Wednesday, March 9, 2011


Cal Memorial Stadium
Getting Ready for the Second Half

We're at the halfway mark in game theory. It's time to take stock of the main lessons learned.

1. Outward thinking

The goal of the class is to change how you think, to get you to view the world through an interactive/game theory lens. Outward thinking is the shorthand used to describe this process. It means analyzing situations by anticipating the rival's response and then "changing the game" with this in mind to find a successful outcome. Outward thinking sheds light on new opportunities (like how to make money when you have no form of competitive advantage whatsoever) as well as new ways to use the tools you've already developed (like using an option to stifle competition).

2. Mental Models

At the heart of outward thinking is the process of building mental models. To forecast a rival's moves correctly requires that you get inside the head of the rival. This means determining pecuniary aspects of various strategies as well as non-pecuniary aspects such as pride, perceived fairness, reference points and so on. Good mental modeling is a mix of financial forecasting and psychology. Good mental modeling also factors in the mix of possible moves--it takes the strategy idea of core capabilities and asks how these capabilities might be used in new and unexpected ways to create opportunities.

3. Commitment

Many times, there are opportunities to shape the strategic response of a rival. Typically, these shaping opportunities are referred to as commitment. By committing to an action or strategy, the rival is forced to react and this can be advantageous. Commitment strategies are not always obvious. They may involve divulging information that one might think should best be kept secret. For instance, in the McCain-Schumer exercise, Pharma was able to gain an advantage by disclosing its lobbying strategy even though this was a key input for the rival to develop its most effective counter strategy. Commitment also takes the forms of threats or promises. The key here is that these threats or promises must be credible to be effective. Sometimes, the best strategy to ensure credibility is to destroy the flexibility to choose other options. For instance, in the Coors case, it was better for Coors to have financially committed to its aggressive marketing strategy for deterrence to be effective.

4. Leverage the future

The fourth key idea is to leverage the future in order to promote good behavior today. This is an intuitive idea--if reputation matters, then I may not act opportunistically today since the reputation loss will be costly tomorrow. Most informal contracts rely on this idea. Game theory helps in two ways. First, it identifies situations where informal contracts will not be sufficient. For instance, in declining industries, reputation is worth much less. Second, it identifies key aspects for making informal contracts work: clarity, detection, rewards/punishments, and forgiveness. Often, one can change the game to strengthen reputational aspects and obtain good performance, as in GE v Westinghouse.

5. Change the game

While many analyses consist merely of assessing a given strategic situation and determining the best path to follow, in the long-run, there is often scope for changing the game. This idea is sometimes called market design or mechanism design. Game theory provides a powerful set of tools for determining the right design to solve a problem. For instance, in the teams problem, we saw how game theory could be used to shed light on finding the right types of incentives to generate employee effort. In the auctions unit, we saw how different designs affected the surplus created as well as value captured by the auctioneer. The second half of the course dives much deeper into the design problem. Here, we will not simply use the tools of game theory to analyze situations as we find them. Rather, we will use the tools to reshape these situations into the outcomes we want.

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