Strategic Behavior in Business and Economics UAB – Study Abroad FALL 2010 Xavier Vilà

The Course This course in designed as a brief introduction to individual decision making. Its main objective is to provide the students with Decision Theory and Game Theory techniques that can be useful to face and understand, using logical reasoning, strategic situations that appear not only in business environments, but also in everyday life. “A theory provides a way to organize our thinking. Theory is the science of business, not the art.” Mike Shor Vanderbilt University

Administrativia 23 regular lectures + 1 review session + 1 in-class presentations + 1 in-class exam = 26 sessions Up to four Problem Sets will be distributed during the course, collected one week later, graded, and returned back A Strategic Memo, that will consist of the analysis of one real-world-case using the tools learned in class, will be written in teams (of up to 5 members) and submitted before December 13 th. In-class presentations will take place on December 13 th. (Length: 2 pages including figures)

Administrativia A Final Exam consisting of questions and exercises on the topics covered in class and in the problem sets is scheduled for December 15 th Your final grade will be based on the scores of the three activities above according to the following table WEB Problem Sets 45% Strategic Memo 25% Final Exam 30%

Administrativia Dixit.A.K and B. J. Nalebuff (2010) The Art of Strategy: A Game Theorist's Guide to Success in Business and Life. W.W. Norton & Company. New York Dixit.A.K and B. J. Nalebuff (1991) Thinking Strategically: The Competitive Edge in Business, Politics and Everyday Life. W.W. Norton & Company. New York Gibbons R. (1992) A primer in game theory. Pearson Higher Education Gardner, R. (1995) Games for Business and Economics. New York: Wiley

What are we going to do ? The whole picture

Game and Decision Th. Social Choice Theory Game Theory Decision Theory Decision Th. Under Cert. Decision Th. Under Uncert. Decision Problem Individual Decision Collective Decision Unipersonal Without Risk With Risk Multipersonal

Decision Problem The problem is to make the best choice possible, according to our interests, from a given set of feasible alternatives

Examples How many pears and how many apples to buy ? What President should we have ? Should Georgia be allowed to join NATO ? How much to bid in an auction ? What chess move ? How many lotto tickets to buy ?

Individual Decision Problem The decision has to be made by an individual agent (a person, a firm, a government)

Examples of Individual Decision How many pears and how many apples to buy ? What President should we have ? Should Georgia be allowed to join NATO ? How much to bid in an auction ? What chess move ? How many lotto tickets to buy ?

Collective Decision Problem The decision has to be made by a group of agents (a group of countries, an electoral pool, a jury, etc. )

Examples of Collective Decisions How many pears and how many apples to buy ? What President should we have ? Should Georgia be allowed to join NATO ? How much to bid in an auction ? What chess move ? How many lotto tickets to buy ?

Game and Decision Theories They study how rational agents take individual decisions in different scenarios

Unipersonal Scenario The final outcome of the decision depends only on the own decision (and maybe on chances), and not on the decisions of others – How many pears and how many apples to buy ? How much to bid in an auction ? What chess move ? – How many lotto tickets to buy ?

Multipersonal Scenario The final outcome of the decision depends on the own decision, and also on the decisions of others. Such situations are called “Games” How many pears and how many apples to buy ? – How much to bid in an auction ? – What chess move ? How many lotto tickets to buy ?

Decision Theory Studies how rational agents take individual decisions in a unipersonal scenario. The focus is on the expected outcome.

Game Theory Studies how rational agents take individual decisions in a multipersonal scenario (a Game). The focus is on the expected outcome.

Some “game” situations Team Projects Dating Tennis Poker Traffic Market Entry Patent Races OPEC-like behavior Procurement Corporate Takeovers Competition

What are we actually going to do? Real World situation ModelOutcome of the model Real Outcome Compare Create Models as a simplification of reality !

Models A model is a simplified (mathematical) representation of a real situation. Models are constructed in such a way that the analysis of such situation becomes easier A good model contains only those key elements that are necessary for the analysis and is tailored to the situation at study Example: A Map is a simplified representation of something real (a city), and so is a Travel Guide Find your wayKnow the museums Map ✔✖ Travel Guide ✖✔

Models Models are based on simplifying assumptions, that are necesary to acomplish their goals In this course... Rationality: Selfish players, profit maximizers, perfect calculators Common Knowledge: I am rational, you know that I am rational, I know that you know that I am rational, you know that I know that you know that I am rational, I know that you know that I know that you know that I am rational,... Perfect Information: All relevant information is available

ATTENTION !! There is some MATH !!

Models Mathematics is a convenient language to create models. Mathematics makes it easier to explore and unfold all the logical consequences and implications.

The Prisoners' Dilemma After a crime has been committed, of which the police has no clues, two suspects are arrested and kept in solitary confinement. In order to gather some evidence to take them to court, the police explains the situation to the two of them in the following terms...

What we are going to propose to you, we will propose to the other suspect in exactly the same terms. We know that one of you two is guilty, but we do not have any evidence. Your deposition might be the only evidence we can take to court. If in your deposition you accuse the other suspect, we can use it in court as an evidence against him, and you will be freed right away. Nevertheless, if in his deposition the other suspect accuses you, then the judge will find the evidence inconclusive and both of you will be condemned to 1 year each. If you do not agree to collaborate with us and refuse to make a deposition, then the other suspect might do and hence all the evidence will point towards you. In such case the judge will condemn you to 5 years. If both of you refuse to make a deposition, then there is no way we can take you to court without any evidence. Nevertheless, just because you did not agree to collaborate with us, we will keep you two in jail 2 weeks.

Key information: The “rules of the game” are clear: What the police just said The “players” are the other suspect and myself. My “choices” are clear: To accuse or To remain silent Depending on my decision, and on the decision of the other suspect, I may end up free or spend 2 weeks, or 1 year, or 5 years in jail.

Key Information: Accuse Silent Accuse Silent Prisoner 1 Prisoner 2 1, 1 0, 5 5, 0 2 w., 2 w. Payoff to Player 1 Payoff to Player 2

Brief Game Theory Timeline Late XIXth century: Mathematicians became interested in Economics John Von Neumann, Oskar Morgenstern John Nash Links Games-Economics are stablished Developement Nobel prize: Nash-Selten-Harsanyi 2000 First World Congress of Game Theory 2005 Nobel Prize: Robert Aumann (et al.) 2007 Nobel Prize: Roger Myerson (et al.)

Lessons and Disclaimers Game theory does not teach you “how to win” Framework for thinking strategically in a logical, systematic way Helps to predict the logical outcome of a “game situation” Helps to understand and use the “rules of the game” Helps to organize your thinking The course is an introduction to the field