Game Theory and Business Applications

406 Pages·2014·2.9 MB·English

by  Kalyan Chatterjee

International Series in
Operations Research & Management Science
Kalyan Chatterjee
William Samuelson Editors
Game Theory
and Business
Applications
Second Edition
International Series in Operations
Research & Management Science
Volume 194
SeriesEditor
FrederickS.Hillier
StanfordUniversity,CA,USA
SpecialEditorialConsultant
CamilleC.Price
StephenF.AustinStateUniversity,TX,USA
Forfurthervolumes:
http://www.springer.com/series/6161

Kalyan Chatterjee William Samuelson
•
Editors
Game Theory and Business
Applications
Second Edition
123
Editors
KalyanChatterjee WilliamSamuelson
DepartmentofEconomics SchoolofManagement
PennsylvaniaStateUniversity BostonUniversity
UniversityPark,Pennsylvania Boston,Massachusetts,USA
USA
ISSN0884-8289
ISBN978-1-4614-7094-6 ISBN978-1-4614-7095-3(eBook)
DOI10.1007/978-1-4614-7095-3
SpringerNewYorkHeidelbergDordrechtLondon
LibraryofCongressControlNumber:2013937176
©SpringerScience+BusinessMediaNewYork2014
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Contents
1 Introduction................................................................. 1
KalyanChatterjeeandWilliamSamuelson
2 GameTheoryModelsinFinance ......................................... 17
FranklinAllenandStephenMorris
3 GameTheoryModelsinAccounting..................................... 43
ChandraKanodia
4 MarketingApplicationsofGameTheory................................ 81
SridharMoorthy
5 ApplicationsofGameTheoryinOperationManagement
andInformationSystems.................................................. 103
LodeLiandSeungjinWhang
6 IncentiveandStrategicContracting:Implicationsforthe
FranchiseDecision.......................................................... 137
FrancineLafontaineandMargaretE.Slade
7 GameTheoryandthePracticeofBargaining........................... 189
KalyanChatterjee
8 AGame-TheoreticApproachtoLegalSettlements..................... 207
WilliamSamuelson
9 GameTheoryandtheLaw................................................ 233
JonHanson,KathleenHanson,andMelissaHart
10 CooperationinR&D:Patenting,Licensing,andContracting......... 265
SudiptoBhattacharya,Clauded’Aspremont,SergeiGuriev,
DebapriyaSen,andYairTauman
11 AGame-TheoreticModelofTenure...................................... 287
KalyanChatterjeeandRobertC.Marshall
v
vi Contents
12 ExperimentallyTestingGameTheory ................................... 307
RachelCroson
13 Auctions:AdvancesinTheoryandPractice............................. 323
WilliamSamuelson
14 TheEconomicsofBidderCollusion...................................... 367
RobertC.Marshall,LeslieM.Marx,andMichaelJ.Meurer
Index............................................................................... 399
Chapter 1
Introduction
KalyanChatterjeeandWilliamSamuelson
Likeitspredecessor(ChatterjeeandSamuelson2002),theaimofthisnewedition
is to provide the interested reader a broad and (we hope) deep view of the way
business decisions can be modelled and analyzed using game theory.The chapter
contentsembraceawidevarietyofbusinessfunctions–fromaccountingtofinance
tooperationstomarketingtoorganizationaldesign.Moreover,specificapplication
areasincludeR&Dstrategies,bargaining,settlementnegotiationsintheshadowof
litigation, strategic behavior in legal settings, contractual issues in the academic
labor market, auctions and competitive bidding, and experimentaleconomics. All
oftheseapplicationsinvolvecompetitivedecisionsettings–thatistosay,situations
whereanumberofeconomicagentsinpursuitoftheirrespectiveself-intereststake
actions that together affect all of their fortunes. In the language of game theory,
playerstake actions consistentwith the given“rulesof the game,”and these joint
actions determine final outcomes and payoffs. Besides providing a structure in
whichtomodelcompetitivesettings,gametheorygoesalongwaytowardanswering
thekeyquestion:Whatoptimaldecisionoractionshouldacompetitortake,allthe
while anticipating optimal actions from one’s rivals? Provided the game-theoretic
description faithfully captures the real-world competitive situation at hand, game
theoryprovidesacompellingguideforbusinessstrategy.
From its birth with von Neumann and Morgenstern’s, Theory of Games and
EconomicBehavior(1944),andforitsnext25years,gametheorywasprincipallya
mathematical discipline. To be sure, elegant solution concepts were developed –
but for a relatively limited class of settings (such as zero-sum games). In the
last 30 years, however, game theory has been applied to a growing number of
K.Chatterjee((cid:2))
DepartmentofEconomics,PennsylvaniaStateUniversity,UniversityPark,PA,USA
e-mail:[email protected]
W.Samuelson
SchoolofManagement,BostonUniversity,595CommonwealthAve.,Boston,MA,USA
e-mail:[email protected]
K.ChatterjeeandW.Samuelson(eds.),GameTheoryandBusinessApplications, 1
InternationalSeriesinOperationsResearch&ManagementScience194,
DOI10.1007/978-1-4614-7095-3 1,©SpringerScienceCBusinessMediaNewYork2014
2 K.ChatterjeeandW.Samuelson
practicalproblems:from antitrustanalysis to monetarypolicy;from the design of
auctioninstitutionsto the structuringof incentiveswithinfirms; frompatentraces
to dispute resolution. Game theory is a staple of doctoral studies in economics,
finance, and management science. Indeed, there are many excellent texts in the
subject: Fudenberg and Tirole (1991), Osborne and Rubinstein (1994), Myerson
(1997) Rasmusen (2006), or Dixit et al. (2009) to name a few. Perhaps, a better
barometer of the growing importance of game-theoretic ideas in business and
managementisthegrowingplaceofthedisciplineinmainstreamtextsinstrategy,
microeconomics,andmanagerialeconomics.NotableamongtheseareMilgromand
