WIRTSCHAFTSUNIVERSITÄT WIEN

DEPARTMENT OF STRATEGY AND INNOVATION

INSTITUTE FOR MARKETS AND STRATEGY

SBWL Strategy and Data

Strategic Thinking and Analysis I

Lecture I-1
 Organization
 Name tags

 Aims of this course:

• Economics (game-theoretical) tools applied to
managerial decision-making

• Strategic thinking
• Analysis of strategic situations and behavior
• (Behavioral insights)

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 Organization
 About your lecturers:

• Lecturer: Christine Grimm (you will meet in lecture 2)

• Lecturer: Diya Abraham - from India, Bachelor in

Math, Master in Econ; Research - trust, vulnerability,
public goods.

• TA: Anna Pilipentseva (participation + data +

experiments)

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 Organization
 About you:

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 Organization
 About your lecturer
 About you

 Contact (D5, 4th floor)

• Administrative: ims@wu.ac.at
• Content: diya.abraham@wu.ac.at;
christine.grimm@wu.ac.at

 Consultations after appointment by email.

 Learn@WU: slides, assignments, instructions,
data, other materials …
 Ask questions!
 (Some answers may need a little more time.)
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 Organization
 This course will be taught as a combined lecture/tutorial
spanning the three hours in each meeting.

 Wednesdays in D4.0.022

 First 2-2.5 hours:

• Discussions with student input, lecture

 Last 0.5-1hour:
• Experiments in oTree

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 Organization
 Experiments:
• Interactive decision situations
 Homework: Analysis of:
• strategic situations
• data from real decisions
• individually or in groups of up to 3
 Participation and discussions:
• Cold calls
• Comment, question, answer
 Lecture:
• Game-theoretical background, research findings
• Slides after class

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 Experiments
 Interactive economic decision situations
 For research: real money

 Typical procedure:
• You receive written instructions about a situation,
describing your role, your choice options, and their
consequences.

• You make decisions (orally, pen and paper, computer).

• You are informed about outcomes.

• Repeat …
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 Laboratory

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 Experiments
 (borrowed from Bergstrom & Miller’s preface)

Taking part in classroom experiments is a little like going

to dinner at a cannibal’s house. Sometimes you will be the
diner, sometimes you will be part of the dinner,
sometimes both.

If you are in the laboratory in the physical sciences, you

get to mix smelly chemicals, or dissect a frog, but you are
always the experimenter and never the subject of the
experiment. In the experiments conducted in this class,
you and your classmates will be the participants as well as
the scientific observers who try to understand the results.

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 Experiments
It is hard to imagine that a chemist can put herself in the
place of a hydrogen molecule. A biologist who studies
animal behavior is not likely to know what it feels like to
be a duck.
You are more fortunate. You are studying the behavior
and interactions of people in economically interesting
situations. And as one of these interacting economic
agents, you will be able to experience the problems faced
by such an agent first hand. We suspect that you will learn
nearly as much about strategic analysis and behavior from
your experience as a participant as you will from your
analysis as an observer.

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 Experiments

 Let’s start right away with an experiment:

THE TRADING PIT

 Read instructions

 Come and pick up the paper corresponding to your

Experiment ID.

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 Trading pit market
 Buyers (Apple Demanders)  Buyer Value $V
 Sellers (Apple Suppliers)  Seller Cost $C
 Suppliers and Demanders find each other and trade  $P
• Apple Supplier income: $P – $C
• Apple Demander income: $V – $P
• If no trade: income $0 (better than loss!)
 Each person can be involved in one transaction only.
 Go around the room and find trading partners, negotiate
prices. Come to the front to report your contract to me:
exp id seller, exp id buyer, price.
 Shared Excel sheet: lists trades and prices.
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 Experiments

Experiment

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 Experiments
 How did it feel?

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 Experiments
 In each experiment, you will earn Experiment-Dollars E$
 Handle these E$ as if it were real dollars, that is: as if they
have value to you. Only then your decisions will be
economic decisions.
 To support this view:
• All the E$ you earn in the experiments of this course
will be added up.
• In the last lecture of the course, each of your E$ will be
converted into a lottery ticket.
• Out of all lottery tickets earned in the course, one will
be drawn, and the owner will be awarded a prize.
• Thus: the more $E you earn, the higher your chance to
win the prize.

