Game Theory and Business Strategy

B65.3323.20
Spring 2005

Adam Brandenburger
J.P. Valles Professor of Business Economics & Strategy
7-74 KMC (office)
998.0430 (v)
[email protected]

Class times: Wednesdays 1:30-4:20pm

Office hours: Thursdays 5:00-7:00pm

1. Overview
This is a course on game theory and its application to business strategy. We will develop the
basic tools of game theory through lectures and exercises, and we will put the tools to work by
applying them to business examples and cases.*

2. Game Theory
Game theory studies competitive and cooperative behavior in strategic environments, where the
fortunes of several players are intertwined. It provides methods for identifying optimal strategies
and predicting the outcome of strategic interactions.

The field of game theory began around 1900 when mathematicians began asking whether there
are optimal strategies for parlor games such as chess and poker, and, if so, what these strategies
might look like. The first comprehensive formulation of the subject came in 1944 with the
*
The course was developed jointly with Ken Corts. I thank him for the many hours spent working on it together. I
am also very grateful to May Cowan (Stern MBA 2003) for assistance on the course.

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publication of the book Theory of Games and Economic Behavior by famous mathematician
John von Neumann and eminent economist Oskar Morgenstern. As its title indicates, this book
also marked the beginning of the application of game theory to economics. Since then, game
theory has been applied to many other fields, including political science, military strategy, law,
computer science, and biology, among other areas. In 1994 three pioneers in game theory were
awarded a Nobel Prize, marking the ‘arrival’ of the field.

Among the other applications, game theory today is finding its way into the world of business.
(Pick up a business magazine or book and there is a good chance that it will use some game-
theory jargon: zero-sum game, Prisoner’s Dilemma, win-win game, etc.) As well as learning the
underlying theory in the course, we’ll be looking at how game theory can indeed be applied to
business.

3. Course Content
The course consists of five modules, which proceed from simpler games to progressively more
complicated ones. (You can find a detailed day-by-day schedule in Section 7 below.)

Module: Thinking About What They’re Thinking

In this module we begin with a tour of some of the best-known games studied in game theory.
With these games in mind, we then ask the basic question: How can a player choose a good
strategy when the best choice depends on what strategies the other players in the game choose?
To answer, we will introduce techniques for thinking through the game from the positions of the
other players, and anticipating their choices. Topics covered in this module include:
• The Prisoner’s Dilemma, the Battle of the Sexes, the Coordination Game, asymmetric
games, market entry, innovation games, promotions strategy, “upping the ante,” …

Module: Valuing the Players’ Positions

In this module, we will examine how value is created by the players in a game and how that
value is divided up among them. We will ask: What determines how much value each player
gets? To answer, we’ll define the concept of added value, and we’ll look at ways in which
players can change their own added values and also the added values of other players. Topics
covered in this module include:
• Generic strategies, buyer power, strategic positioning, “pay me to play,” globalization,
multibusiness strategy, …

Module: Moving First or Second

In this module, we look at games in which one player goes first, and then another player has to
make a choice in response to what the first player did. We will ask: When is there a first-mover
advantage in games of this kind, and when is there a second-mover advantage? To answer, we
will look at how to analyze a game by starting at the end of the game and reasoning backwards to
the beginning. We’ll also see the importance of being able to commit to particular moves in the
game. Topics covered in this module include:
• Strategic commitment, incentives to innovate, entry and exit, “eating-your-own-lunch”
strategy, “fast follower” strategy, …

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Module: Being Rational or Irrational
In this module, we look at more complicated games in which one player moves, then another
player responds, then the first player moves again, etc. This is where strategies of bluffing,
signaling, etc. come into play. We will ask: How can the players try to shape or influence what
other players think about the game? We will see that a player will sometimes want other players
to believe that it is acting rationally; and sometimes want other players to believe that it is acting
irrationally! Topics covered in this module include:
• Games of bluffing, games of signaling, entry, betting, wars of attrition, contract
negotiations, …

Module: Linking Games

In this final module, we look at how separate games can be linked together to make a larger
game. We will ask: When does a player do better—or worse—by playing the larger game rather
than the smaller ones? Topics covered in this module include:
• Repeated games, bundling, complements, judo strategy, …

4. Philosophy of the Course

This section describes some of the ‘design rules’ that are behind the course, and that we shall
follow in the classroom.

4.1. Role of Mathematics Game theory is a mathematical field, and we will use some
mathematics in the course. But this doesn’t mean that there’ll be lots of numbers or techniques.
Rather, it means that we’ll be extremely clear about what we are assuming and about what
follows from our assumptions. The ability to be clear in this way is, in fact, the essence of
mathematics! So, think of what we’ll do as more an exercise in careful logic—with some simple
calculations thrown in. The mathematics in the course shouldn’t be a hurdle for anyone. (But,
for those interested there will also be additional technical readings available.)

4.2 A First or Second Course? The course presupposes no knowledge of game theory. This
said, it should also be of interest to people who have already taken a course in the subject, since
it contains quite a bit of theory that isn’t covered in many courses. Also, most of the applications
to business were developed especially for this course.

