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Chapter 14
Slides by Pamela L. Hall
Introduction
Game theory considers situations where agents (households or firms) make decisions as strategic reactions to other agents actions (live variables) Instead of as reactions to exogenous prices (dead variables) One of the most general problems in economies is outguessing a rival For example, a firm seeks to determine its rivals most profitable
counterstrategy to its own current policy
For example, in 1996 Pepsi supplied its cola aboard Russias space station Mir Coca-Cola countered by offering its cola aboard shuttle Endeavour
In this chapter, we see how theory of how agents interact (called game theory) has extended classical approach By considering in greater detail interaction among firms in oligopoly
markets
Introduction
Game theory provides an avenue for economists to investigate and develop descriptions of strategic interaction of agents
Strategic interdependence
Each agents welfare depends not only on her own actions but also on actions of other agents
(players) Best actions for her may depend on what she expects other agents to do
Theory emphasizes study of rational decision-making based on assumption that agents attempt to maximize utility
Recent progress in game theory has resulted in ability to view economic behavior as a special case of game theory
Binding agreements among agents are not assumed Cooperation may or may not occur among agents as a result of rational decisions In contrast to cooperative game theory, where binding agreements are assumed For example, interaction of two football teams playing a game is non-cooperative In contrast, two people forming a loving relationship to jointly increase their welfare is a
cooperative game
Introduction
Strategic interdependence of perfectly competitive firms or a monopoly firm is either minor or nonexistent
Models of perfect competition and monopoly do not require incorporating game theory In contrast, strategic interdependence is a major characteristic of imperfect
competition
Game theory has become the foundation of models addressing imperfect-competition firm
behavior
Economic models based on game theory are abstractions from strategic interaction of agents
Allows tractable interactions, yielding implications and conclusions that can then be
used for understanding actual strategic interactions
In this chapter, we first develop both strategic and extensive forms of game theory In discussing Prisoners Dilemma we see difficulties of obtaining a cooperative solution without some binding agreement
However, we show a cooperative solution may result if game is played repeatedly Prisoners Dilemma games assume that all players move simultaneously
Introduction
An alternative set of games are sequential games One player may know other players choices prior to making a
decision Within set of sequential games are preemption games
Sometimes a players first move is to threaten other players We investigate consequences of idle threats
One game theory model explains why people will generally drive their automobiles right through a green light Another investigates Prisoners Dilemma game with incomplete information Discuss possible mixed strategies for players to follow As a final application of game theory, we discuss quid pro quo Games are not resolved in isolation
The Game
Interaction among players is foundation of game theory The game is a model representing strategic interdependence of agents in a particular situation Strategic interdependence implies that optimal actions of a player
may depend on what he expects other players will do
Players are decision makers in game With ability to choose actions within a set of possible actions they
may undertake Players may be an individual or group of households, firms, government, animals, or environment as a whole Number of players is finite
Games are characterized by number of players (for example, a twoplayer or n-player game)
The Game
Outcome Payoffs
Some reward or consequence of playing game Assumed that payoffs can at least be ranked ordinally in terms of
each players preferences
May be in form of a change in (marginal) utility, revenue, profit, or some nonmonetary change in satisfaction
The Game
Each player simultaneously makes the figure rock, paper, or scissors with one of Rock dominates (crushes) scissors, scissors dominate (cut) paper, and paper
dominates (covers) rock
Outcome
In a two-person game, player who makes dominating figure wins the game When both make same figure, its a draw and neither player wins
Strategy (also called a decision rule) is set of actions a player may take Specifies how a player will act in every possible distinguishable
circumstance in which he may be placed
For example, how a firm will react to a competitors possible price changes is
firms strategy for this competitors action
In Rock, Paper, Scissors, strategy is the decision about when to form a rock,
paper, or scissors with ones hand
The Game
A players strategy is his complete contingent plan If it could be written down, any other agent could
follow the plan and duplicate players actions Thus, a strategy is a players course of action involving a set of actions (moves) dependent on actions of other players For instance with the game of chess, player develops
a specific set of actions for each possible move her opponent could make
The Game
Strategic form lists set of possible player strategies and associated payoffs Table 14.1 shows strategic form for Rock, Paper,
Scissors Strategy pairs consist of combination of strategies from the two
agents If player F chooses rock and player R selects scissors
Strategy pair is (rock, scissors) with outcome that rock crushes scissors Player F then wins and player R loses
Strategies and payoffs can be summarized in a game matrix (a payoff matrix) Lists payoffs for each player given their strategies
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Table 14.1 Strategic Form for the Rock, Paper, Scissors Game
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The Game
Extensive form provides an extended description of a game Reveals outcomes and payoffs from each set of player strategies
and possible actions each player can take in response to other players moves
