Game Theory

“The power to constrain an adversary depends upon

the power to bind oneself.”- Thomas Schelling

Topic 6Strategic Moves

Credibility

Review

Cooperation requires sacrificing immediate profits for a future relationship

The sacrifice is only made if the punishment is both severe enough and credible

But what is credibility?

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Review

Credible commitments require Severe enough punishment to change behavior Irreversible and clear actions

Strategic Moves: Changing the game for strategic advantage Being credible Overcoming the prisoner’s dilemma

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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

Replace playersby eliminating strategic control

Remove “human meddling”

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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

It is credible because it is now in our own best interest!

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Commitment & Competition

Consumers want companies to compete Companies prefer to cooperate Credible commitment by companies:

Change payoffs toMaximize joint gainsPromise higher pricesThreaten competitors that lower prices

Three practices consumers like but economists hate

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Promises and Threats

Getting the promise or threat right Making it credible

Firms want to promise each other high prices threaten rivals who lower prices

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Getting the Threat Right

The Operation1. Select a victim2. Threaten to beat him up if he pays the “protection”

money The Other Operation

1. Select a victim2. Threaten not to beat him up if he pays the

“protection” money The Other Other Operation

1. Select a victim2. Threaten to beat him up if he doesn’t pay the

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Monty Python’s Piranha Brothers

Making it Credible

Promises can sometimes be credible through a contract with the party to whom you are making the promise

Threats can never be credible through a contract with the party to whom you are making the threat

Must contract with third party

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The Bocchicchio Family

“ Once a particularly ferocious branch of the Mafia in Sicily, it had become an instrument of peace in America. ”

How can Michael invite Don Tessio for a meeting and guarantee that Don Tessio will not be harmed?

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Customers as Hostages

Firms can contract with customers as a third party to make credible threats and promises

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Customers as Hostages:Promises

“I promise to keep prices high”

Most Favored Customer clause If I ever offer a lower price to any other customer,

I will offer it to you as well

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High

Firm 1Low 65 , 35 65 customers @ $1

High 60 , 60 30 customers @ $2

Firm 2

Most Favored Customer Clause

Say, in period 1, both firms charge high In period 2, pricing low requires a $1 refund

to 30 customers from last period

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High

Low 65 , 35

High

Low 35 , 35Firm 1:

65 – 30 = 35

Most Favored Customer Clause

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Low High

Firm 1Low 10 , 10 35 , 35

High 35 , 35 60 , 60

Firm 2

Low High

Firm 1Low 40 , 40 65 , 35

High 35 , 65 60 , 60

Firm 2

Customers as Hostages:Threats

“I will punish you if you lower prices”

Price Matching Guarantee If any competitor offers a lower price,

I will match it

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High

Low 65 , 35

Low

Low 40 , 40

Price Matching Guarantee

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Low High

Firm 1Low 40 , 40 40 , 40

High 40 , 40 60 , 60

Firm 2

Low High

Firm 1Low 40 , 40 65 , 35

High 35 , 65 60 , 60

Firm 2

Customers as Hostages

Price matching guarantees and most favored customer clauses exploit: customer price sensitivity customer price awareness low customer switching costs

Exactly the factors that make price competition brutal!

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Other Price Guarantees

What is the impact of:

“Drug companies should not be allowed to charge Americans more than Canadians”

China requests a “Most Favored Nation” clause with the United States

WalMart requires a price from suppliers that is no worse than its competitors

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Increasing Search Costs:Theory

It costs a consumer a transportation cost, t, to “visit” another firm

If consumers expect prices of pe, how much should you charge?

Can charge up to pe + t But, if you iterate this

If you charge pe+t, competitor can charge pe+t+t, but then you can charge pe+t+t+t

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Increasing Search Costs:Implementation

Prevent price advertising Government regulation (liquor stores) Industry agreement (likely illegal) Professional trade groups (doctors)

Limit store hours Closing laws (florists)

Obfuscate price information (Dilbert “confusopolies”) Make comparison difficult (mattresses,

insurance) Use multiple prices (banking, auto

dealers)

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Strategic Moves

A strategic move is an action taken prior to the play of the game

Transforms the original game into a two-stage game Setting the Rules Playing the Game

"Victorious warriors win first and then go to war.

Defeated warriors go to war first and then try to win.“ -- Sun Tzu

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Strategic Moves

A credible strategic move must be Observable Irreversible Incentive-changing

Incentive-changing Change strategies, payoffs, or players Be creative

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The Prisoner’s Dilemma

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Firm 2

Low High

Firm 1Low 40 , 40 65 , 35

High 35 , 65 60 , 60

Equilibrium: $40 K

Cooperation: $60 K

Joint Ventures & Cross-Shareholding

If each firm acquires 20% of the other:

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Low

High 35 , 65

Low

High 41 , 59

Firm 1:

(4/5) 35 + (1/5) 65

= 41

Firm 2:

(4/5) 65 + (1/5) 35

= 59

Joint Ventures & Cross-Shareholding

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Low High

Firm 1Low 40 , 40 59 , 41

High 41 , 59 60 , 60

Firm 2

Low High

Firm 1Low 40 , 40 65 , 35

High 35 , 65 60 , 60

Firm 2

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.

Delegation Delegate decision to a disinterested third party In contract negotiation, can “squabble” over many

details Instead, send an agent with power of attorney to

“sign as is” or “walk away”

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

Reputation “I burn all cities about to be conquered” “We do not negotiate with terrorists” Takeover defenses

Irreversibility Pressing the “send” button Turning off the phone Extreme form: Last Will and Testament

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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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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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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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Commitment Under Uncertainty

An offer you can’t refuse After a seemingly successful interview,

the interviewer asks where the firm ranks on your list of potential employees

Before answering, you are told:The firm only hires applicants who rank it firstIf the firm is in fact your first choice,

then you must accept a job offer in advance, should one be made

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Commitment Under Uncertainty

Why make such proposals?Take advantage of your uncertaintyTake advantage of your risk-aversionMake you commit before they do!

Binding early-decision college applications

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Flexibility vs. Commitment

Must balance:

Value of commitment Change in others’ behavior from your

committing to some course of action generates value

Value of flexibility Keeping your options open and remaining

flexible allows you to react to changing situations (option value)

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Philips, N.V.

Commitment in CD introduction Philips: innovator’s 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.”

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Calculating Option Value

The science Option Value:

Added profit from flexibility (can’t lose)

The art Countervailing forces:

By waiting, the firm risks: Failing to capitalize fully on an opportunity. Having the opportunity preempted by competitors.

What to do?

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Philips, N.V. (continued)

q probability of mass acceptance of CDs

Pure option value In the absence of any competition

Philips should wait if q < 0.380

Commitment value If Sony is as well informed about the market as Philips

Philips should wait if q < 0.006

Informational advantage Because of proprietary market information obtained

through its CD operations in Europe:Philips should wait if q < 0.130

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Resolution

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