FIN 580ST / MBA 505ST Strategic Thinking, Incentives, and Information Course Syllabus Winter 2011 Charles M. Kahn

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1 University of Illinois Department of Finance FIN 580ST / MBA 505ST Strategic Thinking, Incentives, and Information Course Syllabus Winter 2011 Charles M. Kahn Tuesdays and Thursdays 11 am, BIF 3039 Note that the first team assignment is due on Sunday, January 23. Students are required to get their teams together by Thursday, January 20. See below for more details. This course provides a systematic approach to strategic thinking. The first part of the course applies game theory to the analysis of business decisions. It uses these concepts to understand how businesses interact strategically and to develop general principles for such interaction. The second portion of the course introduces incentive mechanisms. In order to cope with the strategic behavior of other parties (employees, customers, investors, suppliers and competitors) businesses are organized so as to channel strategic behavior through incentive mechanisms. We will examine some basic incentive devices and see some of the principles of their design. The course provides grounding that is particularly valuable for work in corporate finance and business strategy. It is also useful for aspects of work in other branches of finance and marketing and in international business. Objectives I have three different goals for the students in this class; various assignments and lectures are intended to help with one or another of these goals. First I want you to understand the concepts underlying game theory, strategic thinking and design of incentive systems. Second I want you to recognize and analyze strategic situations as they arise in real-world examples. Third I want you to practice applying the principles by developing strategies for simple strategic situations and seeing how your strategies fare against those of your classmates. Communication My address is c-kahn@illinois.edu. When sending a message for an assignment or with respect to this course, the words Strategic Thinking must be included in the subject field; otherwise the messages may get lost. This is particularly important when submitting timesensitive assignments. If an assignment is not received in time because this requirement has been forgotten, it will be treated as late. When team assignments are submitted by , always cc: all members of the team. 1

2 Teams You are encouraged to put together your own teams for this course. Teams will typically contain four members each. Please let me know your team rosters in class on Thursday, January 20. Choose a team name and me with the team name and the names of the team members (do not send them in an attachment). Be sure to cc: each member of the team. Those students who have not found teams by Thursday evening will be randomly allocated to teams by me. Course Organization A course schedule with readings and assignments is attached. Due dates for post-class assignments are indicated in the schedule. The outline also indicates which assignments should be done individually and which are team assignments. Course materials are available on Compass, under Fin 580 / MBA 505 ST; assignments and other information will be posted on this site and students are responsible for checking the site regularly. Quiz and Exam There will be a quiz during the session on Tuesday, February 1. There will be a final exam during the week of March If you miss the quiz or the final exam you will receive a score of 0 for that component of your grade. Exceptions will be made only upon presentation of documented evidence indicating a serious illness, family emergency, job interview, or University-authorized absence. If an exception is granted, then the decision will be at my discretion whether to schedule a make-up exam or to adjust the weight of the other components of the course grade. You are strongly urged to make every effort to take quizzes and exams as scheduled. Assignments The problem set is to be prepared individually. You may consult with other students on it, but you may not examine another student's solution. For the team projects and group memos, discussion must be confined to team members. Copying of solutions from any source is prohibited under any circumstances. Assignments must be submitted on time. Late submissions will be heavily penalized; submissions received after the grading has been completed will not be accepted. Grades The grade for the course will be determined as follows: Team Projects (2) 20% Quiz 10% Problem Set 10% Team Memos (3) 30% Final Exam 30% The course grade will be determined by aggregating the scores from each component shown above. Scores on components may be standardized to adjust for differences in means or variation. The resulting standardized aggregate score will determine the course grade. Plus/minus grading will be used for the course grade. 2