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 The Prize

 Pick your own:

• Choose your own prize on Amazon.de up
to the value of 50 €.

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 Organization
 Experiments:
• Interactive decision situations
 Homework: Analysis of
• strategic situations
• data from real decisions
• individually or in groups of up to 3
 Presentations and discussions:
• Cold calls
• Comment, question, answer
 Lecture:
• Game-theoretical background, research findings
• Slides after class

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 Organization
 Lectures are structured around applications
• vs. around game theory fields
 Managerial decisions/applications covered:
• Markets: competition, monopoly, oligopoly, timing,
commitment, herding, bubbles
• Bargaining and Cooperation: giving, ultimatums,
negotiations, dilemmas
• Reputation in competition and cooperation
• Auctions: price rules, value structure, units
• Information: coordination, signalling, cheap talk
 The limits of game theory: rationality & preferences
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 Organization
 No required textbook. Use Wikipedia, Youtube, & other
sources of your liking.

 But some reading recommendations:

• Dixit & Skeath (&Reiley): Games of Strategy
(comes closest in terms of level and content)

• Holt: Markets, Games, and Strategic Behavior

• Dixit & Nalebuff: Thinking Strategically
• Nalebuff & Brandenburger: Co-opetition
• Harford: Undercover Economist
• (Nasar: A Beautiful Mind)
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 Organization
 Marking:
• 30% preparation/participation
– Prepare well
– Be on time
– Participate (including experiments)
• 2 x 10% written homework, announced when given out
• 50% exam
– practice by participating
 Exam
• Strategic situation: like instructions
• Data on behavior: like experimental data
•  Strategic analysis, discussion of data: like homework

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 Organization

Questions?

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 What is a “strategic situation”?

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 Strategic situations
 Strategic situation:
• An interaction with other “agents”, where your and the
other agents’ outcome from the interaction (think:
payoffs) depend both on your choices and their
choices.
• More specifically: What your best choice is depends on
what other agents choose, and the best choices of
other agents depend on what you choose.
• “Agents” can be firms, individuals, …

 We model such interactions as “games”.

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 What is a “strategy”?

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 Strategy
 In business:

 a plan

 to achieve an organization’s goals and objectives,

 from which – ideally – each unit of the organization can

derive the necessary action in each operational decision
situation.

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 Strategy
 Strategy in Game Theory:
a complete plan of action for a game
 So, when you have a strategy, you will know what to do at
any point while playing the game.

 So a strategy may condition on:

• Time of action
• Outcomes of nature moves (random events)
• New information arriving
• The observed actions of other players

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 Strategy
 In this sense, a strategy is different from
• a simple plan to do something
• a specific action or response to some action of
somebody else
• a tactic or other approach which only covers part of the
game

 A strategy covers the complete game, with all its details,

eventualities, over all time the game is played …
 It tells us for each point in the game where we might
have to take an action, what action to take …

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 Strategic situations
 How to develop a good strategy?
 Think about
• The rules of interaction
• The strategies/actions available to other players
• The role of nature/randomness
• The value of information
 Then think about your best action
• in each point of time
• in each state of the world
• for each move of other players
 Write it down.

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 What is an “equilibrium”?

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 Equilibrium
 Equilibrium:
• A resting point
• A situation where nobody wants to move, given the
current situation (i.e. given what everybody else is
doing).

 Game theory is about searching for equilibria in strategies,

where nobody wants to choose a different strategy given
the strategies others are choosing.
 These are seen as good predictions for outcomes of
games.

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 Game Theory

 Framework to think about strategic, interactive situations

 “Theory”, because abstract: applicable to all kinds of

situations

 “Game”, because we use the metaphor of a game (rules,

players, strategies, outcomes) to describe strategic
situations

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 Game Theory

 What the press says:

• “When government auctioneers need worldly advice,
where can they turn? To mathematical economists, of
course … As for the firms that want to get their hands on
a sliver of the airwaves, their best bet is to go out first
and hire themselves a good game theorist.”
[The Economist]

• “Game Theory, long an intellectual pastime, came into

its own as a business tool.” [Forbes]

• “Game theory is hot.” [The Wall Street Journal]

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 John F. Nash, Nobel Prize 1994 in Economics
for his work in Game Theory

