Game Theory

Chapter 14

Slides by Pamela L. Hall

Western Washington University
©2005, Southwestern
 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 rival’s most profitable
counterstrategy to its own current policy
• Formulates an appropriate defensive measure
 For example, in 1996 Pepsi supplied its cola aboard Russia’s 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 2
 Introduction
 Game theory provides an avenue for economists to investigate and develop
descriptions of strategic interaction of agents
 Strategic interdependence
• Each agent’s 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
 Alternatively, agents’ behavior could be expanded by considering a sociological,
psychological, or biological perspective
 Recent progress in game theory has resulted in ability to view economic
behavior as a special case of game theory
 In economics, this strategic interdependence among agents is called noncooperative
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 3
 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

4
 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
• Being first to make a move may have certain advantages
 Sometimes a player’s 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 Prisoner’s 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 5
 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 two-
player or n-player game)

6
 The Game
 A game-theory model is composed of
 Players
 Rules by which game is played
• Rules involve what, when, and how game is played
 What information each player knows before she moves (chooses
some action)
 When a player moves relative to other players
 How players can move (their set of choices)
 Outcome
 Payoffs
• Some reward or consequence of playing game
 May be in form of a change in (marginal) utility, revenue, profit, or
some nonmonetary change in satisfaction
• Assumed that payoffs can at least be ranked ordinally in terms of
each player’s preferences

7
 The Game
 An example of a game is the children’s hand game: Rock, Paper,
Scissors
 Rules for game
• Each player simultaneously makes the figure rock, paper, or scissors with one of
their hands
 Outcome
• Rock dominates (crushes) scissors, scissors dominate (cut) paper, and paper
dominates (covers) rock
 In a two-person game, player who makes dominating figure wins the game
 When both make same figure, it’s a draw and neither player wins
 Players each develop strategies for playing game
 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 competitor’s possible price changes is
firm’s strategy for this competitor’s action
 In general, a strategy is a player’s action plan
 In Rock, Paper, Scissors, strategy is the decision about when to form a rock,
paper, or scissors with one’s hand
8
 The Game
 A player’s strategy is his complete contingent
plan
 If it could be written down, any other agent could
follow the plan and duplicate player’s actions
 Thus, a strategy is a player’s 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
 Actions implement a given strategy

9
 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
 In strategic form, only strategies are listed

10
Table 14.1 Strategic Form for the
Rock, Paper, Scissors Game

11
 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
player’s 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 player’s 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
12
Figure 14.1 Game tree for Rock,
Paper, Scissors

13
 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 F’s action and always win
• If at initial decision node (also called a root) player F chooses rock
 Player R—observing player F’s choice—will choose paper
 Yields terminal node with an associated payoff
 Player F loses and player R wins
 Sequential moves put player who moves first at a disadvantage
 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

14
 Equilibrium
 Market equilibrium exists when there is no incentive for agents to
change their behavior
 Yields an equilibrium price and quantity
 In game theory, a similar equilibrium may exist where players have no
incentives to change their strategy
 One equilibrium is called dominant strategy
• One strategy is preferred to another no matter what other players do
• When all players have a dominant strategy, an equilibrium of dominant strategies
exists that is determined without a player having to consider behavior of other
players
 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
 Generally, players who do not believe in rationalizable strategies will attempt
to maximize utility independent of other players

15
 Equilibrium
 A unique equilibrium or a set of equilibria may occur within a set of
strategies
 Called a Nash equilibrium (after mathematician John Nash)
• Each player’s selected strategy is his or her preferred response to strategies
actually played by all other players
 Strategies are in a state of balance
 An equivalent definition of a Nash equilibrium is where each player’s
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

