The Art of Strategy; A Game Theorist's Guide to Success in (PDF)

 The Art of Strategy A GAME THEORIST’S GUIDE TO SUCCESS IN BUSINESS & LIFE 2  Also by AVINASH K. DIXIT & BARRY J. NALEBUFF Lawlessness and Economics: Alternative Modes of Governance (Gorman Lectures in Economics, University College London) by Avinash K. Dixit Investment Under Uncertainty by Avinash K. Dixit & Robert S. Pindyck Thinking Strategically by Avinash Dixit & Barry J. Nalebuff Co-opetition by Adam Brandenburger & Barry J. Nalebuff Why Not? by Ian Ayres & Barry J. Nalebuff 3  The Art of Strategy A GAME THEORIST’S GUIDE TO SUCCESS IN BUSINESS & LIFE 4  Avinash K. Dixit Barry J. Nalebuff W. W. NORTON & COMPANY New York • London 5  Copyright © 2008 by Avinash K. Dixit and Barry J. Nalebuff All rights reserved Doonesbury cartoon: © 1993 G. B. Trudeau. Reprinted with permission of Universal Press Syndicate. All rights reserved. Peanuts cartoon: © United Features Syndicate, Inc. For information about permission to reproduce selections from this book, write to Permissions, W. W. Norton & Company, Inc. 500 Fifth Avenue, New York, NY 10110 Library of Congress Cataloging-in-Publication Data Dixit, Avinash K. The art of strategy : a game theorist's guide to success in business & life / Avinash K. Dixit, Barry J. Nalebuff.—1st ed. p. cm. Includes bibliographical references and index. ISBN: 978-0-393-06995-2 1. Strategic planning. 2. Strategy. 3. Game theory. 4. Decision making. I. Nalebuff, Barry, 1958–II. Title. HD30.28.D587 2008 658.4'012—dc22 6  2008021347 W. W. Norton & Company, Inc. 500 Fifth Avenue, New York, N.Y. 10110 www.wwnorton.com W. W. Norton & Company Ltd. Castle House, 75/76 Wells Street, London W1T 3QT 7  To all our students, from whom we have learned so much (especially Seth—BJN) 8  CONTENTS Preface Introduction: How Should People Behave in Society? PART I 1. Ten Tales of Strategy 2. Games Solvable by Backward Reasoning 3. Prisoners’ Dilemmas and How to Resolve Them 4. A Beautiful Equilibrium Epilogue to Part I PART II 5. Choice and Chance 6. Strategic Moves 7. Making Strategies Credible Epilogue to Part II: A Nobel History PART III 8. Interpreting and Manipulating Information 9. Cooperation and Coordination 10. Auctions, Bidding, and Contests 11. Bargaining 12. Voting 13. Incentives 9  14. Case Studies Further Reading Workouts Notes 10  Preface WE DIDN’T SET out to write a new book. The plan was simply to revise our 1991 book, Thinking Strategically. But it didn’t quite turn out that way. One model for writing a revision comes from Borges’s character Pierre Menard, who decides to rewrite Cervantes’s Don Quixote. After great effort, Menard’s revision ends up being word-for-word identical to the original. However, 300 years of history and literature have passed since Quixote, including Quixote itself. Although Menard’s words are the same, his meaning is now entirely different. Alas, our original text wasn’t Don Quixote, and so the revision did require changing a few words. In fact, most of the book is entirely new. There are new applications, new developments in the theory, and a new perspective. So much is new that we decided a new title was called for as well. Although the words are new, our meaning remains the same. We intend to change the way you see the world, to help you think strategically by introducing the concepts and logic of game theory. Like Menard, we have a new perspective. When we wrote Thinking Strategically, we were younger, and the zeitgeist was one of self-centered competition. We have since come to the full realization of the important part that cooperation plays in strategic situations, and how good strategy must appropriately mix competition and cooperation.* We started the original preface with: “Strategic thinking is the art of outdoing an adversary, knowing that the adversary is trying to do the same to you.” To this we now add: It is also the art of finding ways to cooperate, even when others are motivated by self-interest, not benevolence. It is the art of convincing others, and even yourself, to do what you say. It is the art of 11  interpreting and revealing information. It is the art of putting yourself in others’ shoes so as to predict and influence what they will do. We like to think that The Art of Strategy includes this older, wiser perspective. But there is also continuity. Even though we offer more real-life stories, our purpose remains to help you develop your own ways of thinking about the strategic situations you will face; this is not an airport book offering “seven steps for sure strategic success.” The situations you face will be so diverse that you will succeed better by knowing some general principles and adapting them to the strategic games you are playing. Businessmen and corporations must develop good competitive strategies to survive, and find cooperative opportunities to grow the pie. Politicians have to devise campaign strategies to get elected and legislative strategies to implement their visions. Football coaches plan strategies for players to execute on the field. Parents trying to elicit good behavior from children must become amateur strategists—the children are pros. Good strategic thinking in such numerous diverse contexts remains an art. But its foundations consist of some simple basic principles—an emerging science of strategy, namely game theory. Our premise is that readers from a variety of backgrounds and occupations can become better strategists if they know these principles. Some people question how we can apply logic and science to a world where people act irrationally. It turns out that there is often method to the madness. Indeed, some of the most exciting new insights have come from recent advances in behavioral game theory, which incorporates human psychology and biases into the mix and thus adds a social element to the theory. As a result, game theory now does a much better job dealing with people as they are, rather than as we might like them to be. We incorporate these insights into our discussions. While game theory is a relatively young science—just over seventy years old—it has already provided many useful insights for practical strategists. But, like all sciences, it has become shrouded in jargon and mathematics. These are essential research