Game Theory

Source: Google

Game to play
Mr. x
You A B A (1,1) (0,3) B (3,0) (2,2)

GAME THEORY
Game theory
The tool used to analyze strategic behaviorbehavior that recognizes mutual interdependence and takes account of the expected behavior of others.

Game Theory
Def. Game theory: it is the that model formally problem of strategic interaction, e.g. problems in which the utility (payoff) of an individual (player) is affected by the choice made by other individuals (players).

GAME THEORY
What Is a Game?
All games involve three features:
Rules Strategies Payoffs

Prisoners dilemma
A game between two prisoners that shows why it is hard to cooperate, even when it would be beneficial to both players to do so.

GAME THEORY
The Prisoners Dilemma
Art and Bob been caught stealing a car: sentence is 2 years in jail. DA wants to convict them of a big bank robbery: sentence is 10 years in jail. DA has no evidence and to get the conviction, he makes the prisoners play a game.

GAME THEORY
Rules Players cannot communicate with one another.
If both confess to the larger crime, each will receive a sentence of 3 years for both crimes. If one confesses and the accomplice does not, the one who confesses will receive a sentence of 1 year, while the accomplice receives a 10-year sentence. If neither confesses, both receive a 2-year sentence.

GAME THEORY
Strategies The strategies of a game are all the possible outcomes of each player. The strategies in the prisoners dilemma are:
Confess to the bank robbery Deny the bank robbery

GAME THEORY
Payoffs Four outcomes:
Both confess. Both deny. Art confesses and Bob denies. Bob confesses and Art denies.

A payoff matrix is a table that shows the payoffs for every possible action by each player given every possible action by the other player.

Nash Equilibrium
If there is a set of strategies with the property that no player can benefit by changing her strategy while the other players keep their strategies unchanged, then that set of strategies and the corresponding payoffs constitute the Nash Equilibrium

GAME THEORY
The Nash equilibrium for the two prisoners is to confess. Not the Best Outcome The equilibrium of the prisoners dilemma is not the best outcome.

Dominance and Dominance Principle

Definition: A strategy S dominates a strategy T if every outcome in S is at least as good as the corresponding outcome in T, and at least one outcome in S is strictly better than the corresponding outcome in T. Dominance Principle: A rational player would never play a dominated strategy.

Dominant Strategy Equilibrium

If every player in the game has a dominant strategy, and each player plays the dominant strategy, then that combination of strategies and the corresponding payoffs are said to constitute the dominant strategy equilibrium for that game.

An example: Big Monkey and Little Monkey

Monkeys usually eat ground-level fruit Occasionally climb a tree to get a coconut (1 per tree) A Coconut yields 10 Calories Big Monkey expends 2 Calories climbing the tree. Little Monkey expends 0 Calories climbing the tree.

An example: Big Monkey and Little Monkey

If BM climbs the tree
BM gets 6 C, LM gets 4 C LM eats some before BM gets down

If LM climbs the tree

BM gets 9 C, LM gets 1 C BM eats almost all before LM gets down

If both climb the tree

BM gets 7 C, LM gets 3 C BM hogs coconut

How should the monkeys each act so as to maximize their own calorie gain?

An example: Big Monkey and Little Monkey

Assume BM decides first
Two choices: wait or climb

LM has four choices:

Always wait, always climb, same as BM, opposite of BM.

These choices are called actions

A sequence of actions is called a strategy

An example: Big Monkey and Little Monkey

Big monkey
Little monkey w w c w

c
c

0,0 9,1 6-2,4 7-2,3 What should Big Monkey do? If BM waits, LM will climb BM gets 9 If BM climbs, LM will wait BM gets 4 BM should wait. What about LM? Opposite of BM (even though well never get to the right side of the tree)

An example: Big Monkey and Little Monkey

These strategies (w and cw) are called best responses.
Given what the other guy is doing, this is the best thing to do.

A solution where everyone is playing a best response is called a Nash equilibrium.

