilemma

Both firms prefer:
{High,High}
Only equilibrium:
{Low , Low}
Cannot credibly promise to play High
Even if committed to High,
other firm would still respond with Low

How to resolve this?

Third party contracts with customers

Game Theory - Mik

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Most Favored Customer

Say in period 1, the firms colluded and

each sold to 5000 customers

In period 2, firms must refund to last

periods customers $1 each if price is low

What is the impact on the game?

Game Theory - Mik

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Most Favored Customer

Firm 2
Firm 1

Low

Low
20 , 20

High
28 , 15

High

15 , 28

25 , 25

Firm 2
Firm 1

Low
High

Low
15 , 15
15 , 23

Game Theory - Mik

High
23 , 15
25 , 25
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Contracting with Lenders

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:
$210 million:
with penalty:

$18.6 million / year

$19.6 million / year
$21.9 million / year

Game Theory - Mik

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Extravagance in Nature

Game Theory - Mik

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Extravagance in Business

Game Theory - Mik

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Irrationality

Burning money
Commit to long-term market plan
Commit to high quality products

Firm can produce high or low quality

Customers cannot observe quality
Once customers buy a product the first time,
observe quality, punish dishonest firms

Quality

Marginal cost Value

High

$8

Low

$4
$20
Game Theory - Mik

$50
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Burning Money

Producing high quality is more profitable

$50 - $8 = $42 > $16 = $20-$4

Pretending you are high quality is best

$50 - $4 = $46

Incentive to lie:
Customers do not believe in high quality
Customers only pay for low quality
Firm only produces low quality
INEFFICIENT AND UNPROFITABLE

Game Theory - Mik

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Burning Money

Announce high quality and burn $50

Quality

Profit

High

$42/year

Money
Burned
$50

Net Profit

Low

$46 once

$50

$8 loss this year,

$42 in the future
$4 loss this year

No
Entry

$0

$0

$0

Game Theory - Mik

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Burning Money

By burning $50, convince

customers of your high quality:
$8 loss this year, $42 profit in the future

Without burning money, can only

sell low quality:
$16 profit this year and in the future

Gaining credibility by burning $50

Invest in future relationship with customers
Game Theory - Mik

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Forcing Your Opponent

Similar tactics for making your opponent

commit to strategies in your favor
Increasing his strategy space
Excluding bargaining agents
Lowering his payoffs
Poison pills
Raising his payoffs
Reputation bolstering
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Price Matching

If one firm charges low, it does not

gain any additional customers, since
the competitor automatically
matches it.

What is the effect on the game?

NASDAQ order preferencing?

Game Theory - Mik

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Price Matching
Firm 2
Firm 1

Low

Low
20 , 20

High
28 , 15

High

15 , 28

25 , 25

Firm 2
Firm 1

Low
High

Low
20 , 20
20 , 20

Game Theory - Mik

High
20 , 20
25 , 25
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Commitment Is
Counterintuitive

Hurt yourself to help yourself

Help your opponent to help yourself
COMMANDMENT.
Reduce your strategy space and
decrease your own payoffs to commit.
Increase your opponents strategy space
and alter your opponents payoffs
to
preclude the rival from committing.
Game Theory - Mik

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Commitment
Under Uncertainty

An offer you cant refuse

After a seemingly successful interview, the

interviewer asked where the firm ranks on
your list of potential employees
Before answering, you are told:
The firm only hires applicants
who
rank it first
If the firm is in fact your first choice,
then you must accept a job offer in
advance, should one be made

Game Theory - Mik

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Commitment
Under Uncertainty

What to do?

Binding early-decision
college applications

Why make such proposals?

Take advantage of your uncertainty
Take advantage of your risk-aversion
Make you commit before they do!

Game Theory - Mik

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Flexibility vs. Commitment

Flexibility in light of uncertainty about

eventual outcomes generates value
Keeping your options open
Must be balanced against strategic value
of commitment
Option Value:
The additional expected profit from
remaining flexible above the expected profit
earned from committing
Game Theory - Mik

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Example
Option Value of Delay

A firm can spend $100 million on an

investment to enter a new market

Market demand uncertain:

High acceptance: revenues of $300m
(Probability=0.5)
Low acceptance: revenues of $50m
(Probability=0.5)

Two options:

Invest today in the presence of uncertainty

Wait a year for full revelation of information

Game Theory - Mik

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Calculating Option Value

Immediate investment:
E[]=(1/2)(300-100) + (1/2)(50-100) = $75 million

Delayed investment:
Only invest if high acceptance
E[]=(1/2)(300-100) + (1/2)(0)

= $100 million

Option value:
$100 - $75 = $25 million

Countervailing force: by waiting, the firm risks

having the opportunity pre-empted by competitors
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Philips, N.V.

Capacity commitment in CD introduction

Philips: innovators advantage
Initiate construction of plant ahead of
competitors

Decision problem of Philips in 1982:

Build a disk-pressing plant in the U.S. And
invest in a substantial amount of capacity to
deter potentially entry (Sony, etc.)
Delay decision until commercial appeal of
CDs can be determined. Import CDs to the
U.S. To test the waters.

Game Theory - Mik

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Option Value: Three Cases

q probability of mass acceptance of CDs

Monopoly Benchmark:
Philips should wait if q < 0.380

Sony competition, equal information

Philips should wait if q < 0.006

Sony competition, better information

Philips should wait if q < 0.130
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Summary

Pure option value

In the absence of competition, Philips would have
been better off waiting and retaining flexibility if the
probability of acceptance was 0.38 or lower

Commitment value
Faced with competitors who are as well informed,
Philips would be better off building the U.S. plant
right away even in the presence of uncertainty

Informational advantage
Given proprietary information through its CD
operations in Europe, Philips should remain flexible
if the probability of acceptance was 0.13 or lower

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Evidence

Philips did not build a U.S. Plant in 1983

Its assessment of the likelihood of general
acceptance did not meet the threshold

Market realization (surprise!)

Sony constructed a U.S. Plant in 1984
Terry Haute, Indiana

Philips attempted to compete

Increased capacity in Hanover, Germany plant

Philips decided to invest in a U.S. Plant

Only after the Sony plant was fully operational

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