4.3 Legal and Ethical Aspects Discussions of game theory and business strategy may touch on
legal issues. For example, antitrust laws determine, among other things, what types of business
contracts are legal and what types are not. In this course, we will try to note some of the legal
issues that can arise. This is the important domain of courses on the law and business. The
course—like any course on business—will also likely raise very basic questions about what is
ethical behavior in business, what is the purpose of business, etc. These are legitimate—indeed,
vital—matters for discussion.

4.4 The Course and Beyond Some of the ideas I’ll bring to this course I have taught many
times. But some course materials will be untested, as I try out new ideas that I think are
important. I hope we’ll have many successes together in the classroom, but there are bound to be

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a few failures as well. Still, I hope that even the failures will be, to use the language of the
Apollo 13 mission, “successful failures.” (And I am pretty confident that we’ll arrive at the end
of the course in one piece.) Most important, I consider the course only the start of a conversation
among us that I hope continues long after the course itself is over.

5. Course Format
Most classes will have the following two-part format.

In the first part of the class, I’ll introduce the game theory we’ll learn that day, going over any
notes on the theory that were assigned. We’ll then learn the theory by working through the
assigned exercises together. We’ll go over the exercises in detail, making sure not just to
calculate but also to understand! (I’ll also put complete solutions on Blackboard at the end of
each class.)

In the second part of the class, we’ll connect the theory to business via the illustrations you were
assigned to read. I’ll also have slides giving various applications of the theory.

6. Grading and Participation

There will be three graded pieces of work. One is a short, take-home midterm exam. This is
designed so you’ll be able to test your understanding of the course concepts covered to that
point. You’ll be asked to state definitions given in the readings, and to work through some
simple exercises. The midterm will count for 30% of the overall grade.

There will be a short take-home quiz, handed out towards the end of the course. This will ask
you to analyze a specific game, and counts for 15% of the overall grade.

Finally, there is a short paper (a limit of 10 pages), which you should write in teams of four or
more members. The paper will count for 55% of the overall grade. It should be a game-theoretic
analysis of a real-world situation. I expect most students will write about business situations
(either for-profit or non-profit), but some may choose to write about other areas. The paper
should have five sections: (i) a short executive summary; (ii) a short description of the situation
being analyzed; (iii) a game model of the situation; (iv) a discussion of the strategies employed
by the players; and (v) brief comments on issues outside the scope of the formal model. The
emphasis of the paper should be on clear logic rather than lots of calculations.

On participation, everyone is expected to attend all classes and to participate actively in class. In
class, we’ll go through the exercises together and discuss readings. Going through the exercises
will be a very important part of how we learn game theory. You are expected to have prepared
the exercises, and to come to class ready to try out your analyses, ask questions, and help all of
us along. Over the course, I will make a judgment about each student’s level of involvement in
class discussions, and, if a student’s written work falls between two grades, use this to decide the
grade.

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If you need to miss a class, please send me an email (in advance, if at all possible) letting me
know. Remember that the course depends on each of us being present and participating.

7. Detailed Schedule
The table below gives a detailed schedule of classes, topics, materials, and assignments. You
will see that there are three headings referring to course materials:

a. Materials are the required readings for the classes. Most of these will be posted on
Blackboard. A few items are in the XanEdu coursepack.

b. Readings are mostly illustrations of the theory, and will help a lot in seeing how to apply
the theory we develop. You should cover these as well. Several of these items are from
the books Co-opetition (by Adam Brandenburger and Barry Nalebuff, Doubleday, 1996)
and Thinking Strategically (by Avinash Dixit and Barry Nalebuff, Norton, 1991). Please
read through these books alongside the course. Articles listed in this section are in the
coursepack.

c. Technical Background Material is optional. This will be of interest to those of you

who want to delve more deeply into the formal development of game theory, but it is
okay to omit this set of materials.