No one can unilaterally change and improve things.

This representation of a game is called extensive form.

An example: Big Monkey and Little Monkey

What if the monkeys have to decide simultaneously?
Big monkey Little monkey w 0,0

w
c w

c c

9,1 6-2,4 7-2,3

Now Little Monkey has to choose before he sees Big Monkey move Two Nash equilibria (c,w), (w,c) Also a third Nash equilibrium: Big Monkey chooses between c & w with probability 0.5 (mixed strategy)

Simultaneous games
Def. simultaneous game: it is a game where both players move at the same time without possibility to communicate their choices

An example: Big Monkey and Little Monkey

It can often be easier to analyze a game through a different representation, called normal form (simultaneous game)
Little Monkey c Big Monkey c v 5,3 9,1 v 4,4 0,0

Choosing Strategies
How can a monkey maximize its payoff, given that it knows the other monkeys will play a Nash strategy?

Eliminating Dominated Strategies

The first step is to eliminate actions that are worse than another action, no matter what.
Big monkey
w Little monkey w c w c c w 9,1

c
4,4

0,0
Little Monkey will Never choose this path.

9,1 6-2,4 7-2,3

Or this one

We can see that Big Monkey will always choose w. So the tree reduces to: 9,1

 We can also use this technique in normal-form games:

Column a a Row 9,1 b 4,4

Eliminating Dominated Strategies

5,3

0,0

 We can also use this technique in normal-form games:

a a 9,1 b 4,4

Eliminating Dominated Strategies

5,3

0,0

For any column action, row will prefer a.

 We can also use this technique in normal-form games:

a a 9,1 b 4,4

Eliminating Dominated Strategies

5,3

0,0

Given that row will pick a, column will pick b. (a,b) is the unique Nash equilibrium.

Prisoners Dilemma
Each player can cooperate or defect
Column
cooperate defect

cooperate
Row defect

-1,-1
0,-10

-10,0
-8,-8

Prisoners Dilemma
Each player can cooperate or defect
Column
cooperate defect

cooperate
Row defect

-1,-1
0,-10

-10,0
-8,-8

Defecting is a dominant strategy for row

Prisoners Dilemma
Each player can cooperate or defect
Column
cooperate defect

cooperate
Row defect

-1,-1
0,-10

-10,0
-8,-8

Defecting is also a dominant strategy for column

Prisoners Dilemma
Even though both players would be better off cooperating, mutual defection is the dominant strategy. What drives this?
One-shot game Inability to trust your opponent Perfect rationality

Prisoners Dilemma
Relevant to:
Arms negotiations Online Payment Product descriptions Workplace relations

How do players escape this dilemma?

Play repeatedly Find a way to guarantee cooperation Change payment structure

Tragedy of the Commons

Game theory can be used to explain overuse of shared resources. Extend the Prisoners Dilemma to more than two players. A cow costs a dollars and can be grazed on common land. The value of milk produced (f(c) ) depends on the number of cows on the common land.
Per cow: f(c) / c

Tragedy of the Commons

To maximize total wealth of the entire village: max f(c) ac.
Maximized when marginal product = a Adding another cow is exactly equal to the cost of the cow.

What if each villager gets to decide whether to add a cow? Each villager will add a cow as long as the cost of adding that cow to that villager is outweighed by the gain in milk.

Tragedy of the Commons

When a villager adds a cow:
Output goes from f(c) /c to f(c+1) / (c+1) Cost is a Notice: change in output to each farmer is less than global change in output.

Each villager will add cows until output- cost = 0. Problem: each villager is making a local decision (will I gain by adding cows), but creating a net global effect (everyone suffers)

Tragedy of the Commons

Problem: cost of maintenance is externalized
Farmers dont adequately pay for their impact. Resources are overused due to inaccurate estimates of cost.

Relevant to:
Bandwidth and resource usage, Spam Overfishing, pollution, etc.

