EC 491

“I don’t skate to where the puck is, I skate to where it’s going to be.”

- Wayne Gretzky

February 2, 2011Putting Theory into Practice

Mike ShorGame Theory & Business Strategy

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Toys “R” Us

Competitive Landscape Toy & department stores

Do not compete with TRU on price (50% markups) General discounters (Wal-Mart,

Target) Cannot compete with TRU on selection (9% markups) Toys exhibit high product differentiation

Specialized discounters (only TRU) Enjoyed 20% market share nationally

Warehouse clubs (Costco, Pace) Introduced in the 1980s By 1989, about 200 items in competition

Cause of concern for Toys “R” Us!

Mike ShorGame Theory & Business Strategy

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Toys “R” Us

Other examples of specialty discounters? Petsmart Staples (competitors Office Depot, Office Mart) Best Buy (Circuit City gone) Itunes

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Toys “R” Us (continued)

Market research into the future of warehouse clubs Manufacturers estimated 3-5% annual growth rate Toys “R” Us conducted comprehensive but proprietary study Manufacturers were aware of the study, but not its results Toys “R” Us expected warehouse clubs to grow quite fast

Idea! Issue statement to manufacturers: You may not sell to warehouse clubs

without losing Toys “R” Us as a customer Effectively, choose between a $5 billion market (TRU)

and a less than $500M market (warehouse clubs)

Mike ShorGame Theory & Business Strategy

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Toys “R” Us (continued)

Issues for the Manufacturers?:

What about for Toys “R” Us?

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Toys “R” Us (continued)

What would you do?

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Toys “R” Us (continued)

Manufacturers agreed to TRU deal

Warehouse club toy sales decreasedPre-agreement growth of 51% per yearOverall growth of clubs of over 10% per year

But …

Mike ShorGame Theory & Business Strategy

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Defining the Game

CAVEAT

Predict opponents’ reaction to your behavior.

BUT

Be sure you understand who your opponents are.

(Do you know everyone who may react to your decisions?)

Mike ShorGame Theory & Business Strategy

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SummaryDefining the Game

The strategic environment Who are the players? (Decision makers) What strategies are available? (Feasible actions) What are the payoffs? (Objectives)

Rules of the game What is the time-frame for decisions? What is the nature of the conflict? What is the nature of interaction? What information is available?

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.

Mike ShorGame Theory & Business Strategy

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Common Knowledge

Do people really behave as the theory predicts?

If not, what good is the theory?

Mike ShorGame Theory & Business Strategy

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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 a bubble’s burst?

Mike ShorGame Theory & Business Strategy

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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 there’s a greater fool down the road.

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

Mike ShorGame Theory & Business Strategy

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“_________ “_________ “_________ “_________

“_________ “_________ “_________ “_________

Which Month Am I? 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”

Mike ShorGame Theory & Business Strategy

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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?

Mike ShorGame Theory & Business Strategy

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October 1987

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October 2008

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– Wall Street Journal, quoting Mark Twain

The Worst Month for Stocks

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

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”

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.”

Mike ShorGame Theory & Business Strategy

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1988

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01234

MAY

Excess Returns prior to IPO Lock-Up Expiration

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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

Summary

You’re always 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?Mike ShorGame Theory & Business Strategy

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