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 Date Topic Materials Readings Assignment Technical Background Material
(Available at
www.stern.nyu.edu/~abranden)
MODULE 1: THINKING ABOUT WHAT THEY’RE THINKING
1. 1/26 Introduction to Matrix Syllabus Co-opetition, Ch.1 Please read the note “Introduction “Technical Note on Dominance and
Games “Introduction to Game Thinking Strategically, to Game Theory.” In class, I’ll Iterated Dominance”
Theory” Ch.3 introduce the course, and then “Technical Notes on Nash
we’ll go through the note together Equilibrium: Definition; Existence;
and discuss applications. Self-Enforcing Agreement, Self-
Fulfilling Beliefs, Randomization,
Evolution”
MODULE 2: VALUING THE PLAYERS’ POSITIONS
2. 2/2 Introduction to Added “Bargaining Games” Co-opetition, Ch.3, Please read “Bargaining Games” “Technical Notes on Cooperative
Value “Exercises on Added Value” pp.40-49 and also the reading. Then work Game Theory: Characteristic
through “Exercises on Added Functions, Allocations, Marginal
Value.” In class, we’ll finish our Contribution; The Core”
discussion of “Introduction to
Game Theory,” and then turn to the
new material.
3. 2/9 Added Value Contd. “Added Value and Buyer Co-opetition, Ch.4, Please work through the exercise
Power” pp.71-76; Ch.5, pp.110- “Added Value and Buyer Power,”
117 and do the reading. In class, we’ll
“Value-Based Business continue going through “Exercises
Strategy,” by Adam on Added Value,” then look at
Brandenburger and some applications of the added-
Harborne Stuart, Journal value concept, and then turn to the
of Economics & new exercise.
Management Strategy,
1996
“Reality Checks,” by
Brooks Barnes, Wall
Street Journal, 07/27/04
4. 2/16 Strategic Positioning “A Positioning Game” Please read the exercise “A
“Mixing It Up: Ben & Positioning Game” and “Mixing It
Jerry’s vs. Haagen-Dazs, by Up,” and then work through the
Ken Corts, 11/04 questions in the exercise.

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5. 2/23 Added Value and We’ll finish “A Positioning “Biform Games,” by Adam
Business Strategy Game,” and then look at further Brandenburger and Harborne Stuart,
applications of added value to rev. 08/04
business strategy.
MODULE 3: MOVING FIRST OR SECOND
6. 3/2 Game Trees “Game Trees” Thinking Strategically, Please read “Game Trees” and “Technical Note on Game Trees”
“First-Mover Advantage?” Chs. 2, 5, 6 work through the “First-Mover “Technical Note on Backward
Advantage?” exercise. In class, I’ll Induction”
introduce the module, and then
we’ll turn to the exercise.
7. 3/9 Incentive to Innovate “The Incentive to Innovate” “For Jet Rivals, Caution Please read the exercise “The
Excerpt from “Airbus vs. Here, Swagger There,” Incentive to Innovate” and the
(Midterm exam handed Boeing in Superjumbos,” by by Edward Wong, The excerpt from “Airbus vs. Boeing in
out this week; to be Ben Esty and Pankaj New York Times, Superjumbos,” and then work
submitted by end-week) Ghemawat, Harvard 07/28/02 through the questions in the
Business School, 08/01 exercise.
3/16 SPRING BREAK
MODULE 4: BEING RATIONAL OR IRRATIONAL
8. 3/23 Rationality and “Rationality and Co-opetition, Ch.3, Please read “Rationality and “Technical Note on Common
Irrationality Irrationality” pp.59-64 Irrationality,” work through the Knowledge”
“An Entry Game” “Why We’re So Nice: exercises “An Entry Game” and “A
“A Good Bet?” We’re Wired to Good Bet?” and read the article
Cooperate,” by Natalie “Why We’re So Nice.” In class,
Angier, The New York I’ll introduce the module, and then
Times, 07/23/02 we’ll turn to the exercises.
9. 3/30 Signalling “Signalling Games” Co-opetition, Ch.7, Please work through the exercise “Technical Note on Forward
pp.198-211 “Signalling Games” and also the Induction”
“Logic Behind Air Fares readings.
Often Defies
Economics,” by Scott
McCartney, Wall Street
Journal Online, 10/01/03
Excerpt from The
Handicap Principle: A
Missing Piece of
Darwin’s Puzzle, by
Amotz and Avishag
Zahavi, Oxford
University Press, 1997,
xiii-xvi

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MODULE 5: LINKING GAMES
10. 4/6 Bundling “Bundling” Co-opetition, Ch.3, Please work through the exercise
pp.57-58 “Bundling.” In class, I’ll introduce
the module, and then we’ll turn to
the exercise.

11. 4/13 Complements “Cheap Complements” Co-opetition, Ch.2, Please work through the exercise
pp.11-34; Ch.4, pp.100- “Cheap Complements.” Also, read
103 the article “Reckonings; Microsoft:
“Reckonings; Microsoft: What Next?”
What Next?” by Paul
Krugman, The New York
Times, 04/26/00
12. 4/20 Judo Strategy “Judo Strategy: Fear of Co-opetition, Ch.8, Please work through the exercise
Failure” pp.236-245 “Judo Strategy: Fear of Failure.”
(Take-home quiz handed “Judo in Action” Excerpt from Judo Also, read “Judo in Action” and
out this week) “Judo Strategy: Fear of Strategy, by David answer Question 1 there. If time
Fighting” Yoffie and Mary Kwak, permits, we’ll start on “Judo
Harvard Business School Strategy: Fear of Fighting,” so
Press, 2001 please start preparing this exercise,
too.
13. 4/27 Judo Strategy Contd. Review of Judo Strategy, We’ll continue going through
Course Summary by Adam Brandenburger, “Judo Strategy: Fear of Fighting,”
Manageris, 02/02 and also discuss Question 2 in
“Judo in Action.” After that, I’ll
give a summary of the course.
14. 5/10 Papers due
game-syllabus-20-01-08-05