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 Game Theory

 Short History:
• 1944 von Neumann/Morgenstern
• 1951 Nash: equilibrium
• 1965 Selten: subgame perfection
• 1967 Harsanyi: incomplete information
• 1972/82 Maynard Smith: evolutionary games
• 1994 Nobel Prize for Nash, Harsanyi, Selten
• 2005 Nobel Prize for Aumann, Schelling
• 2007 Nobel Prize for Hurwicz, Maskin, Myerson
• 2012 Nobel Prize for Roth and Shapley
• 2014 Nobel Prize for Jean Tirole
• 2017 Nobel Prize for Richard Thaler
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 Game Theory: Nobel Prize 1994
John F. Nash Introduction of Nash equilibrium, further
(1950): development of the theory of non-zero-sum games
(=situations, in which both players can win or lose
jointly)

Reinhard Selten Generalization of the idea of Nash equilibrium to

(1965, 1975): dynamic games (situations which unfold sequentially
over time)

John C. Generalization of the idea of Nash equilibrium to

Harsanyi (1967- situations in which players only have incomplete
68): information about preferences or available strategies
of other players

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 Game Theory: Nobel Prize 2005
Robert J. … was the first to conduct a full-fledged formal analysis of so-called
Aumann infinitely repeated games. His research identified exactly what outcomes
(1974,1975): can be upheld over time in long-run relations. […] Why is it more difficult
to cooperate when there are many participants, when they interact
infrequently, when interaction is likely to be broken off, when the time
horizon is short or when others' actions cannot be clearly observed?
Insights into these issues help explain economic conflicts such as price
wars and trade wars, as well as why some communities are more
successful than others in managing common-pool resources.
Thomas … showed that a party can strengthen its position by overtly worsening its
Schelling (1960) own options, that the capability to retaliate can be more useful than the
ability to resist an attack, and that uncertain retaliation is more credible
and more efficient than certain retaliation. These insights have proven to
be of great relevance for conflict resolution and efforts to avoid war.
Schelling's work prompted new developments in game theory and
accelerated its use and application throughout the social sciences. Notably,
his analysis of strategic commitments has explained a wide range of
phenomena, from the competitive strategies of firms to the delegation of
political decision power.
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 Game Theory: Nobel Prize 2007
Leonid Adam Smith's classical metaphor of the invisible hand refers to
Hurwicz an ideal, efficient market. But in practice, competition is not
completely free, consumers are not perfectly informed and
privately desirable production and consumption may generate
social costs and benefits. Many transactions take place in other
Eric S. institutions than open markets: within firms, in negotiations,
Maskin etc. How well do different such institutions, or allocation
mechanisms, perform? What is the optimal mechanism to reach
a certain goal?
These questions are difficult since information is often private to
egoistically acting actors. Mechanism design theory (initiated by
Leonid Hurwicz and further developed by Eric Maskin and Roger
Roger B. Myerson) aims to find the optimal mechanisms/set of
Myerson rules/institutions to implement certain goals: like finding an
optimal taxation scheme for the government to reach welfare
maximization, or finding the best auction design to maximize the
revenue of the seller, or finding the voting procedures which
allow to reveal the true preferences of the majority.

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 Game Theory: Nobel Prize 2012
Lloyd This year's Prize concerns a central economic problem: how to match different agents as well as
possible. For example, students have to be matched with schools, and donors of human organs
Shapley with patients in need of a transplant. How can such matching be accomplished as efficiently as
possible? What methods are beneficial to what groups? The prize rewards two scholars who
have answered these questions on a journey from abstract theory on stable allocations to
practical design of market institutions.

Lloyd Shapley used so-called cooperative game theory to study and compare different matching
methods. A key issue is to ensure that a matching is stable in the sense that two agents cannot
be found who would prefer each other over their current counterparts. Shapley and his
Alvin E. colleagues derived specific methods – in particular, the so-called Gale-Shapley algorithm – that
Roth always ensure a stable matching. These methods also limit agents' motives for manipulating
the matching process. Shapley was able to show how the specific design of a method may
systematically benefit one or the other side of the market.

