Game Theory

In War the Will Is Directed at an

Animate Object That Reacts.
- Karl Von Clausewitz, On War

Mike Shor
Lecture 2

Review

Game Theory
Description of strategic interaction
between mutually aware players
You are self-interested and selfish
So is everyone else

Tools

Recognize that you are in a game

Recognize the type of game
Know the possible outcomes
Manipulate the game structure

Game Theory - Mik

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

Game Theory - Mik

The Strategic Environment

Players
Everyone who has an effect on your earnings

Strategies

What actions are available to each player?

Complete plan of action
Specifies an action for each possible decision
Tactics vs. Strategies vs. Moves

Payoffs
Numbers associated with each possible outcome
Expected payoffs if outcomes are random

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The Rules

Timing of moves
What is the order of play?
Are the moves simultaneous? Sequential?

Nature of conflict and interaction

Are players interests in conflict? Cooperation?
Will players interact once, or repeatedly?

Informational conditions
Is there full information? Advantages?

Enforceability of agreements or contracts

Can agreements to cooperate work?

Game Theory - Mik

Example: Toys R Us

Players

Toys R Us
Warehouse clubs: Costco, Pace
Manufacturers: Hasbro, Mattel, etc.

Strategies

To threaten or not to threaten

To deal or not to deal with warehouse clubs
To follow through on threats or not

Game Theory - Mik

Rules

Sequential timing

Threat Manufacturers decisions

How will my opponents react?

Simultaneous timing

Manufacturers decisions
What is my opponent doing right now?

Information

Future profitability of warehouse clubs

What can I infer from the actions of others?

Agreements

Enforceability of contracts & agreements

What happens if someone cheats?
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Changing the Rules

Are the rules of the game fixed?

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

Example: voting and agenda setting

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Before the Supreme Court:

Gore v. Bush

Four judges prefer:

Bush

to Gore

to Remand

(B>G>R)

Gore

to Remand

to Bush

(G>R>B)

Remand

to Bush

to Gore

(R>B>G)

Three judges prefer:

Two judges prefer:

No majority in three-way race

Chief Justice selects voting order:
B v. G than winner v. R
B v. R than winner v. G
G v. R than winner v. B
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Member Preferences

Preferences:
4: B > G > R
3: G > R > B
2: R > B > G

Majority rule results:

B beats G

G beats R

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R beats B

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Rules of Voting

Majority rule results:

B beats G ; G beats R ; R beats B

B vs. G

then winner vs. R

B vs. R

then winner vs. G

G vs. R

then winner vs. B

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R
G
B

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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.

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Examples

Biased beauty contest

(3/4) 100
(3/4) 75
(3/4) 56
24, 18, 14, 10,

=
75
56
32
8, 6, 4, 3, , ,
2

Intentional failure to coordinate

Bluffing
Stock Market

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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 the bubbles burst?
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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
theres a greater fool down the road.
And if youre right, then of course
you arent being foolish
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The Worst Month for Stocks

October. This is one of the peculiarly dangerous
months to speculate in stocks. The others are
July, January, September, April, November, May,
March, June, December, August, and February."
Mark Twain

Fun with probabilities:

If each month is equally likely to go up or down,

there is over an 80% chance that some month
will be bad three years in a row!
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October 1987

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May 1988

Wall Street Journal:

Clear Road Ahead

Will record gains through the Fall

October looms on the horizon
the dreaded though inevitable slide.

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1988
M
A
Y

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0
19

Cumulative Abnormal Return

Excess Returns prior to IPO

Lock-Up Expiration

-20

-16

-12

-8

-4

Event Day
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16

20

20

Now keep in
mind this is
just a
ballpark
figure

Equilibrium

What is likely to happen

when rational players interact in a game?

Type of equilibrium depends on the game

Simultaneous or sequential
Perfect or limited information

Concept always the same:

Each player is playing the best response
to other players actions
No unilateral motive to change
Self-enforcing

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Summary

Recognizing that you are in a game

Identifying players, strategies, payoffs
Understanding the rules

Manipulating the rules

Next time: Equilibrium

The Search for outcomes of games

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