Choice (1)

Reinhard Selten: The Thought Leader Interview
by Matthias Hild and Tim Laseter
Strategy & Business
©2005 Booz Allen Hamilton Inc.

Students in a German university classroom sit contemplating a jar filled with a large, but unknown, number of coins. The professor at the front of the room asks the students to tender a silent bid for the contents of the jar by writing an offer on a sheet of paper. After examining the submissions, the professor invites the highest bidder to come forth, pay the bid, and claim the coins. Once the funds have changed hands, the professor sympathetically explains that the bid exceeded the value of the coins and that the student has fallen victim to the “winner’s curse.”

Through analysis of such experiments, Reinhard Selten, professor emeritus of economics at the University of Bonn in Germany, explores behavioral economics and game theory — fields in which he has made several decisive breakthroughs. In 1994, his groundbreaking work in game theory was honored with the Nobel Prize in Economics, which he received jointly with John C. Harsanyi and John F. Nash (the enigmatic subject of the book and film A Beautiful Mind). Professor Selten expanded upon Nash’s original concept of an equilibrium point in noncooperative games. In a “Nash equilibrium,” when players interact repeatedly over time, they start to anticipate their competitors’ future responses, perceiving each other’s possible moves as potential threats or promises. These perceptions influence players’ present behavior, and thus affect the outcome of the game — often leading players to keep their current strategies intact even if there is reason to change. In the Selten “subgame perfect equilibrium,” competitors react only to threats and promises that they perceive as credible. The winning players are those who learn to distinguish credible threats and promises from bluffing, and this process of bluffing, counter-bluffing, and discernment becomes a feature of the ongoing game. Professor Selten’s refinement of this concept has opened new avenues for analysis of predatory pricing, entry deterrence, oligopolies, and similar competitive situations.

In addition to working on the foundations of game theory, Professor Selten has applied his research to numerous high-stakes problems in business and politics. During the early years of the Cold War, he belonged to a pioneering group that developed models of nuclear deterrence under a contract with the U.S. Arms Control and Disarmament Agency (which later became the U.S. State Department’s Bureau of Arms Control). More recently, he worked with a group of military experts to apply game theory to the strategic analysis of the Kosovo conflict. The results were published in Zur Lösung des Kosovo-Konfliktes (Toward a Resolution of the Kosovo Conflict), a volume he edited with Erich Reiter, director-general of the Austrian Ministry of Defense (Nomos Verlag, 2003).

Professor Selten has been one of the most influential developers of the theory of “bounded rationality” as an explanation of economic activity. This theoretical paradigm was first posited by Herbert A. Simon, another Nobel Prize winner. It builds on the observation that human perception, judgment, and memory are imperfect in ways that profoundly influence our economic and organizational choices over time. Proponents of bounded rationality aim to create, as Professor Selten puts it, a “more realistic” economic theory. After all, real people do not behave like the “hyperrational” creatures posited by conventional game theory and traditional economics. They behave, instead, like the students in Professor Selten’s experiments — or like the decision makers in real organizations.

The classroom experiment demonstrating the winner’s curse illustrates the complex relationship between game theory, human intuition, and optimal decision making. The mathematical explanation for the winner’s curse, first observed in bidding for oil fields, reveals the subtle intricacies of this apparently simple game. When bids for an item are based on estimates of the item’s value, the winner is the bidder who overestimates this value the most. As more bidders enter the auction, the range of estimates increases, which in turn increases the likelihood that the highest bid will exceed the true value. Intuitively, most people bid more aggressively when faced with more bidders, but more aggressive bidding increases the chances that a bidder will fall victim to the winner’s curse.

Exploring this counterintuitive lesson, Professor Selten repeats a computerized version of the coin game multiple times with his students, offering them a chance to learn from their mistakes. Looking closely at their behavior, Professor Selten has discovered that many people, after winning and overpaying once or twice, prudently adjust their bid downward in the next round of bidding. With these lower, less competitive bids in play, the jar may go to a lucky bidder who actually manages to turn a profit. In the following round, the disappointed bidders respond with more aggressive, upwardly adjusted bids, which makes the system once again more likely to produce a winner’s curse. Such behavior demonstrates why changes in organizations and markets alike can take a long time to take root. People alter their behavior through continual feedback mechanisms — responding in each round to their experience in the previous round, but failing to discover the “optimal” yet counterintuitive strategies needed to win in the long run.