MICROECONOMICS FOR PLANNERS

Lecture 15 Game Theory and Strategic Thinking: Problems and Opportunities

Professor Albert Saiz

10/28/2013

Microeconomics

Game Theory

Logical analysis of goal-oriented behavior in strategic (interdependent) situations with limited allocation of resources or outcomes

Microeconomics

The Big Picture

Game Theory A method for analyzing decisions, and identifying strategies and choices, when motivation or objectives are inter-dependent. Insights into what organizations (or individuals) might do in the realworld situation we are modeling, and why they might do that. Practical examples: Failures of coordination Anti-social outcomes Pre-emptive behavior: first mover advantage Facilitating Cooperation Among Local Agents Credibility of threats or promises in negotiations Strategic bidding in auctions Panics, Multiple equilibria and policy outcomes

Microeconomics

Types of games Cooperative v non cooperative. We focus on non cooperative games where you are individually playing with other agents and each pursues his/her own objectives (i.e. payoff). PAYOFFS CAN INCLUDE ALTRUISTIC CONSIDERATIONS Simultaneous v sequential. In a simultaneous game, the players choose action at the same time without observing each others moves. In a sequential game, one party moves and the other party observes what the first has done before taking an action. Single period v repeated games. A game can be played just once then ends, or it may be repeated for a specific, or unspecified number of rounds. Repeated games are the topic of next class.
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Microeconomics

Two Illustrations of a Simultaneous Single Period Game Extensive Form (tree)

10; 5 left Player 2 moves left 15; 0 Player 1 moves up Payer 1 moves down 10 6 5 8 Player 2 moves right 15 20 0 2

Normal Form

2
Up right

1
Down left right

6; 8

20; 2

These are simply two different ways of depicting the SAME game

2 does not know of 1s action here!

Microeconomics

Reading a Game Matrix for a Simultaneous Move Game Conventions for summarizing payoffs in a game matrix
Cells show the players payoffs for that combination of choices . Player 1 chooses rows; first payoff value in cells shows their payoff Player 2 choose columns; 2nd payoff value in cells shows their payoff

In simultaneous games, parties move at the same time, but each knows the payoffs to themselves and to their rival in each cell
Player 2 moves left Player 1 moves up Payer 1 moves down 10 6 5 8 Player 2 moves right 15 20 0 2

Could use non-numerical payoff but that just complicates notation!

Microeconomics

About Analyzing Games

A solution to a game can be a prediction of how rational players would act

Assumptions of common knowledge and rationality (objectives) Nash solution: Each chooses an optimal strategy, given what the other player actually does (mutual no regrets) Dominance solution: A special case where some strategies can be ruled out, regardless of what the other player does.

Purpose: Not (just) to solve a game; rather, to understand:

1. Motivations/objectives of players; 2. Sensitivity of predictions to our assumptions (about others sophistication, what they know, the motivations, etc.); 3. How complex the whole strategic situation is. 4. How to identify ways to act (in reality) that will change the game to get better outcomes. 5. How important or valuable is communication in strategic situations

Microeconomics

Dominant Strategy
Dominant Strategy A strategy (choice, course of action) that is better for the player regardless of what other players do

Dominated Strategy A strategy (choice, course of action) that is worse for the player regardless of what other players do

Dominant Strategy Equilibrium Simplest equilibrium

Both parties have a dominant strategy

Microeconomics

Two adjacent state economic development teams (KY, and TN) deciding on preparing a package of benefits to attract firms Gains measured in 1,000 workers to the local economy minus opportunity cost of incentives measured in worker-equivalent Start with Tennessees decision

KY incentives TN incentives TN no incentives 10 6

KY no incentives 0 2

5 15 8 10

Microeconomics

Dominant Strategy Equilibrium Equilibrium when only one player has a dominant strategy
TN can ANTICIPATE that KY will provide incentives Therefore TNs best strategy is also to provide incentives

KY incentives TN incentives TN no incentives 10 6

KY no incentives 0 7
10

5 15 6 8

Microeconomics

Over-thinking when you shouldnt; thinking when you need to Think logically about the decisions you can make Many decisions will be dominated: never a good idea under any circumstances Do not ever consider dominated strategies: discard them and never look back When thinking strategically it is of key importance to put yourself in the position of the other agents

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Microeconomics

Iterative Dominance

Wallet-Get

Tar-Mart

Prices $1 $1.35 $1.65

$1
3,6 5,1 6,0

$1.35
7,1 8,2 6,2

$1.65
10 , 4 14 , 7 8,5

Tar-Mart dominant/dominated strategies?

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Microeconomics

Iterative Dominance

Wallet-Get Prices Tar-Mart $1 $1.35 $1.65 $1 3,6 5,1 6,0 $1.35 7,1 8,2 6,2 $1.65 10 , 4 14 , 7 8,5

Tar-Mar would never price at $1 because it is dominated by a price of $1.35 => Remove row 1 from game.
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Microeconomics

Wallet-Get

Prices
Tar-Mart

$1
5,1 6,0

$1.35
8,2 6,2

$1.65
14 , 7 8,5

$1.35 $1.65

Now there is a dominant strategy equilibrium:

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Microeconomics

What if there are no dominant or dominated strategies?

