Game Theory Lecture 1

Intermediate Micro
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Beautiful Mind
Adam Smith was wrong.
Beautiful Blond game: up to 1:20.
How is this an example of the failure of the First Welfare Theorem
(Adam Smiths invisible hand)?
The first welfare theorem states: given any endowment, perfect
competition will lead to a pareto-efficient outcome.
If every one does what is best for themselves, this leads to the greater
good.
What key assumption, that fails in the beautiful blond game, is
necessary for the first welfare theorem to be valid?
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Externalities
Under perfect competition every individual is a price taker.
The price is determined in the market. No individual consumer or
producer can change the price when buying and selling.
There are no externalities: by-products of consumption and
production may benefit or harm other people.
What is the externality in the beautiful blonde game?
If I dance with the blond, you dont.
Externalities break down the first welfare theorem (the invisible hand).
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Acting strategically

If I have to worry whether you will ask the blond to dance, I have to
behave strategically.
I have to take into account your strategy.
Taking into account the behavior of others when making decision is
the essence of Game Theory.
But how do I predict your strategy? What do I think your strategy is?

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Defining a Game
Denote a strategy for player i as si , and let Si be the set of all her
possible strategies.
For a n-player game, a strategy profile is a n-tuple of strategies,
s = (s1 , s2 , ..., sn ), one for each player.
Let S be the set of all strategy profiles for the game, denoted as
S = S1 .... Sn .
A payoff function assigns a payoff to each strategy profile ui (s).
A Normal Form Game is the collection of strategy sets for each
player, together with their payoff functions:
G = hS1 , ..., Sn , u1 , ..., un i.
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The Prisoners Dilemma

The players are Baldrick and Blackadder.
They get arrested for committing a crime. The police puts them on
separate rooms. The police explains the strategies available to both
of them and the respective payoff they face.
Blackadder
Confess Deny
Baldrick Confess
-5, -5
0, -20
-20, 0
-1, -1
Deny
How will they play this game? Does Blackadder have to consider
what Baldrick may do?
Lets formalize our first Solution Concept.

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Solution Concept - Strict Dominance

Definition of Strict Dominance. Give a Normal Form game G, a

strategy si Si of player i is strictly dominated by another of her
strategies, si Si , if and only if
ui (
si , si ) > ui (si , si ) si Si .
If i is the row player and i is the column player, then si strictly
dominates si when for any column, the payoff of player i in that
column in row si is strictly larger than the payoff of player i in the
same column in row si .
First Solution Concept: Strict Dominance. Rational players dont
play strictly dominated strategies.

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Solution Concept - Strict Dominance

What is the solution to the Prisoners Dilemma game if we apply

Strict Dominance as the solution concept?

Baldrick

Confess
Deny

Blackadder
Confess Deny
-5, -5
0, -20
-20, 0
-1, -1

Note that Deny is a strictly dominated strategy: 5 > 20, 0 > 1.

(Confess, Confess) is the unique strategy profile that this solution
concept predicts.

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Prisoners Dilemma - discussion

Why may some people dislike the predicted solution to the Prisoners
Dilemma?

Baldrick

Confess
Deny

Blackadder
Confess Deny
-5, -5
0, -20
-20, 0
-1, -1

Is the predicted equilibrium (Confess, Confess) pareto efficient?

No. Both would be better off if they played (Deny, Deny).
Note that all we assume is individual rationality, and that gives us a
pareto inefficient solution.

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Solution Concept - Strict Dominance

Example - What is the solution predicted by strict dominance?

Player 1

A
B

X
3, 3
0, 0

Player 2
Y
Z
0, 5 0, 4
3, 1 1, 2

If player 2 is rational, player 2 does not play X.

Thats all the concept of Strict Dominance can predict. This solution
concept required the player to be individually rational and thats it.
We can go further if we assume players are rational and know that
the other players are also rational.

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Solution Concept - Rationalizability

Player 1

A
B

Player 2
X
Y
Z
3, 3 0, 5 0, 4
0, 0 3, 1 1, 2

If player 1 knows player 2 is rational. What else can we eliminate?

Player 1 knows that player 2 will not play X because X is a strictly
dominated strategy. Player 1 then, should play B.
If player 2 knows that player 1 is rational and player 2 knows that
player 1 knows that player 2 is rational, then player 2 knows that
player 1 will play B. Hence, what should player 2 play?
Player 2 should play Z.
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Solution Concept - Rationalizability

Player 1

A
B

X
3, 3
0, 0

Player 2
Y
Z
0, 5 0, 4
3, 1 1, 2

Assuming Rationality only, the solution concept of Strict Dominance

predicts: ((A, B), (Y, Z)).
If we assume common knowledge of rationality, we can iteratively
eliminate strictly dominated strategies. We call this solution
concept Rationalizability or (Iteratively elimination of strictly
dominated strategies). The predicted solution is now:((B), (Z)).

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Solution Concept - Rationalizability

Friends: They dont know we know.

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