3 Academic Integrity Academic integrity is fundamental to the intellectual life of any university. Consistent with University and MBA and MSF Program policies, violations of academic integrity will be considered a serious offense. Any student who is judged to have violated academic integrity in this course will be subject to the penalties discussed in section 31 of the Code on Campus Affairs. These penalties include, among others, failure for the course or dismissal from the University. Copying results on an exam, plagiarizing homework, or unauthorized use of materials from this course in previous years constitutes a violation of academic integrity. Texts The main text for the course is The Art of Strategy by Avinash K. Dixit and Barry J. Nalebuff. (DN) For those who would like a more formal account of game theory, I recommend: Games and Information by Eric Rasmussen, and Fun and Games by Ken Binmore. These additional texts are not required. Instead, I will provide handouts covering the material in a more applied fashion. I will also provide relevant newspaper articles via electronic reserve. The schedule for these articles and a link to electronic reserves will be available on Compass. You may wish to make copies to bring to class. During the course we will examine two case studies; instructions for purchasing them will be provided later. Office Hours I am happy to meet with you. I will plan to go to the BIF atrium immediately after class for informal discussions. If you wish to meet at another time, please call to arrange a meeting, or Ms. Mary Barker at mdietz@illinois.edu. (Let her know you are in the Strategic Thinking course.) Tentative Schedule Part I, Game Theory Note: Handouts will be provided explaining the team projects in greater detail. In addition to the readings listed below, I will provide newspaper articles online, which you are required to read before the next class. SESSION 1: Tuesday, January 18, Sequential Games What is the key to strategic thinking? What is the fundamental rule for strategic behavior in sequential games? Read DN chapter 2 and work through game tree examples provided in class. Put together your team. Bring a copy of the roster to the next session, and send me an e- mail of the roster by 8 pm January 20. SESSION 2: Thursday, January 20, Simultaneous Move Games What are the principles for play in simultaneous move games? How do you distinguish simultaneous and sequential situations? Group Project 1: Develop a team strategy for playing a repeated prisoner's dilemma. This is due at 5 pm on Sunday, January 23. 3

4 SESSION 3: Tuesday, January 25, Repeated Interaction How can repeated interaction avoid the prisoner's dilemma? What factors contribute to successful cooperation by rivals? Read DN chapters 3-4. SESSION 4: Tuesday, January 27, Strategic Moves When is it advantageous to move pre-emptively? When are threats and promises useful? How can a player make a credible commitment to a strategy? Read DN chapters 6-7. Post-Class Assignment Several newspaper articles will be provided. For each article, think about how to reinterpret some significant aspect of the article as a game and decide how the players in that game should play. This assignment will form the basis of a quiz during the session on February 1. SESSION 5: Tuesday, February 1, Examples of Strategic Behavior and QUIZ Practice at recognition and analysis of strategic situations Prepare for quiz; see above. Team memo: Find a newspaper article; reinterpret the situation described as a game. Describe the game and analyze the players' strategies in that game. Due at beginning of final class session, March 1 SESSION 6: Thursday, February 3, Unpredictability When is unpredictability advantageous? How can a player ensure that rivals are unable to take advantage of his actions? Read DN chapter 5 Prepare memo for case SESSION 7: Tuesday, February 8, Case 1 (team memo for case 1 due) Problem set (individual). Due at beginning of class on February 17 Part II, Mechanisms SESSION 8: Thursday, February 10, Coordination How do market imperfections affect strategic behavior? How can coordination be achieved when markets fail? Read DN Chapters 9 and 11 SESSION 9: Tuesday, February 15, Auctions and Bidding What bidding strategies will be most effective in different forms of auctions? none Read DN, chapter 10 4

5 SESSION 10: Thursday, February 17, Auctions and Bidding II (hand in problem set) When does the winner's curse occur? How can it be avoided? Group Project 2: Develop a team bidding strategy for our simulation of the Nationwide Narrowband Electromagnetic Spectrum Auction. Bidding begins Sunday, February 20. The first written portion of this assignment will be due before 5 pm on Monday afternoon, February 21; additional portions will be due as the auction progresses. (Supplementary readings by Peter Cramton, "Money out of thin air: The Nationwide Narrowband PCS Auction" and The FCC Spectrum Auctions: An Early Assessment, and Richard Thaler, The Winner s Curse will be available on reserve). SESSION 11: Tuesday February 22, Information and Incentives How do moral hazard and adverse selection affect incentives? How can contracts alter incentives? How can contracts be used to elicit information? What is a lemon? What is a signal and when is it effective? Read DN chapters 8 and 13 SESSION 12: Thursday, February 24, Case 2 (team memo for case 2 due) SESSION 13: Wrap-up: Ethics and Strategic Thinking (team memo analyzing newspaper article due) * (The date for this final session will be scheduled later) Is ethical behavior strategic? Is strategic thinking ethical? 5