Game tree is used to represent extensive form of a game Illustrated in Figure 14.1 for Rock, Paper, Scissors
Game is played from left to right
Each node (point) represents a players decision Connected by branches that indicate available actions a player
Extensive form of a game can be used to model everything in strategic form plus information about sequence of actions and what information each player has at each node Contains more detailed information
May help eliminate some possible equilibrium outcomes
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The Game
For example, in Figure 14.1, two players F and R have the action choice of making a rock, paper, or scissors
If players move sequentially with player F moving first, player R can observe
player Fs action and always win
Player Robserving player Fs choicewill choose paper Yields terminal node with an associated payoff Player F loses and player R wins
Other player will always choose an action that results in a win As a result of this disadvantage, player R will not reveal his action unless
player F also reveals her action
When players thus simultaneously reveal their actions, neither player has any
prior information on the actions of the other player
In a game of simultaneous moves, game tree can be constructed with either players actions at root
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Equilibrium
Market equilibrium exists when there is no incentive for agents to change their behavior
In game theory, a similar equilibrium may exist where players have no incentives to change their strategy
However, usually a player must consider other players strategies May then reduce his set of strategy choices based on rational behavior
By assuming all players are rational and attempting to maximizing utility, a player determines a rationalizable strategy
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Equilibrium
An equivalent definition of a Nash equilibrium is where each players belief about other players preferred strategies coincides with actual choice other players make
No incentive on part of any players to change their choices In a two-player game, a Nash equilibrium is a pair of player strategies where
strategy of one player is best strategy when other player plays his or her best strategy
Not all games have a Nash equilibrium and some games may have a number of Nash equilibria
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Strategic Form
Strategic form of a game is a condensed version of extensive form Actions with each players strategy are not reported in strategic form (how you play is not reported)
Only possible strategies of each player with associated payoffs (win or lose) are listed
Each player knows his own payoffs and strategies and other players payoffs and
In strategic form, a players decision problem is choosing his strategy given strategies he believes other players will choose
Players simultaneously choose their strategies, and payoff for each player is
determined
For example, firms interacting within a market could compete in advertising or jointly advertise
in an effort to increase total demand for their products
In most economic situations, agents can jointly or independently influence total payoff
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Strategic Form
An example of a strategic interaction among players is the Battle-of-the-Sexes game Strategic form of this game is presented in Table 14.2
Payoff matrix composed of (wifes payoff, husbands payoff)
Two players are a wife and husband deciding what to do on a Saturday night Two choices: going to opera or to the fights
If they both go to the opera (fights) they each receive some positive
utility
Wifes (husbands) level of satisfaction is higher than husbands (wifes) They each enjoy their respective activity but not as much as if they went together to either event Both receive disutility
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Strategic Form
As shown in Table 14.2, sum of payoffs is higher in two strategy pairs where they go together to same event Compared with each going to a different event A result of payoffs is possibility of multiple Nash equilibria Both going to opera is a Nash equilibrium
Because if either one picks fights instead their utility is decreased
For example, if husband picks fights, his utility is reduced from 2 to 1 If wife picks fights, her utility falls from 5 to -7
In general, even if a Nash equilibrium exists, it may not be unique Problem of multiple Nash equilibria can be avoided when players
can choose a strategy mix
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Prisoners Dilemma
In general, Prisoners Dilemma game is a situation where two prisoners are accused of a crime D.A. does not have sufficient evidence to convict them
Unless at least one of them supplies some supporting testimony
If one prisoner were to testify against the other, conviction would be a certainty D.A. offers each prisoner separately a deal If one confesses while his accomplice remains silent If neither confesses, both will be prosecuted on a lesser offense If both confess, in which case testimony of neither is essential to the
prosecution
Talkative prisoner will receive only 1 year in prison Silent prisoner will be sent up for maximum of 10 years
Both will be convicted of the major offense and sent up for 5 years
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Prisoners Dilemma
Unique Nash equilibrium to Prisoners Dilemma is where each prisoner confesses and each is sentenced to 5 years
From Table 14.3, if prisoner R does not confess, prisoner F can increase her
payoff by confessing (reduced jail time by 1 year) If prisoner R confesses, prisoner F will again confess and receive 5 fewer years
Confessing is dominant strategy for prisoner F Confessing is also dominant strategy for prisoner R
Illustrates situation, common in economics, where cooperation (not confessing) can improve welfare of all players
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Prisoners Dilemma
Although dominant strategy of both confessing is Nash equilibrium strategy It is not preferred outcome of players acting jointly Both prisoners would prefer that they jointly do not confess and each
receive only 2 years