Alvin Roth recognized that Shapley's theoretical results could clarify the functioning of important
markets in practice. In a series of empirical studies, Roth and his colleagues demonstrated that
stability is the key to understanding the success of particular market institutions. Roth was later
able to substantiate this conclusion in systematic laboratory experiments. He also helped
redesign existing institutions for matching new doctors with hospitals, students with schools,
and organ donors with patients. These reforms are all based on the Gale-Shapley algorithm,
along with modifications that take into account specific circumstances and ethical restrictions,
such as the preclusion of side payments.

Even though these two researchers worked independently of one another, the combination of
Shapley's basic theory and Roth's empirical investigations, experiments and practical design has
generated a flourishing field of research and improved the performance of many markets. This
year's prize is awarded for an outstanding example of economic engineering.

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 Game Theory: Nobel Prize 2014
Jean Jean Tirole is one of the most influential economists of our time. He has made important
theoretical research contributions in a number of areas, but most of all he has clarified how to
Tirole understand and regulate industries with a few powerful firms.

Many industries are dominated by a small number of large firms or a single monopoly. Left
unregulated, such markets often produce socially undesirable results – prices higher than those
motivated by costs, or unproductive firms that survive by blocking the entry of new and more
productive ones.

From the mid-1980s and onwards, Jean Tirole has breathed new life into research on such
market failures. His analysis of firms with market power provides a unified theory with a strong
bearing on central policy questions: how should the government deal with mergers or cartels,
and how should it regulate monopolies?

Before Tirole, researchers and policymakers sought general principles for all industries. They
advocated simple policy rules, such as capping prices for monopolists and prohibiting
cooperation between competitors, while permitting cooperation between firms with different
positions in the value chain. Tirole showed theoretically that such rules may work well in certain
conditions, but do more harm than good in others. Price caps can provide dominant firms with
strong motives to reduce costs – a good thing for society – but may also permit excessive profits
– a bad thing for society. Cooperation on price setting within a market is usually harmful, but
cooperation regarding patent pools can benefit everyone. The merger of a firm and its supplier
may encourage innovation, but may also distort competition.

The best regulation or competition policy should therefore be carefully adapted to every
industry's specific conditions. In a series of articles and books, Jean Tirole has presented a
general framework for designing such policies and applied it to a number of industries, ranging
from telecommunications to banking. Drawing on these new insights, governments can better
encourage powerful firms to become more productive and, at the same time, prevent them from
harming competitors and customers.
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 Behavioral Economics: Nobel Prize 2017
Richard Richard H. Thaler has incorporated psychologically realistic assumptions into analyses of
economic decision-making. By exploring the consequences of limited rationality, social
H. Thaler preferences, and lack of self-control, he has shown how these human traits systematically affect
individual decisions as well as market outcomes.
Limited rationality: Thaler developed the theory of mental accounting, explaining how people
simplify financial decision-making by creating separate accounts in their minds, focusing on the
narrow impact of each individual decision rather than its overall effect. He also showed how
aversion to losses can explain why people value the same item more highly when they own it
than when they don't, a phenomenon called the endowment effect. Thaler was one of the
founders of the field of behavioural finance, which studies how cognitive limitations influence
financial markets.
Social preferences: Thaler's theoretical and experimental research on fairness has been
influential. He showed how consumers' fairness concerns may stop firms from raising prices in
periods of high demand, but not in times of rising costs. Thaler and his colleagues devised the
dictator game, an experimental tool that has been used in numerous studies to measure
attitudes to fairness in different groups of people around the world.
Lack of self-control: Thaler has also shed new light on the old observation that New Year's
resolutions can be hard to keep. He showed how to analyse self-control problems using a
planner-doer model, which is similar to the frameworks psychologists and neuroscientists now
use to describe the internal tension between long-term planning and short-term doing.
Succumbing to shortterm temptation is an important reason why our plans to save for old age, or
make healthier lifestyle choices, often fail. In his applied work, Thaler demonstrated how
nudging – a term he coined – may help people exercise better self-control when saving for a
pension, as well in other contexts.
In total, Richard Thaler's contributions have built a bridge between the economic and
psychological analyses of individual decision-making. His empirical findings and theoretical
insights have been instrumental in creating the new and rapidly expanding field of behavioural
economics, which has had a profound impact on many areas of economic research and policy.

