Game Theory Mike Shor Lecture 7 “The difference between genius and stupidity is that genius has its limits.” - Albert Einstein

Punishment and Credibility Review Cooperation requires sacrificing immediate profits for a future relationship The sacrifice is only made if the punishment is severe enough Punishment that is too severe is not credible Outline: What is credibility? Payoffs, strategies, irrationality A credibility check list Mike Shor Game Theory & Business Strategy

The Winning Lottery Ticket “It won’t change me one bit!” Mike Shor Game Theory & Business Strategy

Game Theory & Business Strategy 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 Mike Shor Game Theory & Business Strategy

Game Theory & Business Strategy How to be Credible? Reduce payoffs from those strategies that may tempt you Make it costly to renege Remove strategies from among those that may tempt you in the future Destroy avenues of retreat Become irrational by eliminating strategic control Remove “human meddling” Mike Shor Game Theory & Business Strategy

Game Theory & Business Strategy Talk is Cheap “ Continental Airlines said yesterday that it would raise airfares on about two-thirds of its routes … to take effect September 5.” - The New York Times August 29, 1992 Mike Shor Game Theory & Business Strategy

Game Theory & Business Strategy 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.’ ” Mike Shor Game Theory & Business Strategy

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 Them In Out Us -2 , -2 3 , 0 0 , 3 0 , 0 Mike Shor Game Theory & Business Strategy

Game Theory & Business Strategy 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 Them In Out Us -2 , -2 3 , 0 -1 , 3 -1 , 0 Mike Shor Game Theory & Business Strategy

Game Theory & Business Strategy 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 Them In Out Us -2 , -2 3 , 0 -3 , 3 -3 , 0 Mike Shor Game Theory & Business Strategy

Game Theory & Business Strategy Credible Commitment By reducing our own payoffs from staying out, we have committed to entry Other examples: Financing of takeovers Mike Shor Game Theory & Business Strategy

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 / year with penalty: $21.9 million / year Mike Shor Game Theory & Business Strategy

Game Theory & Business Strategy 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 Mike Shor Game Theory & Business Strategy

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 Mike Shor Game Theory & Business Strategy

Game Theory & Business Strategy 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 Mike Shor Game Theory & Business Strategy

Game Theory & Business Strategy 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 … Mike Shor Game Theory & Business Strategy

Game Theory & Business Strategy Removing Strategies I You are not always better off with more options. Delegation In contract negotiation, can “squabble” over many details Instead, send an agent with power of attorney to “sign as is” or “walk away” Haggling over prices in a department store Learn from government bureaucracy: “The rules won’t allow me to do what you ask!” Mike Shor Game Theory & Business Strategy

Game Theory & Business Strategy 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 Mike Shor Game Theory & Business Strategy

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 Mike Shor Game Theory & Business Strategy

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 firm Commit to chip supply to production plants Commit to no opportunistic behavior Mike Shor Game Theory & Business Strategy

Game Theory & Business Strategy 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? Mike Shor Game Theory & Business Strategy

Commitment Is Counterintuitive COMMANDMENT 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) Mike Shor Game Theory & Business Strategy

Game Theory & Business Strategy 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 Mike Shor Game Theory & Business Strategy

Game Theory & Business Strategy Irrationality A takeover defense tactic: “I will burn the factories down!” If threatening the irrational – take it out of your control, permanently Reversible commitment is akin to no commitment at all Mike Shor Game Theory & Business Strategy

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” Mike Shor Game Theory & Business Strategy

Game Theory & Business Strategy Changing the Rules Question the clichés: Less options may be better Sometimes, burn bridges Commitments change the game. Which game is best for you to play? Looking ahead: How commitments can resolve the prisoner’s dilemma Mike Shor Game Theory & Business Strategy