tools, but they prevent all but the specialists from understanding the basic ideas. Our main motive for writing Thinking Strategically was the belief that game theory is too interesting and important to leave to the academic journals. The insights prove useful in many endeavors—business, politics, sports, and everyday social interactions. Thus 12  we translated the important insights back into English and replaced theoretical arguments with illustrative examples and case studies. We are delighted to find our view becoming mainstream. Game theory courses are some of the most popular electives at Princeton and Yale, and most other schools where they are offered. Game theory permeates strategy courses in MBA programs, and a Google search for game theory produces more than 6 million pages. You’ll find game theory in newspaper stories, op- eds, and public policy debates. Of course, much of the credit for these developments belongs to others: to the Economics Nobel Prize Committee, which has awarded two prizes in game theory—in 1994, to John Harsanyi, John Nash, and Reinhard Selten and in 2005, to Robert Aumann and Thomas Schelling;* to Sylvia Nasar, who wrote A Beautiful Mind, the best-selling biography of John Nash; to those who made the award-winning movie of the same name; and to all those who have written books popularizing the subject. We might even share a bit of the credit. Since publication, Thinking Strategically has sold 250,000 copies. It has been translated into numerous languages, and the Japanese and Hebrew translations have been best sellers. We owe a special debt to Tom Schelling. His writings on nuclear strategies, particularly The Strategy of Conflict and Arms and Influence, are justly famous. In fact, Schelling pioneered a lot of game theory in the process of applying it to nuclear conflict. Michael Porter’s Competitive Strategy, drawing on the lessons of game theory for business strategy, is equally important and influential. An annotated guide to the works of Schelling, Porter, and many others is provided in our Further Reading section. In this book we do not confine the ideas to any particular context. Instead, we offer a wide range of illustrations for each basic principle. Thus readers from different backgrounds will all find something familiar here. They will also see how the same principles bear on strategies in less familiar circumstances; we hope this will give them a new perspective on many events in news as well as history. We also draw on the shared experience of our readers, with illustrations from, for example, literature, movies, and sports. Serious scientists may think this trivializes strategy, but we believe that familiar examples are an effective vehicle for conveying the important ideas. 13  The idea of writing a book at a more popular level than that of a course text came from Hal Varian, now at Google and the University of California, Berkeley. He also gave us many useful ideas and comments on earlier drafts. Drake McFeely at W. W. Norton was an excellent if exacting editor for Thinking Strategically. He made extraordinary efforts to fashion our academic writing into a lively text. Many readers of Thinking Strategically gave us encouragement, advice, and criticism, all of which have helped us when writing The Art of Strategy. At the grave risk of omitting some, we must mention ones to whom we owe special thanks. Our coauthors on other related and unrelated book projects, Ian Ayres, Adam Brandenburger, Robert Pindyck, David Reiley, and Susan Skeath, generously gave us much useful input. Others whose influence continues in this new book include David Austen-Smith, Alan Blinder, Peter Grant, Seth Masters, Benjamin Polak, Carl Shapiro, Terry Vaughn, and Robert Willig. Jack Repcheck at W. W. Norton has been a constantly supportive, understanding, and perceptive editor for The Art of Strategy. Our manuscript editors, Janet Byrne and Catherine Pichotta, were generous to our faults. Every time you don’t find a mistake, you should thank them. We owe special thanks to Andrew St. George, book critic for the Financial Times. In choosing Thinking Strategically as a book he enjoyed reading most in the year 1991, he said: “it is a trip to the gym for the reasoning facilities” (FT Weekend, December 7/8, 1991). This gave us the idea of labeling some intriguing challenges we pose to the readers in this edition “Trips to the Gym.” Finally, John Morgan, of the University of California, Berkeley, gave us a powerful incentive with the threat, “If you don’t write a revision, I will write a competing book.” And after we saved him the trouble, he helped us out with many ideas and suggestions. AVINASH DIXIT BARRY J. NALEBUFF October 2007 14  INTRODUCTION How Should People Behave in Society? OUR ANSWER DOES not deal with ethics or etiquette. Nor do we aim to compete with philosophers, preachers, or parents. Our theme, although less lofty, affects the lives of all of us just as much as do morality and manners. This book is about strategic behavior. All of us are strategists, whether we like it or not. It is better to be a good strategist than a bad one, and this book aims to help you improve your skills at discovering and using effective strategies. Work, even social life, is a constant stream of decisions. What career to follow, how to manage a business, whom to marry, how to bring up children, and whether to run for president are just some examples of such fateful choices. The common element in these situations is that you do not act in a vacuum. Instead, you are surrounded by active decision makers whose choices interact with yours. This interaction has an important effect on your thinking and actions. To illustrate the point, think of the difference between the decisions of a lumberjack and those of a general. When the lumber-jack decides how to chop wood, he does not expect the wood to fight back: his environment is neutral. But when the general tries to cut down the enemy’s army, he must anticipate and overcome resistance to his plans. Like the general, you must recognize that your business rivals, prospective spouse, and even your children are strategic. Their aims often conflict with yours, but they may well coincide. Your own choice must allow for the conflict and utilize the 15