16
 Strategic Form
 Strategic form of a game is a condensed version of extensive form
 Actions with each player’s 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
 Initially we assume that both players possess perfect knowledge
 Each player knows his own payoffs and strategies and other player’s payoffs and
strategies
 Each player knows that other player knows this
 In strategic form, a player’s 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
 Indicates a possibility of cooperation or collusion
• Collusion is a joint strategy that improves position of all players
17
 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 (wife’s payoff, husband’s 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
 Wife’s (husband’s) level of satisfaction is higher than husband’s (wife’s)
• If husband goes to fights while the wife goes to the opera
 They each enjoy their respective activity but not as much as if they went
together to either event
• If husband went to opera and wife to the fights
 Both receive disutility
18
Table 14.2 Battle-of-the-Sexes
Game

19
 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
 Both going to fights is a Nash equilibrium
• If either one instead picks opera, wife’s utility falls from 2 to 1 and
husband’s from 5 to -1
 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 20
 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
• Talkative prisoner will receive only 1 year in prison
• Silent prisoner will be sent up for maximum of 10 years
 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
• Both will be convicted of the major offense and sent up for 5 years
 As shown in Table 14.3, payoff matrix is composed of (F’s
payoff, R’s payoff)
21
Table 14.3 Prisoners’ Dilemma

22
 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
• Thus, for prisoner F confessing is always preferred to not confessing
 Confessing is dominant strategy for prisoner F
 Confessing is also dominant strategy for prisoner R
 Thus, Nash equilibrium is both confessing
 No other pair of strategies is in Nash equilibrium
• If prisoner F does not confess, she will receive 10 years, because prisoner R will
believe that if prisoner F confesses and he does not confess then he will receive
10 years
 Thus, prisoner R will confess
 Illustrates situation, common in economics, where cooperation (not
confessing) can improve welfare of all players
23
 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
• Classic example of rational self-serving behavior not resulting in a social
optimum
 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
 Otherwise, there is an incentive on part of at least one player to break agreement
 Table 14.3 highlights difference between what is best from an individual’s point
of view and that of a collective
 Conflict endangers almost every form of cooperation
 Reward for mutual cooperation is higher than punishment for mutual defection
 But a one-sided defection yields a temptation greater than that reward
• Leaves exploited cooperator with a loser’s payoff that is even worse 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 player’s move
 Leads to mutual defection unless some type of enforcement exists

25
 Cooperation
 In general, agents attempt to cooperate
 Agents defecting from cooperative agreements are usually not observed in
societies
 Agents often instead cooperate, motivated by feelings of solidarity or
altruism
 In business agreements, defection is relatively rare
 Cooperation among agents in an economy may be as essential as
competition for economic efficiency and enhancing social welfare
 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
• Cooperative strategy of not confessing may dominate single-game Nash
equilibrium of confessing
26
 Cooperation
 Consider first a finite number, T, of repeated games (a
finitely repeated game)
 Last round, T, is same as playing game once
• Solution will be the same and both players will defect by confessing
 In round (T - 1), there is no reason to cooperate since in round T they
both defected
• Thus, in round (T - 1) they both defect
• Defection will continue in every round unless there is some way to
enforce cooperation on last round
 However, if game is repeated an infinite number of times (an
infinitely repeated game)
 Player does have a way of influencing other player’s behavior
• If one player refuses to cooperate this time, other player can refuse to
cooperate next time

27
 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

28
 Cooperation
 An alternative strategy is win-stay/lose-shift
 If a player wins with a chosen strategy, she keeps same strategy for
next round
• If she loses, she changes to an alternative strategy
 Similar to tit-for-tat strategy in terms of preventing exploiters from
invading a cooperative society
• Will provide incentives for any exploiter to cooperate
 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 player’s
choice before she has to make a choice
 Many economic games have this structure
• For example, a monopolist can determine consumer demand prior to producing
an output, or a buyer knows sticker price on a new automobile before making an
offer
 As an example of a sequential game, consider Battle-of-the-Sexes game
in Table 14.2
 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 30
Figure 14.2 Game tree for Battle-
of-the- Sexes