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 Game Theory
 Cooperative game theory (not in this course)
• Players are able to make binding commitments. They
can/cannot make monetary transfers outside the game.
• What coalitions will form? What will these coalitions
agree on?
• Concepts: Core, Shapley value, …

 Non-cooperative game theory (in this course)

• Players cannot commit to anything or make any
transfers except if it is part of the game definition itself.
• Concepts: equilibrium, refinements, …

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 Game Theory
 Games can be:
• Simultaneous or sequential
• Finite or infinite
• Symmetric or asymmetric
• One-shot or repeated
• Zero/constant-sum or non-zero/constant-sum
• Discrete or continuous
• With complete or incomplete information
• With perfect or imperfect information

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 Analyzing games
 Step 1: Determine players, strategies, payoffs

 Step 2: Write down the game

 Step 3: Find equilibria

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 Game Theory
 A Game is defined by
• the players
• their potential strategies (possible courses of action)
• utility payoffs associated with combinations of strategies

 Strategies – complete plans of playing a game

 … must be conditioned on
• reaching certain nodes in the path of sequential
interaction (i.e what others decide, what information
comes in, …)
 … interact with
• information sets (i.e. what players know at each point of
time)
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 Game Theory
 Formally:
• Players i = 1, ..., n
• Strategies si  Si
• Payoffs ui (si , s-i )

 Si – set of potential strategies for player i

 si – strategy of player i
 s-i – set of strategies chosen by all other players j  i
 ui (si , s-i ) – payoff (utility) of player i if player i chooses si
and other players have chosen their strategies s-i

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 Game Theory
 A strategy of a player is a complete plan of action in the
game. For each point in time where the player is called
upon to act, it describes which action to choose.

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 Game Theory
 Example 1:
• 2 player price competition
– 2 companies produce the same product: bolts
– Each can set a price of 0.08 or 0.12 per unit
– Buyers buy from cheaper one, randomly if equal
– Resulting demand: 800 for 0.08, 500 for 0.12
– Production costs 0.05 per unit

 What potential strategies does each player have?

• Simultaneous Game
• Strategies:
– Player 1: price 0.08, price 0.12
– Player 2: price 0.08, price 0.12
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 Game Theory
 Example 1:
• 2 player price competition
 What outcomes and payoffs can there be?

Player 1 Player 2
P1: 0.08, P2: 0.08 12.0 12.0
P1: 0.08, P2: 0.12 24.0 0.0
P1: 0.12, P2: 0.08 0.0 24.0
P1: 0.12, P2: 0.12 17.5 17.5

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 Game Theory
 Example 2:
• 2 player Scissors, Paper, Rock game:
– Scissors > Paper
– Paper > Rock
– Rock > Scissors

 What potential strategies does each player have?

• Simultaneous Game
• Strategies:
– Player 1: Scissors, Paper, Rock
– Player 2: Scissors, Paper, Rock

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 Game Theory
 Example 2:
• 2 player Scissors, Paper, Rock game:
 What outcomes and payoffs can there be?
Player 1 Player 2
Scissors-Scissors tie (0) tie (0)
Scissors-Paper win (1) lose (-1)
Scissors-Rock lose (-1) win (1)
Paper-Scissors lose (-1) win (1)
Paper-Paper tie (0) tie (0)
Paper-Rock win (1) lose (-1)
Rock-Scissor win (1) lose (-1)
Rock-Paper lose (-1) win (1)
Rock-Rock tie (0) tie (0)

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 Game Theory
 Example 3:
• Product differentiation game
– Firm 1 chooses color blue or red
– Then, after observing Firm 1’s choice, Firm 2 chooses
either blue or red

 What potential strategies can Firms 1 and 2 play?

• Sequential game
• Strategies:
– Firm 1: blue, red
– Firm 2 can condition its choice on the choice of Firm 1
– A full strategy defines an answer on each of Firm 1’s
possible moves!
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 Game Theory
 Example 3:
• Product differentiation game

• Strategies:
– Firm 1: blue, red
– Firm 2:
– If 1 blue then blue, if 1 red then blue
– If 1 blue then blue, if 1 red then red
– If 1 blue then red, if 1 red then blue
– If 1 blue then red, if 1 red then red

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 Game Theory
 Example 3:
• Product differentiation game
 People prefer and pay more for blue (6) than red shirts
(4). If having no color choice, people just buy one shirt
randomly from one company. If they can choose from
different colors, they will buy shirts from both colors.
 What outcomes and payoffs can there be?
Firm 1 Firm 2
• blue – blue 3 3
• blue – red 6 4
• red – blue 4 6
• red – red 2 2

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 Analyzing games
 Step 1: Determine
• Players
• Strategies
• Payoffs

 Step 2: Write down the game

• 2 possibilities:
– Normal Form (Table)
– Extensive Form (Game tree)

 Step 3: Analyze Normal form / Extensive form

and find equilibria
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 What is an “equilibrium”?

