6 pages 48 hours (A0109)

KEY ISSUES

Key Terms

 Sequential

 Simultaneous

 Reasoning Backwards

 Commitment

 Credible Threat

 Sealed Bid

 Open Auction

 Winner’s Curse

 Single Shot Game

 Iterated Game

 Prisoners’ Dilemma

 Tit-for Tat

Information & Organisational Design

Lecture 4 - Elements of Decision-Making: Insights From Game Theory

INTRODUCTION

In this session we introduce the topic of game theory. Game theory has had a massive

impact on economics and particularly on issues of organisation al economics. This session

builds upon the work carried out on the economics of information. In particular you will see

how game theory can be applied to many areas of economics, management and organisation,

particularly negotiating, contracting, bargainin g, bidding and strategic decision -making.

We tackle the topic of game theory in two main ways. First, by varying the number of players

who participate in the game. Second by varying the number of times the game is played.

A major part of the session is set aside for the study of the prisoners’ dilemma. This is one

particular form of game theory which has proved very popular, being applied to topics

beyond that of organisations: the arms race, advertising, law, insurance, competition, the

structure of markets and so on.

Further reading:

Brandenburger and Nalebuff. ‘The Right Game: Use of Game Theory to Shape Strategy’.

Harvard Business Review, July-August 1995

Ortmann. Andreas and Richard Squire. ‘A Game-theoretic explanation of the administrative

lattice in institutions of higher learning’. Journal of Economic Behavior and Organization, vol

43 (2000), pp399-391.

De Vries Henk and George Hendrikse. ‘The Dutch Banking Chipcard Game: Understanding a

Battle Between Two Standards’. International Studies of Mana gement and Organisations, vol

31, no. 1, Spring 2001.

OBJECTIVES

After completing this unit you should be able to:

 Apply the concepts of game theory to a wide range of business scenarios.

 Use game theory to develop better strategic decision -making in a number of business

areas.

 Understand how your fellow members in the game will respond to your actions and what

the likely outcome of a given strategy is likely to be.

 Develop ideas of what are the most stable strategies to use to get people to share their

information and co-operate

The Prisoners’

Dilemma

Single and Repeated

Games

Auctions

The Co-ordination

Game

The Entry Game

Reputation

Information and

Organisational Design LUBS5002

Lecture 4

Elements of Decision- Making

“Business is a game - the greatest game in the world if you know how to play it”

(Thomas J. Watson founder of IBM)

“Business negotiations are essentially a game of predicting what the other person will do”

“To every action, there is a reaction”.

Introduction

Introduction to Game Theory

Game theory seeks to understand economic as well as political and social rivalries by using a method of analysis specifically designed to understand games of all types, particularly

 negotiating,

 contracting,

 bargaining,

 bidding and strategic decision-making.

Methodological Backdrop

 Game theory pioneered by John von Neumann and Oskar Morgenstern’s book Theory of Games and Economic Behaviour (1944) .

 Two basic types of games

 Rule based and freewheeling games.

Both games require a shift in perspective. Many people view games egocentrically - that is they focus on their own position. The primary insight of game theory is the importance of focusing on others - or allocentrism.

The Location Game

Two beer vendors, Mr Joshua and Mr Tetley, operate on a beach. They are required to charge the same price, but they can choose where to locate themselves on the beach. Their customers, sunbathers, do not like to be near each other, so they are spread evenly along the beach. Sunbathers are also averse to walking (because they might spill their beer), so they purchase beer from the vendor closest to them.

Where on the beach will the vendors, seeking large sales, locate themselves ?

Game Theory: Key Elements

According to game theory there are five main elements of the game:

 Players  Added Value  Rules  Strategies  Payoffs These elements in turn will be influenced by the character

of the game, namely:

 number of players involved  number of stages of the game

One Stage Games

 In one stage games the key to how co-ordination is achieved centres on whether decision-making is simultaneous or sequential.

 The realisation of the preferred outcome being realised is dependent upon the level of information in the game and its ability to facilitate efficient decision making.

Two Stage Games

 Two stage games permit some form of communication to occur between the parties.

