Tuesday, April 19, 2011

Class # 23 Highlights

Band of Brothers
Surviving the War of Attrition

We closed the auction unit with a cautionary tale about modeling behavior. The key to fighting a war of attrition is to determine the hazard rate of concessions. Now, there is a tendency toward overoptimism in estimating this hazard rate and, as a consequence, the war tends to lost longer than expected. We saw this vividly in the $20 bill auction where the total spend exceeded the value of the bill by $7. This also illustrates that the revenue equivalence theorem is a starting point rather than an ending point. Accounting for behavioral factors, risk preferences, framing and so on is essential in developing good mental models.

The second half of the class was about pricing. While most of pricing is concerned with identifying and segmenting consumer WTP in various ways, in our setting pricing strategies were strongly driven by outward thinking. The "right" price is the one slightly lower than what is being offered by rivals in the market. Thus, the mental model is to guess what this price might be based on past actions, market dynamics, and so on. This interdependence means that a predictable pricing strategy is vulnerable to exploitation. Thus, the right strategy is an unpredictable strategy. In class #24, we will discuss how to operationalize this idea through mixed strategy equilibria.

In the meantime, check out the results of the experiment here. On the first page, I list all of the prices charged by each team. Look for patterns. Are there tendencies you could exploit? Is your strategy exploitable. On page 2, the market interactions are shown. Notice that period 4 is very different from the other periods. Here, cooperation is almost achieved. Thinking back to OPEC, is it possible to maintain high prices in this setting?

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