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 Game Theory
 Nash Equilibrium
• Nash (1951): 10-page paper
– definition, existence, applications
– includes “mixed strategies”
– extremely influential
• Players formulate strategies.
• If the combination of strategies leads to an outcome of
a game in which – given the strategies of the other
players – no player wants to deviate, then we call it a
stable outcome, or “equilibrium”
• Any other outcome is an implausible way of playing the
game, because at least one player could improve by
selecting another strategy.
• Note: Equilibrium exists in strategies, not in actions.
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 Game Theory
 Nash Equilibrium
 Formally:
• Players i = 1, ..., n
• Strategies si  Si
• Payoffs ui (si , s-i )

 The strategy profile s* = (s1*, s2*, s3*, …, sn*)  S constitutes

a Nash equilibrium if for each player i the strategy si*  Si
is a best response to the strategies of the other players, si*
 Si*, i.e. if
ui (si*, s-i*)  ui (si , s-i*)  si  Si , i = 1, ..., n.

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 Game Theory
 There can be multiple Nash equilibria.
•  equilibrium refinements, equilibrium selection
 There can be the case that there is no equilibrium in pure
strategies.
•  mixed strategies: randomize over pure strategies
 There can be pure plus mixed strategy equilibria.

 There is always at least one equilibrium in pure or mixed

strategies.

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 Game Theory
 Example 1:
• 2 player price competition
 What is an equilibrium here?

Player 1 Player 2
P1: 0.08, P2: 0.08 12.0 12.0
P1: 0.08, P2: 0.12 24.0 0.0
P1: 0.12, P2: 0.08 0.0 24.0
P1: 0.12, P2: 0.12 17.5 17.5

 Player 1 chooses a price of 0.08

 Player 2 chooses a price of 0.08

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 Game Theory
 Example 3:
• Product differentiation game
 What is an equilibrium here?
Firm 1 Firm 2
• blue – blue 3 3
• blue – red 6 4
• red – blue 4 6
• red – red 2 2

 Firm 2 chooses: If 1 blue then red, if 1 red then blue

 Firm 1 chooses: blue

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 Game Theory
 Example 3:
• Product differentiation game

• Firm 1:
– blue
– red
• Firm 2:
– If 1 blue then blue, if 1 red then blue
– If 1 blue then blue, if 1 red then red
– If 1 blue then red, if 1 red then blue
– If 1 blue then red, if 1 red then red

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 Game Theory
 Example 2:
• 2 player Scissors, Paper, Rock game:
 What is an equilibrium?
1 Player 1 Player 2
Scissors-Scissors tie (0) tie (0)
Scissors-Paper win (1) lose (-1)
Scissors-Rock lose (-1) win (1)
Paper-Scissors 2 lose (-1) win (1)
3 Paper-Paper tie (0) tie (0)
Paper-Rock win (1) lose (-1)
Rock-Scissor win (1) lose (-1)
Rock-Paper lose (-1) win (1)
Rock-Rock tie (0) tie (0)

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 Game Theory
 Example 2:
• 2 player Scissors, Paper, Rock game
 There is no equilibrium in pure strategies.

 There is one equilibrium in mixed strategies:

• Player 1
– plays Scissors with probability 1/3
– plays Paper with probability 1/3
– plays Rock with probability 1/3
• Player 2
– plays Scissors with probability 1/3
– plays Paper with probability 1/3
– plays Rock with probability 1/3
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 Game Theory

 Recap
• Strategies as complete plans of action in a game
• Conditional on other player’s moves, nature, …
• Game theory as a framework to study strategic
interaction
• Types of games
• Defining a game: players, strategies, utility payoffs
• Nash equilibrium

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 Break and Experiments

 Break for 5 minutes.

 Then: Experiments

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 Experiments
 Use laptop.

 Open your oTree link

(http://otree.wu.ac.at/...

 Green screen? Great! Wait!

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