Lecture 7 Course Summary

1. Lecture 7Course Summary The tools of strategy provide guiding principles that that should help determine the extent and nature of your professional interactions. This summary seeks to encapsulate those principles as a “mental reference” for thinking about bargaining, contracting, and the formation of longer term strategic interactions, such as alliances and employment relations.

2. Professional interactions as strategy Recall from 45-974 that “strategic” means that you recognize that your actions affect the other parties’ payoffs and vice versa. This course provides a strategic basis for how you should define your professional relationships, and how to behave within them. We started from simple notion that bargains and contracts are made with other players only if there are potential gains from the relationship, and that rational players recognize their actions affect both the size and their share of these gains.

3. Your bargaining position • In bargaining games the rules or conventions for making, accepting and rejecting offers are given to all the players involved: • The strength of your bargaining position depends on: • the information each party has about the potential gains from trade • the number of bargainers and their respective roles • the procedures that govern how bargaining takes place.

4. Bargaining outcomes For example we concluded that in situations where there really are gains from trade that don’t change or might shrink, there is no reason for negotiations to continue for more than one round, unless there is incomplete information. We also argued that in situations where there is incomplete information, not all the gains from trade are invariably realized, and that bargainers sometimes do not disclose their position for strategic reasons.

5. Setting the bargaining rules Since the rules of engagement affect the outcome to each of the bargaining players, every player would prefer to set his or her own rules. The nature of their job often puts managers in positions to set the bargaining rules. They do so by designing an optimal contract and presenting to the other parties as an ultimatum (all or nothing) offer.

6. Characterizing the optimal contract • Intuitively they seek to maximize the size of the pie and extract as much as possible. In such contracts, the private information and outside options available to each party are explicitly modeled through the: • incentive compatibility constraint • participation constraint. • The contract designer extracts the maximal rent from the relationship subject to these two constraints.

7. Complications and complexity • As the complexity of the optimal contract increases, so does the propensity for error, leading to responders: • rejecting the contract • accepting the contract but taking an action the manager did not intend • accepting the contract, taking the intended action, but leaving the manager without any rent.

8. The size and scope of firms Simpler contracts (such as uniform prices or letting another player make an offer) yield less rent than optimal contracts, but are easier to implement without unintended consequences. This led us to consider how strategic interactions help shape the firm’s boundaries. High value activities within the value chain demand the strategist’s attention as the firm seeks to capture the rents. Here the firm is proactive in approaching its bargaining partners and making contract offers. Conversely opportunities that offer little rent are best dealt with at arm’s length, for example within the market place.

9. Leadership Complicated or complex contracts are likely to bring the bargaining parties under the umbrella of the firm. The signed contracts themselves are games (where players make choices and receive payoffs), often repeated, played by the firm’s stakeholders and associates. These games may have multiple solutions. Leaders are adept at discovering self enforcing contracts or equilibrium, communicating to each party their best response within the suggested solution strategy profile, and thus convincing the interacting parties to select the solution of the leader’s choice. Managers often find themselves in precisely that role.

10. Repeated games Multiplicity is the existence of multiple solutions within a game (such as a signed contract that still leaves the bargaining parties discretion about its implementation) It sometimes arises when there are ongoing benefits from continuing a relationship and/or potential for repeated trade. If the solutions to all the kernels forming a finite stage game are unique, then the unique solution to the stage game is to play those kernel solutions. In these cases there is no scope for either leadership or reputation.

11. Strategic investment There is a role for leadership in identifying those solutions that are most beneficial to the firm, when there are multiple solutions to the kernel game stage, and in infinite horizon repeated games. In this case not all the solutions to the overall game can be found by merely piecing together the solutions of the kernel games. Dynamic strategies that preserve long term incentives and cooperation with appropriate rewards and penalties are, under the right circumstances, more lucrative than the outcomes realized from players choosing say, dominant strategies each period.