Roberts (1992), McAfee (2005), and Besanko et al. (2012). Besides economics,
strategy, and finance, the marketing area has also been a fertile area for game-
theoreticapplications.See,forexample,Wernerfelt(1995)andBagwell(2007).As
noted by Sridhar Moorthy in Chap. 4, an analysis of key words of 2,300 articles
publishedinmarketingsciencebetween1982and2011shows“gametheorytobe
thesecondmostpopularkeywordafter‘pricing’.”Bycontrast,30yearsago,game
theorywasabsentfrommosttextbooksandmostresearchwork.
The chapters of this second edition outline some of the most interesting
applicationsofgametheoryinnon-technicalterms.Chapters2,3,and7areretained
fromthefirst edition,whileChaps. 5, 6,13,and14 havebeenextensivelyrevised
andupdatedtoreflectnewresearchoverthelastdecade.Theremainingsixchapters
are new and originalcontributionscoveringmarketing, research and development
strategies, out-of-court settlements, law and economics, the role of academic
tenure,andexperimentaleconomics.We presupposethatthereaderhasa working
knowledgeof basic game-theoreticconceptsandresults: fromNash andBayesian
equilibrium, to moral hazard and adverse selection. (Any of the game theory and
economicstextscitedabovearegoodplacestoturnforre-enforcingthebasictools.)
The first section of this volume discusses game-theoretic applications in five
functional areas of business: finance, accounting, marketing, operations man-
agement and information systems, and organization design. The second section
considersimportantapplicationsincludingstrategicbehaviorinbargainingsettings
and legal settings, the peculiar institution of academic tenure, auctions and com-
petitive bidding institutions, and experimentaleconomics.The emphasis is on the
contributions of game theory to both theory and practice. It goes without saying
that no single book can include the contributionsof game theory in all aspects of
business. Omitted from this volume are such important topic areas as: regulation
(including antitrust practices), strategic aspects of the recent financial crisis, and
ecommerceapplications.
1 FunctionalBusinessAreas
The opening chapter in this section, by Franklin Allen and Stephen Morris, deals
with finance, the area in business that has historically drawn most on economics
for its theoretical development. Allen and Morris consider two broad fields in
1 Introduction 3
finance, asset pricing and corporate finance. The first is concerned primarily with
the decisions of investors and the second with the decisions of firms. The pre-
game-theoreticapproachtothesefieldsreliedheavilyontheassumptionsofperfect
information and perfect markets. While these early models were successful in
explainingmanyempiricalphenomena,sophisticatedempiricalworkuncoveredthe
existence of “anomalies” that the theory could not explain. This was especially
the case in corporate finance, where the puzzle of why firms pay dividends and
howfirmschooselevelsofdebtandequityresistedsimpleexplanationsbased,for
example, on incorporating tax effects into the models of Miller and Modigliani.
Thisgaverisetothefirstwaveofmodelsthatincorporatedasymmetricinformation
and signaling.Allen and Morrisdiscuss these in some detail, notingtheir insights
andalso their limitations.In addition,strategicinteractionplaysan importantrole
whenanalyzingthelinksbetweenproductmarketsandfinancialdecisions–whether
thesebemodelsofdebtlevels,takeoverbidsandthemarketforcorporatecontrol,
or modelsof financial intermediation.The main features of these models are also
considered in this chapter. While the area of asset pricing has seen less game-
theoreticscholarlywork,thechapterdoesexaminethebest-knownmodelsofmarket
microstructure.
AllenandMorrisalsosurveythe“secondwave”ofgame-theoreticmodelingin
finance.Thissecondwavereflectsrecentworkonhigherorderbeliefsandexplores
theconsequencesofdepartingfromthecommonknowledgeassumptionstypicalof
traditional models. The authors take up the recent work on information cascades,
appliedtosuchphenomenaasbankruns(alsothesubjectofinfluential“firstwave”
models) and the effect of different priors versus different information. While the
extensiveuseofgametheoryandcontracttheorymodelshasbroughttheorymore
inlinewithobservation,muchmoreremainstobedone.AllenandMorrisprovide
pointerstowherethisresearchisheadinginthefuture.
The field of accounting, though linked with finance in the popular mind, has
traditionally pursued somewhat different research methods. In Chap. 3, Chandra
Kanodia, discusses the changes in accounting research that have necessitated the
use of game theory and the methods of mechanism design. The focus is now not
so much on ex post analysis of accounting data as on the strategic interactions
amongindividualsandtheexanteincentivestoengageinvariouskindsofbehavior.
Kanodia considers new approachesto managementaccounting, with the focus on
three main research avenues:(1) The design of performanceincentives(including
the role of stochastic monitoring) to alleviate the problems of “moral hazard”
in principal-agent problems; (2) The problems of coordination in organizations,
especially the use of transfer pricing and budgeting to induce efficient internal
decisions;and(3)Strategiesforauditorhiringandauditorpricing.
Concerning the first research topic, moral hazard occurs when an agent takes
actions (in its own self-interest) that are unobservable to the principal and which
mayconflictwiththeprincipal’sinterests.InKanodia’smodel,theprincipalcannot
observe the agent’s action, but can observe two separate signals – performance
measures,ifyouwill–correlatedwithhisaction.Thefirstsignaliscostless,butthe
secondiscostly.Havingobservedthefirstsignal,whenshouldtheprincipalpayto