Then have to look at each cell in the matrix and see if someone wants to deviate from the current situation If they are locked into a situation they cannot individually disengage from: Nash equilibrium If they are happy to disengage individually: not a Nash equilibrium!

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Microeconomics

Festivity Date: a pure coordination game

Recall Nash equilibrium: everyone is responding optimally to others choice. Fireworks, Parade, and Concerts

Somerville 4th of July 4th of July Cambridge Labor Day ( 10 , 10 ) (5,5)

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Labor Day ( 10 , 10 )

(5,5)

Value of Talk?

Microeconomics

Coordination game with one best outcome

Somerville 4th of July Labor Day

4th of July Cambridge Labor Day

(3,3)

( 5 , 15 )

( 15 , 5 )

(3,3)

Value of Talk?

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Microeconomics

Sequential Games: One Player has the First Move

4th Somerville 4th Labor ( 5 , 15 ) (3,3)

Cambridge
( 15 , 5 ) 4th

Labor

Somerville Labor (3,3)

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Microeconomics

Sequential Games: keys to play In 2-stage sequential games the first mover typically has the advantage Have to substantiate talk with some kind of credible commitment: first to make commitment wins Need to play the logic of the game backwards
Anticipate the best response of the other party to your moves Make your move taking into account their best response! Chess player mindset: predict motivations and behavior

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Microeconomics

Coordination game with heterogeneity and regulators

What should state government do?
What if they do not know what is relative best for which, but do know that Cambridge gains and losses are greater?

Somerville 4th of July Labor Day

4th of July Cambridge Labor Day

(8,3)

( 15 , 6 )

( 30 , 5 )

(8,3)
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If you do not know better than the locals (almost always the case), rather than mandate outcome just allow Cambridge to have first choice!!!

Microeconomics

What if you even dont know who benefits more from choice?

Then auction out the right to pick first Explicit or implicit trade-offs For instance, it could be that Somerville would prefer to be first in choosing alternative policy Compensations can make everyone better-off

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Microeconomics

Coordination Games 2: relative positioning Strategic Positioning:

Cost-benefit of investments in economic development two major regional cities

Westown Biotech IT

Biotech Eastown IT

3, 1 5, 5

2, 2 1, 3

What is/are the Nash solution(s)? Here, Eastown has a comparative advantage in IT, and Westown in Biotech. strategic differentiation raises policy benefits!!!

So Does it help we know each others comparative advantage?

How about communication?
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Microeconomics

Chicken Games Two adjacent municipal governments are considering major development plans in alternative sites (perhaps a large commercial space)
Dounton
New Development Undeveloped

Upton

New Development Undeveloped

5, 5 0, 10

10, 0 0, 0

What would you choose? What is/are the Nash solution(s)? Is talk useful? If you repeat the game, does that change how you might play?
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Microeconomics

Sequential Games: One Player has the First Move

dev. Dounton development no dev. 10, 0 5, 5

Upton
0, 10 dev. no development Dounton no dev. 0, 0
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Microeconomics

Individual Rationality Against Collective Outcomes

Prisoners Dilemma
Prisoner 2

Confess

Quiet

Confess

-10, -10 -20, -1

-1, -20 -5, -5

Prisoner 1
Quiet

What is the Nash solution?

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Microeconomics

Golden Balls Game Theory in Practice: Split or Steal Split or Steal: Last round in British game show in which two contestants play a game similar to the Prisoner's Dilemma for the games jackpot. Each contestant can choose to split or steal. If both players split, then each one gets 50% of the jackpot. If one player splits and the other steals, the person who steals gets the full jackpot and the other person gets 0. And if both people steal, then they both get 0. Before playing, the contestants get a few minutes to talk, presumably to convince the opponent that they plan to split.
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http://www.youtube.com/watch?v=hbS_1s985NA&feature=player_embedded

Microeconomics

Split or Steal - Strategies How do people behave? i) Contestants' propensity to choose split (or cooperate) decreases with the stakes, but remains at ~45% even for the highest stakes games. People who have an occupational interest in a cooperative and trustworthy reputation show smaller decreases in cooperation if the stakes increase.

ii)

iii) Contestants are less likely to cooperate if their opponent has tried to vote them off the show in the first two rounds of the game. iv) Young males are less cooperative than young females, but this gender effect disappears when age increases.
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Microeconomics

Note that we can have such outcomes happen even with altruistic motivations

Prisoners Dilemma
Develop NO

Advertisement

No Ad

Revitalize Detroit

Advertisement No Ad

500+250-250=

500, 500+250-250=500

1000-250=

750, 0+375=375

0+375=

375 , 1000-250=750

400+200=

600 , 400+200=600

Two NGOs who invest in central cities Donors will contribute 1,000 million Cost of advertisement is 250 Satisfaction for the NGO=1/2 of net revenues What is the Nash solution?

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