Class 9 Highlights

In class #9, we concluded our unit on dominance with a couple of observations.

1. In auction settings, the only way to get truth-telling and efficiency in equilibrium is to apply Vickrey's Law. No other auctions will work. For example, If we use the rule that in the A,B setting, the winner of A simply pays the amount of the losing bid, then bidding above your value can be profitable. Likewise, in the multi-unit auction setting, using a uniform price auction will also not work in that a bidder's own bid can determine the price of units won. Therefore, bidders have an incentive to bid below their value for units further down the demand curve.

One practical implication of this second finding relates to auction IPOs. Most auction IPOs, such as those run through Hambrecht & Co. use the uniform price auction. For bidders seeking small numbers of shares, bidding is approximately truthful, but large institutional investors seeking many shares will have incentives to shade down bids. Thus, this auction does not completely do away with the "pop" on initial trading as the bid determining the price probably reflects a discount below fundamentals owing to these incentives.

The highlight of the second half of the class was a solution to the teams problem. We first noticed that, in a conventional teams problem, free-riding was an important consideration. In effect, the game was a prisoner's dilemma. Efficiency wages, i.e. paying wages above the market rate, can help to some extent by activating reciprocal motives on the part of employees. For years, this was IBM's strategy. It has also been routinely demonstrated in laboratory settings.

Incentives based solutions include profit sharing and bonus schemes. We saw that unless effort was extremely profitable relative to the personal cost to the employee, profit sharing schemes suffer from the same free rider problem as fixed wage schemes. Bonus schemes transform the problem into a stag hunt. The riskiness of the stag hunt depends on the aggressiveness of the target. The more aggressive the profit target, the more fragile the trust relationship and the less the likelihood of success. As a practical matter, a firm that strives to get more out of its employees may end up getting less than a firm that sets more modest goals. It is important to consider this tradeoff between trust and profits in determining appropriate incentives for a company.

As a practical example, some pundits have noted that the emphasis on "accountability" and ambitious short-term targets at Yahoo led to a culture where cooperation and trust across properties was diminished rather than strengthened. In stag hunt, one can think of the hare strategy as one of "silos" within an organization. Each group pursues its own goals rather than pursuing synergistic opportunities between groups. The lesson from game theory is that, accountability in the form of high powered incentives and severe punishments for missing targets creates exactly the conditions for silos to become the correct best response by managers in the firm. That is, we can use game theory to see how incentives can affect culture--sometimes in unexpected and undesirable ways.