Microeconomics II

Game Theory and Its Applications

PROF. SWAGATA BHATTACHARJEE
Today
 Refresher on Uncertainty
 What is a Game?
 Examples
 Normal form representation of a Game
A Primer on Choice Under Uncertainty
 If the decision making environment is not certain, the objects are called “Lotteries”, where
outcomes and respective probabilities are ordered.
 Example: Consider a bet. A fair coin is tossed. If Head appears, then you get 100 Rs., if Tail
appears you pay 100Rs.
 This situation is written as a lottery: L= (100, -100; ½, ½ )
 In general, if the outcomes are: x1, x2, …, xn, and corresponding probabilities are p1, p2,…,pn ,
the lottery is:
L =(x1, x2, …, xn ; p1, p2,…,pn )
 If consumer’s preference satisfies certain axioms, it can be represented by expected utility.
A Primer on Choice Under Uncertainty
The lottery:
L =(x1, x2, …, xn ; p1, p2,…,pn )
 Consumer evaluates each outcome xi with a Bernoulli utility u(xi )
 Then, expected utility from lottery L:
𝑈 𝐿 = 𝑢(𝑥1 )𝑝1 + 𝑢(𝑥2 )𝑝2 + ⋯ . +𝑢(𝑥𝑛 )𝑝𝑛
 For the example, L=(100,-100; ½ , ½ ); U(L)= u(100) ½ + u(-100) ½
 A commonly used function is: 𝑢 𝑥 = 𝑥 𝑎 , 𝑎 > 0
 If a<1 then the consumer is risk averse, if a=1 risk neutral, if a>1 risk loving
In Game Theory
 There is strategic uncertainty: each player, even when he/she knows all the rules, payoffs of
everyone, will not know what the other players are doing if they act simultaneously.
 We need to use expected utility in these cases.
 Most cases, in game theory, we will assume the agents are risk neutral, so the utility of getting x
is exactly x
Exercise
 Suppose a decision maker currently has 500 Rs. He is deciding whether to buy a lottery ticket
worth 139 Rs. The lottery, if won, will pay 264 Rs. Probability of winning the lottery is 0.5.
 Case A: the decision maker is risk averse. For outcome x, his utility is 𝑢 𝑥 = 𝑥 1/2
 Case B: the decision maker is risk neutral. For outcome x, his utility is 𝑢 𝑥 = 𝑥
 Determine in each case what the DM should do, buy or not.
A Game
 A game is a multi-person strategic interaction context defined by its structure, which includes:

 The players: independent decision makers (Players)

 e.g. a game of chess has 2 players

 The rules: specifies the order of players’ decisions, their feasible decisions at each decision point (action) at each
decision point.
 e.g. different pieces in chess has different moves and at any given point, a subset of the moves are available to
choose from. The players alternate in moving pieces on the game board.

 The information: what each player knows at each decision point.

 E.g. players observe each other’s moves, so each knows the entire history of play as the game progresses

 How players’ decisions jointly determine the outcome.

 E.g. a player who captures the other player’s king wins the game, and otherwise, a draw is declared

 Players’ preferences over outcomes (or probability distributions of outcomes)

 E.g. each player prefers a win over a draw over a loss (generally)
Example 1
 Two companies share a market, in which they currently make $5,000,000 each.
 Both need to determine whether they should advertise.
 For each company advertising costs $2,000,000 and captures $3,000,000 from the competitor
provided the competitor doesn’t advertise.
 What should the companies do?
Example 2
 Three legislators vote whether they allow themselves a raise in salary of $2000 per year.
 Since voters are observing the vote, there is some loss of face for a legislator to vote for a raise.
 Let’s assume that the legislators estimate that loss of face is worth $1000 per year.
 What happens if all three vote at the same time?
Example 3
 Adam and Bob have robbed a bank and been arrested. They are interrogated separately.
 Adam and Bob have the option to confess or to remain silent.
 The police have little evidence, and if both remain silent they will be sentenced to one year on a
minor charge.
 Therefore the police interrogators propose a deal: if one confesses while the other remains silent,
the one confessing goes free while the other is sentenced to three years.
 However, if both talk, both will still be sentenced to two years.
 Each questioned in a separate cell without knowing what the other is doing.
 What will Adam and Bob do?
Example 3: Prisoners’ Dilemma
Adam\Bob Deny Confess
Deny -1,-1 -3,0
Confess 0,-3 -2,-2

 This is a “normal form” representation of this game.