31
 Sequential Games
 If husband picks opera, the subgame is for the wife to choose
 If she picks opera also, husband ends with a payoff of 2 and wife with a
payoff of 5
 If husband picks fights, it is optimal for wife to also pick fights
 Resulting payoffs are 5 for husband and 2 for wife
• For husband (first player), 5 is greater than 2
 So equilibrium for this sequential game is for couple to go to the fights
 One of Nash equilibria in strategic form of the game, Table 14.2
 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

32
 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
 Continue backward process until root node is reached
 Backward induction implicitly assumes that a player’s strategy will consist of
optimal actions at every node in game tree
• Called principle of sequential rationality
 At any point in game tree, player’s strategy should consist of optimal actions from that point
on given other players’ strategies 33
Figure 14.3 Reduced game tree
for Battle-of- the-Sexes

34
 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
 Called preemption gamesstrategic precommitments can affect future
payoffs
• 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
 Ability to seize a market first depends on market’s contestability
 If market is contestable, potential entrant firms can practice hit-and-run entry
• 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
 Example: President Reagan placed a 5-year tariff on motorcycles to rescue
domestic motorcycle company Harley-Davidson 35
 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
• If neither firm enters, both payoffs are 0
 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
 Other firm will not enter and receive a 0 payoff
 Strategy for firms is to be first to enter market
• If one of the firms is a foreign firm and has some advantages of being
first to enter a domestic market
 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 36
Table 14.4 Preemption Game

37
 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 pre-
existing local nondiscount competition and has a local monopoly
• As country gets saturated with these discount stores, opportunities to
establish local monopolies decline
 Discount firms will attempt to fill a market niche instead
 For example, Target stores cater to uppermiddle-income households
 Once a discount store enters a local market, existing nondiscount
stores will attempt to adjust their market in an effort to find a market
niche
• For nondiscount stores, price competing with a discount store is
generally not an optimal choice

38
 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
 Dominant strategy for nondiscount store is to maintain its
high price
• Strategy for discount firm is then to enter and offer slightly lower
prices than nondiscount store
 Nondiscount store can then either develop a market niche around
discount store or eventually go out of business

39
Table 14.5 Discount Entry

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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
 Through research and development, a firm will endeavor to supply a complete
range of a particular product to cover every niche
 Consider two firms entertaining entry into a market for a commodity, say,
breakfast cereals with two niches, sweet cereals, J, and healthy cereals H
 Payoff matrix is provided in Table 14.6
• If both firms move simultaneously, two Nash equilibria result
 With each firm picking a different market niche
• 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

41
Table 14.6 Market Niches

42
 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
• 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
commitment to niche J when in fact it is not
 Assumes asymmetric information
 Idle or empty threats will not succeed in inducing a player
to select some action

43
 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 1’s advertising has a relatively large impact on returns for
the two firms
 In terms of advertising, firm 1 is dominant firm in industry
• Despite Firm 1’s dominance, firm 2’s advertising does positively
affect firm 1’s returns
 By possibly expanding total market in which products are being
advertised

44
Table 14.7 Idle Threats

45
 Threats
 In this case, advertising is not drawing sales from one firm to another
 But instead is making product known to more consumers
• Enlarges both firms’ markets
 Thus firm 1 would prefer that firm 2 also advertise
 However, added expense of advertising by firm 2 is not covered by its returns
• However, even considering dominance of firm 1, it cannot threaten to not
advertise in order to induce firm 2 into advertising
 Because no matter which choice firm 2 makes, firm 1’s 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
 It is very important to always be willing and able to carry out a threat

46
 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
 An example is child rearing
 Through reward and punishment, a parent derives
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
47
Figure 14.4 A game tree for child
rearing

48
 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
• Threat by parent will not be idle
 In Figure 14.4, parent will not reward bad behavior even considering parent’s
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
 Principal is attempting to provide incentives, both positive and negative, to elicit
correct behavior from agent
• 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 principal’s 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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