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

2. 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

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

4. 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

5. 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

6. 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

7. 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

8. 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

9. 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

10. 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

11. 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

12. 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

13. 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

14. 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

15. 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

16. 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

17. 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

18. 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

19. 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

20. 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

21. 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

22. 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

23. 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

24. 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

25. 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

26. 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