Wednesday, January 26, 2011

NBA Free Agency Key Takeaways


The central point of the experiment was to illustrate the difference between the game theoretic value of an option compared to the valuation of options in finance. In the NBA free agency game, the option provokes a strategic response from the rival team. Specifically, the presence of the option destroys the possibility of bidding successfully for the player and hence nullifies competition. The option is only valuable when it is not exercised. Exercising the option means that it has failed to stave off competition.

The broader point is to illustrate the difference between inward and outward thinking. Options are normally thought of as providing value to the holder through the action of exercise. In this experiment, the option derives value from changing the action of the other players in the game.

The value of the option is simply the difference in payoffs to the incumbent firm with and without it. With the option, the incumbent captures the bulk of the surplus, typically around $7mm. Without it, the incumbent captures very little, only about $500k using its best strategy. Thus, the option is worth about $6.5mm even though it is never exercised.

Such options appear in a number of contexts. In core strategy, this same idea appeared in the form of "meet or release" clauses secured by Nutrasweet in advance of entry by Holland Sweetener Company in the US. In venture capital, such clauses are often put into place by early round investors to help damp down competition for later round financing leading to IPO.

The other key point illustrated in the experiment is that pecuniary motives are not the only things determining payoffs in a game. Non-pecuniary factors such as reputation, fairness, and regard for others often play a role. Even when the stakes are large, these factors still matter. A great many professional athletes have chosen to sit out for a season because they perceived being treated unfairly, despite leaving millions of dollars on the table. While the caricature view of game theory/economics has in mind that, in the words of Randy Newman, "it's money that matters," the tools of game theory are flexible enough to incorporate these less easily measured incentives as well. Part of the art of good mental modeling is determining how the non-pecuniary aspects of a strategic situation are valued and incorporating them into the analysis.

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