If the two prisoners could find a way to agree on the joint strategy of not confessing and, of equal importance, a way to enforce this agreement Both would be better off than when they play the game independently
However, it is still in the interest of each prisoner to secretly break
agreement
One who breaks the deal and confesses will only receive 1 year while the other will pay price of receiving an additional 8 years Example of a bilateral externality 24
Enforcement
In Prisoners Dilemma example, Nash equilibrium results in confession when joint optimal solution would be for both prisoners to not confess For this joint cooperation to result, some type of enforcement is required
Table 14.3 highlights difference between what is best from an individuals point of view and that of a collective
Reward for mutual cooperation is higher than punishment for mutual defection
Rankings from temptation through reward and punishment imply that the best move is always to defect, irrespective of the opposing players move
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Cooperation
A solution consistent with cooperation may result if Prisoners Dilemma game is repeatedly played
If one player chooses to defect in one round, then other player can choose
to defect in next round In a repeated game, each player has opportunity to establish a reputation for cooperation and encourage other player to cooperate If a game is repeated an infinite number of times
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Cooperation
Consider first a finite number, T, of repeated games (a finitely repeated game) Last round, T, is same as playing game once
they both defected
Solution will be the same and both players will defect by confessing
However, if game is repeated an infinite number of times (an infinitely repeated game) Player does have a way of influencing other players behavior
If one player refuses to cooperate this time, other player can refuse to
cooperate next time
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Cooperation
Robert Axelrod identifies optimal strategy for an infinitely repeated game as tit-for-tat (also called a trigger strategy) On first round player F cooperates and does not confess On every round after, if player R cooperated on previous
round, F cooperates If R defected on previous round, F then defects Strategy does very well because it offers an immediate punishment for defection and has a forgiving strategy An application is the carrot-and-stick strategy that underlies most
attempts at raising children
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Cooperation
An alternative strategy is win-stay/lose-shift If a player wins with a chosen strategy, she keeps same strategy for
next round
Exploiters in a cooperative society are players who attempt to maximize their payoff given strategies of other players Does not matter to exploiters if their strategy results in cooperation or not Only interested in maximizing their payoff
However, this win-stay/lose-shift strategy fares poorly among noncooperators Against persistent defectors a player employing win-stay/lose-shift
strategy tries every second round to resume cooperation
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Sequential Games
In a sequential, or dynamic, game, one player knows other players choice before she has to make a choice
Husband prefers going to fights and wife prefers opera However, they both prefer spending their leisure time together
Results in two pure-strategy Nash equilibria (both going to the opera or both to
the fights) if both players reveal their choices simultaneously Suppose husband chooses first and then wife
Game tree outlining this sequence of choices is illustrated in Figure 14.2 Game tree is a description of game in extensive form Indicates dynamic structure of game, where some choices are made before others Once a choice is made, players are in a subgame consisting of strategies and payoffs available to them from then on
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Sequential Games
If she picks opera also, husband ends with a payoff of 2 and wife with a
payoff of 5
Both going to the fights is not only an overall equilibrium, but also an
equilibrium in each of the subgames A Nash equilibrium with this property is known as a subgame perfect Nash equilibrium
Unique equilibrium of both going to the fights is conditional on who makes first
choice
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Sequential Games
If instead wife made first move, alternative Nash equilibrium, both going to the opera, would be unique solution of this sequential game
Thus, this strategy pair of opera and fights is really a subset of a larger game
involving the strategies of moving first or second
Use a technique called backward induction to determine a subgame perfect Nash equilibrium, by working backward toward the root in a game tree
Once game is understood through backward induction, players play it forward To apply backward induction, first determine optimal actions at last decision
nodes that result in terminal nodes
Then determine optimal actions at next-to-last decision nodes, assuming that optimal
actions will follow at next decision nodes
At any point in game tree, players strategy should consist of optimal actions from that point on given other players strategies
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Preemption Games
Battle-of-the-Sexes game illustrates advantage of moving first In many economic game-theory models, firms who act first have an advantage
For example, a firm adopting a relatively large production capacity in a new market
can saturate market and make it difficult for ensuing firms to enter
Any economies of scale associated with this production can be achieved with this large capacity Firm moving first has potential of lower average production costs
Will mitigate any advantages of moving first Governments concerned with ability of firms to saturate a market and forestall entry of other firms have attempted to place restrictions on such behavior
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Preemption Games
An example of a preemption game is provided in Table 14.4 Firms 1 and 2 are faced with choice of entering or not entering a
