Think more, think better… think strategically Juan D. Carrillo and Simon Wilkie University of Southern California Masiv 2014

It’s not the theory of how to play poker, bridge or chess It’s the theory of how to: Think strategicallyThink strategically Understand the motivations, the beliefs and ultimately the actions of other playersUnderstand the motivations, the beliefs and ultimately the actions of other players React optimally to the behavior of othersReact optimally to the behavior of others But we do illustrate it with games Game Theory

Think about … 1.What others DO

Think about … 1.What others DO 2.What others THINK

You all submit a one-decimal number between 0 and 100.You all submit a one-decimal number between 0 and 100. We compute the average (and call it A)We compute the average (and call it A) The person whose guess is closest to 2/3 of A wins $1M pride-dollarsThe person whose guess is closest to 2/3 of A wins $1M pride-dollars Meant to capture the role of beliefs about others’ beliefs (Keynes view of stock market: people price shares not based on what they think their fundamental value is, but rather on what they think everyone else think the average assessment of value is). Guessing Game Again, what should you do?

Guessing Game Level 0: “I have no idea, I choose a number at random”.Level 0: “I have no idea, I choose a number at random”. Level 1: “Players are bozos. They choose random numbers. It means A = 50. I am smart. I guess 2/3 of 50 = 33.3”.Level 1: “Players are bozos. They choose random numbers. It means A = 50. I am smart. I guess 2/3 of 50 = 33.3”. Level 2: “Everyone thinks they are smart but others are not. They are guessing I guess 2/3 of 33.3 = 22.2”.Level 2: “Everyone thinks they are smart but others are not. They are guessing I guess 2/3 of 33.3 = 22.2”. Level 3: “Geez, these guys are really smart. To win, I have to guess 2/3 of 22.2 = 14.8”.Level 3: “Geez, these guys are really smart. To win, I have to guess 2/3 of 22.2 = 14.8”. … and so on

Theorists Average = 17.1 Guessing Game Classroom Average = 26.8 Newspaper Average = 23.1

Think about … 1.What others DO 2.What others THINK

Think about … 1.What others DO 2.What others THINK 3.What others KNOW

Jar of Pennies Auction You all make a bid (zero or positive) for this jar of penniesYou all make a bid (zero or positive) for this jar of pennies Highest bidder wins: pay his bid (first-price auction) and get the cash equivalent of the content of the jarHighest bidder wins: pay his bid (first-price auction) and get the cash equivalent of the content of the jar All other bidders: get nothing and pay nothingAll other bidders: get nothing and pay nothing You just want to make as much money as possibleYou just want to make as much money as possible Meant to capture auction of goods that have the same value to everyone but no one knows exactly what this value is (oil drilling rights, timber rights, items for investment or resale) Write down your bid in a piece of paper

Jar of Pennies Auction Did anyone bid more than $14? $12? $10? $8? $6? $4? $2? $0? “Winner’s curse”: winning the auction conveys information Some estimates are too high, some too lowSome estimates are too high, some too low The winner made the highest bid, which generally implies that his estimate of profitability was among the highest onesThe winner made the highest bid, which generally implies that his estimate of profitability was among the highest ones  If you win, it is quite likely that you overestimated the value  If you bid close to your estimate of profitability then you are likely to lose money when you win

Jar of Pennies Auction The “rational” and “best” choice: bid something but shade the bid a ton (shade more if more uncertainty and if more bidders)The “rational” and “best” choice: bid something but shade the bid a ton (shade more if more uncertainty and if more bidders) The bottom line: if there are a lot of “crazy over-bidders”, it’s better that you don’t win.The bottom line: if there are a lot of “crazy over-bidders”, it’s better that you don’t win. “If one wins a tract against two or three others he may feel fine about his good fortune. But how should he feel if he won against 50 others? Ill.” Competitive bidding in high risk situations (Cappen, Clapp and Campbell) By the way, the amount of money in the jar was $8.11

The Betting Game Two players, 1 and 2, choose “bet” or “no bet”Two players, 1 and 2, choose “bet” or “no bet” If at least one chooses “no bet”: nothing happens, both get 0If at least one chooses “no bet”: nothing happens, both get 0 If both choose “bet”, payoffs are:If both choose “bet”, payoffs are: Player 1 learns state is “bad” or “not bad” (good + medium)Player 1 learns state is “bad” or “not bad” (good + medium) Player 2 learns state is “good” or “not good” (medium + bad)Player 2 learns state is “good” or “not good” (medium + bad) Meant to capture trading or betting for informational reasons goodmediumbad Payoff of player Payoff of player

The Betting Game Two players, 1 and 2, choose “bet” or “no bet”Two players, 1 and 2, choose “bet” or “no bet” If at least one chooses “no bet”: nothing happens, both get 0If at least one chooses “no bet”: nothing happens, both get 0 If both choose “bet”, payoffs are:If both choose “bet”, payoffs are: goodmediumbad Payoff of player Payoff of player Suppose you are player 1 and learn state is “not bad”. You know the routine, any guess?

The Betting Game goodmediumbad Payoff of player Payoff of player Not bet: 0 If state is “good”, player 2 chooses “not bet”

The Betting Game goodmediumbad Payoff of player Payoff of player Not bet: 0 If state is “not bad”, player 1 chooses “not bet” because it only matters what he does in “medium”

The Betting Game goodmediumbad Payoff of player Payoff of player Not bet: 0 If state is “not good”, player 2 chooses “not bet” because it only matters what he does in “bad”

The Betting Game goodmediumbad Payoff of player Payoff of player Not bet: 0 The “rational” choice: there is never joint betting (both get 0 always)The “rational” choice: there is never joint betting (both get 0 always) Groucho Marx Theorem: “I will never join a club that accepts someone like me as a member” The “best” choice: it may be optimal to bet if others sometimes mistakenly betThe “best” choice: it may be optimal to bet if others sometimes mistakenly bet The bottom line: trade for purely informational reasons can’t happen (your win is my loss) but it can occur under irrationality, overconfidence, illiquidity, etc.The bottom line: trade for purely informational reasons can’t happen (your win is my loss) but it can occur under irrationality, overconfidence, illiquidity, etc.

Behavioral Biases There are several well documented behavioral biases that can affect reasoning. Neuroeconomics examines the basis of the biases: -Overconfidence -Time consistency and commitment -Ambiguity aversion -Failure to Reason about others

Behavioral Biases There are several well documented behavioral biases that can affect reasoning. Neuroeconomics examines the basis of the biases: -Overconfidence -Time consistency and commitment -Ambiguity aversion -Failure to Reason about others

Conclusion: Think about … 1.What others DO 2.What others THINK 1.What others KNOW 2.What are my BEHAVIORAL BIASES... and use that information to make better decisions