 ‘Communication’ in some instances may be collaborative, aiding the decision making process and increasing the pay-off to each party.

 On the other hand, ‘communication’ may be threatening, indicating that unless the right agreement is reached in stage one, punitive action may be taken by one party against the other.

Negotiating With A Deadline

Reeves and Mortimer are to divide £100 between themselves. Each of the parties knows that the game has the following structure:

Stage 1: Reeves proposes how much of the £100 he gets. Then either Mortimer accepts it, in which case the game ends and Mortimer receives the remainder of the £100; or Mortimer rejects it, in which case the game continues.

Stage 2: The sum to be divided has now shrunk to £90. Mortimer makes a proposal for his share of the £90. Then Reeves either accepts it and gets the remainder; or rejects it, in which case each receives nothing and the game ends.

What will Reeves demand at the first stage ?

Negotiating with a Deadline

Key Findings

 Power of the Deadline

 Look Several Moves Ahead

 Put Yourself in the Other Person Shoes i.e.Backward Induction

Threat of Bluff ?

Consider the outcome of the previous game which, in the first stage Reeves makes an offer to Mortimer, but adds an extra condition stating that “if Mortimer does not accept his offer in the first stage then he will not accept any offer from Mortimer in the second stage.”

Given these changes to the nature of the bargaining game, what is the outcome of the game and the key issues each party needs to consider in evaluating each others bargaining position ?

Threat or Bluff

Key Findings

 Expectations can be manipulated

 Is the threat credible and the player committed to this course of action

 Importance of Reputation

Auctions

 Auctions represent the interplay of many players in a one or more stage game.

 Two types of auctions exist

 open and sealed bid auctions.

 For example investment banks often use an auction process to find the most suitable buyers for the business. It is customary that these auctions are two stage and sealed-bid.

The Prisoner’s Dilemma

 The prisoner’s dilemma represents a famous class of games which has a wide number of applications.

 The game provides useful insights into the difficulty of maintaining co-operation.

Why ?

Because co-operation is individually irrational

and their intent to co-operate is difficult to communicate

and not binding.

The Prisoner’s Dilemma

The Arms Race Game

Two countries - the US and Russia - are locked in talks concerning whether to build new weapons or to disarm. Each country prefers to have more arms that the other because a larger arsenal gives it more influence in world affairs. But each country also prefers to live in a world safe from the other country’s weapons. The game is set out on the next slide.

The Set-Up of the Arms Race

Game

Arm

Arm

Disarm

Disarm

Decision

of Russia

Decision

of the US

•Russia at risk

• US at risk

•Russia at risk and weak

• US safe and powerful

•Russia safe

• US safe

•Russia safe and

powerful

•US at risk and weak

Resolving the Arms Race Game

1 Explain what choices each country has and describe their dominant strategy. What is the outcome of arms negotiations ?

2 Explain how the co-operative outcome is likely to be realised in the arms race game.

The Arms Race Game

Key Findings

 Self-interest drives the participants towards the non-co- operative outcome even though it is not the best possible outcome for wither country nor for world peace.

 The time horizon of the game is important to the emergence of routines and norms and the ability of players to influence other players’ expectations of what their behaviour will be.

 Reputation and retaliation are essential to a successful strategy

Iterated Prisoners’ Dilemma

 Tit-for-tat strategy

 first round co-operate, in the following rounds choose whatever the other player did in the previous round

 Numerous variants of this strategy

 Characteristics of ‘successful’ tit-for-tat

 ‘nice’

 ‘forgiving’

 ‘retalitory

Evolutionary Game Theory

 Games played over many round , focus on population.

 What is an ‘evolutionary stable strategy’

 Hawk-Dove game

 Evolution of strategies – learning and innovation

Summary

There are several key principles to remember:

 the order of the game

 is it sequential or simultaneous ?

 the number of players and the number of times it is played

 is it possible for trust, behavioural norms and routines, and communication to develop

 players should not focus their sole attention on their position, but also focus on others

 the ability to look forwards and reason backwards helps you understand the actions of other parties.