1. Game Theory “In war the will is directed at an animate object that reacts.” - Karl Von Clausewitz, On War Mike Shor Lecture 2

2. Mike Shor Game Theory & Business Strategy 2 Defining the Game Review  Game theory is a description of strategic interaction between mutually aware players  You are self-interested and selfish  So is everyone else Outline:  Defining the rules of the game  Manipulating the rules if they are flexible  Questioning game theory’s assumptions

3. Mike Shor Game Theory & Business Strategy 3 Rules of the Game The strategic environment  Players  Strategies  Payoffs The rules  Timing of moves  Nature of conflict and interaction  Informational conditions  Enforceability of agreements or contracts The assumptions  Rationality  Common knowledge

4. Mike Shor Game Theory & Business Strategy 4 The Strategic Environment Players  Everyone who has an effect on your earnings Strategies  Actions available to each player  Define a plan of action for every contingency Payoffs  Numbers associated with each outcome  Reflect the interests of the players

5. Mike Shor Game Theory & Business Strategy 5 The Rules Timing of moves  Are moves simultaneous or sequential? Nature of conflict and interaction  Are players’ interests in conflict?  Will players interact once or repeatedly? Informational conditions  Are some players better informed? Enforceability of agreements  Can contracts be enforced?

6. Mike Shor Game Theory & Business Strategy 6 Example: Toys “R” Us Sequential timing  Threat  Manufacturer’s decisions How will my opponents react? Simultaneous timing  Manufacturer’s decisions What is my opponent doing right now? Information  Future profitability of warehouse clubs What can I infer from the actions of others? Agreements  Enforceability of contracts & agreements What happens if someone breaks the agreement?

7. Mike Shor Game Theory & Business Strategy 7 Changing the Rules Are the rules of the game fixed? COMMANDMENT When the rules of the game are flexible manipulate them to your advantage.

8. Mike Shor Game Theory & Business Strategy 8 Example: Agenda Setting Gore v. Bush before the U.S. Supreme Court Four judges prefer: Bush to Goreto Remand( B > G > R ) Three judges prefer: Gore to Remand to Bush( G > R > B ) Two judges prefer: Remand to Bush to Gore( R > B > G ) V oting by Majority Rule

9. Mike Shor Game Theory & Business Strategy 9 Agenda Setting (continued) No majority in three way race Chief Justice selects voting rules:  First, Bush v. Gore Then, Bush/Gore winner versus Remand  First, Bush v. Remand Then, Bush/Remand winner versus Gore  First, Gore v. Remand Then, Gore/Remand winner versus Bush

10. Mike Shor Game Theory & Business Strategy 10 Agenda Setting (continued) Recall member preferences: 4 (B>G>R) 3 (G>R>B) 2 (R>B>G) Majority rule results:  B beats G ; G beats R ; R beats B Voting results:  B beats G then winner versus R  R  B beats R then winner versus G  G  G beats R then winner versus B  B

11. Mike Shor Game Theory & Business Strategy 11 The Assumptions Rationality  Players aim to maximize their payoffs  Players are perfect calculators Common Knowledge  Each player knows the rules of the game  Each player knows that each player knows the rules  Each player knows that each player knows that each player knows the rules  Each player knows that each player knows that each player knows that each player knows the rules  Each player knows that each player knows that each player knows that each player knows that each player knows the rules  Etc. Etc. Etc.

12. Mike Shor Game Theory & Business Strategy 12 Common Knowledge Do people really behave as the theory predicts? If not, what good is the theory?

13. Mike Shor Game Theory & Business Strategy 13 Common Knowledge Examples  Intentional failure to coordinate  Financial and grade disclosure  Bluffing  Stock market

14. Mike Shor Game Theory & Business Strategy 14 The Stock Market & Rationality “I can calculate the motions of heavenly bodies, but not the madness of people” - Sir Isaac Newton (upon losing £20,000 in the South Sea Bubble in 1720) QUESTION: When would a sell-off occur if we knew the exact date of a bubble’s burst?

15. Mike Shor Game Theory & Business Strategy 15 Greater Fool Theory He who panics first wins You may be a fool to pay as much as you did, but you are betting that there’s a greater fool down the road. And if you’re right, then of course you aren’t being foolish.

16. Mike Shor Game Theory & Business Strategy 16 often is a good month for stocks” is typically a strong month for stocks” tends to be a good month for stocks” is usually a good month for stocks” is typically a bad month for the stock market” is usually the worst month for stocks” is traditionally a cruel month for stocks” is the worst month for stocks” “_________ Which Month Am I?

17. Mike Shor Game Theory & Business Strategy 17 Fun with Probabilities If, in each month, the stock market is equally likely to go up or go down, then there is over an 80% chance that some month will be “bad” three years in a row! Why is October so bad?

18. Mike Shor Game Theory & Business Strategy 18 October 1987

19. Mike Shor Game Theory & Business Strategy 19 – Wall Street Journal, quoting Mark Twain The Worst Month for Stocks “October. This is one of the peculiarly dangerous months to speculate in stocks. ”

20. Mike Shor Game Theory & Business Strategy 20 Wall Street Journal May 1988 Front Page Story: “Clear Road Ahead …” “Will record gains through the fall” “October looms on the horizon … the dreaded though inevitable slide.”

21. Mike Shor Game Theory & Business Strategy 21 1988 01234 MAYMAY

22. Mike Shor Game Theory & Business Strategy 22 Excess Returns prior to IPO Lock-Up Expiration Event Day Cumulative Abnormal Return -20-16-12-8-40481216 0.005 0 -0.005 -0.010 -0.015 -0.020 -0.025 -0.030

23. Mike Shor Game Theory & Business Strategy 23 What is a “Step”? “Now keep in mind this is just a ballpark figure”

24. Mike Shor Game Theory & Business Strategy 24 Summary You’re in a game The rules are likely to be flexible Think one step ahead The rule of three steps Looking ahead:  Equilibrium: What are the outcome of games?