market Market is not large enough for both to enter, so if they both enter they will each experience losses in payoff of 5
The two pure-strategy Nash equilibria are for one firm to enter and
the other not
Whichever firm moves first and enters market will receive a positive
payoff of 10
Domestic government may attempt to restrict that entry to enable domestic firm to enter first Once domestic firm enters, foreign firm no longer has an incentive to enter
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Market Niches
Preemption games can also help us understand discount stores location strategies In United States, small towns generally only have sufficient
populations to support one major discount store First discount firm to establish a store in town drives out any preexisting local nondiscount competition and has a local monopoly
Discount firms will attempt to fill a market niche instead For example, Target stores cater to uppermiddle-income households
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Market Niches
As implied in Table 14.5, a chain of discount stores will generally, by economies to scale, have lower average costs than a single nondiscount store If nondiscount store attempts to compete by lowering its
price, discount store will also lower its price Results in losses for nondiscount store while discount store still
remains profitable
Nondiscount store can then either develop a market niche around discount store or eventually go out of business
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Market Niches
In general, producers will attempt to occupy every market niche to keep potential entrants from gaining access into a market
Consider two firms entertaining entry into a market for a commodity, say, breakfast cereals with two niches, sweet cereals, J, and healthy cereals H
Whichever firm moves first will capture preferred market niche and receive higher
payoff
To be first, the firm must make a commitment Either by actually providing product first or by advertising in advance that it will supply product for preferred niche If there are large sunk costs associated with this commitment, then the other firm (say, firm 2) will realize firm 1 is in fact committed to preferred product niche J Firm 2 may accede and supply in niche H
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Threats
Firm 1 could attempt to just threaten firm 2 Instead of making a commitment to supply in preferred niche market
J and incurring sunk costs
For example, firm 1 could threaten firm 2 by stating it will produce in niche J regardless of what firm 2 does However, firm 2 has to believe the threat to acquiesce
commitment to niche J when in fact it is not
One way to make a threat credible is to make commitment in sunk cost Or, firm 1 could simply mislead firm 2 into believing it is making a
Assumes asymmetric information
Idle or empty threats will not succeed in inducing a player to select some action
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Threats
Consider two competing firms advertising Payoff matrix in Table 14.7 represents returns from firms
choices of either advertising or not Pure-strategy Nash equilibrium is for firm 1 to advertise and firm
2 not to advertise Firm 1s advertising has a relatively large impact on returns for the two firms
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Threats
In this case, advertising is not drawing sales from one firm to another
Thus firm 1 would prefer that firm 2 also advertise However, added expense of advertising by firm 2 is not covered by its returns
Because no matter which choice firm 2 makes, firm 1s dominant strategy and its subgame perfect Nash equilibrium is to advertise Firm 2 will realize that if firm 1 is rational it will always advertise, so a threat of not advertising by firm 1 is not credible
Subgame perfect Nash equilibrium results in a selection of a Nash equilibrium obtained by removing strategies involving idle threats
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Child Rearing
If one player derives satisfaction from penalizing the other, threats made by player will be more credible The more credible the threat, the more likely it will be
acted upon
satisfaction of good behavior from a child Figure 14.4 shows a game tree representing interactions of a parent and child Child selects her behavior and parent chooses to reward or punish
it
Pure Nash equilibrium is a badly behaved child rewarded Subgame perfect Nash equilibrium is for parent to always reward
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Child Rearing
If child believes parent will always reward any behavior, it will choose bad behavior
In contrast, if child is under impression that parent will punish bad behavior even if it
hurts parent
In Figure 14.4, parent will not reward bad behavior even considering parents payoff increases from 35 to 40
Subgame perfect Nash equilibria are now for parent to reward good behavior and
punish bad
Child will then realize bad behavior will result in punishment with an associated zero payoff Child will select good behavior over bad and increase her payoff from 0 to 15
In general, this example of parent/child interaction is a principal/agent model, where principal is the parent and agent is the child
In a repeated game, consistent behavior on the part of a principal can dominate inconsistent
behavior
For example, if a parent is consistent in following through with any threats Child will realize that probability of punishment for bad behavior is high and correct her bad behavior
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Child Rearing
Establishing a reputation of always being committed to any threats can lead to cooperation by other player In Prisoners Dilemma game, an example of consistent behavior is
where a tit-for-tat strategy is consistently played
Unless these incentives (threats) are taken seriously, agent will not
select principals desirable actions
For example, suppose a pro-business governor relaxes regulatory constraints on small businesses by not enforcing various environmental regulations Threat of enforcement exists, but it is an idle threat
If a pro-environmental governor is later elected
Threat will become credible and firms will likely comply with regulations
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