Avoiding Tragedy of the Commons

Private ownership
Prevents TOC, but may have other negative effects.

Social rules/norms, external control

Nice if they can be enforced.

Taxation
Try to internalize costs; accounting system needed.

Solutions require changing the rules of the game

Change individual payoffs

Duopolists Dilemma
The Duopolists Dilemma
Each firm has two strategies. It can produce airplanes at the rate of:
3 a week 4 a week

GAME THEORY
Because each firm has two strategies, there are four possible combinations of actions:
Both firms produce 3 a week (monopoly outcome). Both firms produce 4 a week.

Airbus produces 3 a week and Boeing produces 4 a week.

Boeing produces 3 a week and Airbus produces 4 a week.

Equilibrium of the Duopolists Dilemma

Both firms produce 4 a week.
Like the prisoners, the duopolists do not cooperate and get a worse outcome than the one that cooperation would deliver.

Conclusion from Duopolist Game

Collusion is Profitable but Difficult to Achieve The duopolists dilemma explains why it is difficult for firms to collude and achieve the maximum monopoly profit. Even if collusion were legal, it would be individually rational for each firm to cheat on a collusive agreement and increase output. In an international oil cartel, OPEC, countries frequently break the cartel agreement and overproduce.

Other Oligopoly Games

Other Oligopoly Games
Advertising campaigns by Coke and Pepsi, and research and development (R&D) competition between Procter & Gamble and Kimberly-Clark are like the prisoners dilemma game. Over the past almost 40 years since the introduction of the disposable diaper, Procter & Gamble and Kimberly-Clark have battled for market share by developing ever better versions of this apparently simple product.

P&G and Kimberly-Clark have two strategies: spend on R&D or do no R&D. Table shows the payoff matrix as the economic profits for each firm in each possible outcome.

The Nash equilibrium for this game is for both firms to undertake R&D.
But they could earn a larger joint profit if they could collude and not do R&D.

Repeated Games
Repeated Games
Most real-world games get played repeatedly. Repeated games have a larger number of strategies because a player can be punished for not cooperating. This suggests that real-world duopolists might find a way of learning to cooperate so they can enjoy monopoly profit. The larger the number of players, the harder it is to maintain the monopoly outcome.

Is Oligopoly Efficient?
Is Oligopoly Efficient?
In oligopoly, price usually exceeds marginal cost. So the quantity produced is less than the efficient quantity. Oligopoly suffers from the same source and type of inefficiency as monopoly. Because oligopoly is inefficient, antitrust laws and regulations are used to try to reduce market power and move the outcome closer to that of competition and efficiency.

Examples
Battle of the sexes (game of coordination)
Girlfriend

Boyfriend

Go to football match
(10,8)

Go to opera
(0,0)

Go to football match Go to opera

(0,0)

(8,10)

In the game above there are two Nash equilibria: NE1={(Go to football match), (Go to football match)} NE2={(Go to opera), (Go to opera)}

Examples
Penalty kicks
Goal keeper

Jump left
(0,1) (1,0)

Jump right
(1,0) (0,1)

Striker

Shoot left Shoot right

In the game above there are no Nash equilibria (in pure strategy!)

Matching Pennies
Column Row Heads Heads (1,-1) Tails (-1,1) Tails (-1,1) (1,-1)

Price cutting game

Firm 2 High Low (15,15) (0,25) (25,0) (5,5)

Firm 1 High Low

Dominant strategy: Low

Avoidance
You Party 1 Party 2 Rocky Party 1 Party 2 (5,15) (20,10) (15,5) (0,20)

Two-persons Game
Colin A Rose A B C D 6, 1 B C D -1, 1 1, -1 0, 0

5, -5 2, -1 6, -6 -9, 9 3, -3 2, -2 4, -4 3, -3 -8, 8 0, 0 0, 0 8, -8

In the game above there are 3 Nash equilibria: NE1={A,A} NE2={B,B} NE3={C,B}