 Players: Adam and Bob
 Actions: Confess and Deny
 Row player (Adam)’s payoff is the first entry, column player’s (Bob’s) is the second one
 Rule of the game: simultaneous move
How to Use Game Theory
To “Model” Your Everyday World
 A model is an abstract, often mathematical, version of reality.
 You can formulate many real life instances around you as a model, that is, a game.
 This is abstract, but is supposed to yield some insight into the particular real-world situation.
 It is important not to confuse the model with reality—in reality there are many other factors that
affect the situation.
 But if we can use game theory to predict the outcome of a “model”, then we can extrapolate it to
predict the real life situation.
A Thought Exercise
 Think of any real life context, try to formulate it (model it) as a game.
 In particular, specify the players, the rules, the order of the plays, the information, how the
outcome is determined, and the players’ preferences.
Representation of Games
Normal Form Games
 A strategy is a complete contingent plan for a player in the game
 In the normal form representation, a game is a tuple:
𝐺 = (𝐼, 𝑆, 𝑢)
 Where I= set of players i=1,2,..,n
Normal Form Representation of
Example 3
Adam\Bob Deny Confess
Deny -1,-1 -3,0
Confess 0,-3 -2,-2

 𝐼 = {𝐴, 𝐵}
 Actions: Confess and Deny
 Row player (Adam)’s payoff is the first entry, column player’s (Bob’s) is the second one
 Rule of the game: simultaneous move
 Representation of Games
Normal Form Games
 A strategy is a complete contingent plan for a player in the game
 In the normal form representation, a game is a tuple:
𝐺 = (𝐼, 𝑆, 𝑢)
 Where I= set of players i=1,2,..,n
 For each player i, the set of pure strategies (actions) available is: 𝑆𝑖 , a particular strategy from this
set is 𝑠𝑖
 Then, 𝑆 = 𝑆1 ∗ 𝑆2 ∗ ⋯ ∗ 𝑆𝑛 is the strategy profile for all the players
 𝑠−𝑖 = (𝑠1 , 𝑠2 , … . 𝑠𝑖−1 , 𝑠𝑖+1 , … 𝑠𝑛 )
Normal Form Representation of
Example 3
Adam\Bob Deny Confess
Deny -1,-1 -3,0
Confess 0,-3 -2,-2

 𝐼 = {𝐴, 𝐵}
 𝑃𝑢𝑟𝑒 𝑠𝑡𝑟𝑎𝑡𝑒𝑔𝑖𝑒𝑠: 𝑆𝐴 = 𝐶𝑜𝑛𝑓𝑒𝑠𝑠, 𝐷𝑒𝑛𝑦 ; 𝑆𝐵 = 𝐶𝑜𝑛𝑓𝑒𝑠𝑠, 𝐷𝑒𝑛𝑦
 𝑆𝑡𝑟𝑎𝑡𝑒𝑔𝑦 𝑃𝑟𝑜𝑓𝑖𝑙𝑒: 𝑆 = 𝐶𝑜𝑛𝑓𝑒𝑠𝑠, 𝐷𝑒𝑛𝑦 , 𝐶𝑜𝑛𝑓𝑒𝑠𝑠, 𝐶𝑜𝑛𝑓𝑒𝑠𝑠 , 𝐷𝑒𝑛𝑦, 𝐶𝑜𝑛𝑓𝑒𝑠𝑠 , 𝐷𝑒𝑛𝑦, 𝐷𝑒𝑛𝑦
 𝑠𝐴 = 𝐶𝑜𝑛𝑓𝑒𝑠𝑠; 𝑠−𝐴 = 𝑠𝐵
 Row player (Adam)’s payoff is the first entry, column player’s (Bob’s) is the second one
 Rule of the game: simultaneous move
 Representation of Games
Normal Form Games
 In the normal form representation, a game is a tuple:
𝐺 = (𝐼, 𝑆, 𝑢)
 Where I= set of players i=1,2,..,n
 For each player i, the set of pure strategies (actions) available is: 𝑆𝑖 , a particular strategy from this
set is 𝑠𝑖
 Then, 𝑆 = 𝑆1 ∗ 𝑆2 ∗ ⋯ ∗ 𝑆𝑛 is the strategy profile for all the players
 For each player i, the payoff function is 𝑢𝑖 : 𝑆 → 𝑅
 Payoffs are interdependent. If player i takes strategy 𝑠𝑖 and other players take strategy 𝑠−𝑖 , the
payoff to player i is: 𝑢𝑖 = 𝑢𝑖 (𝑠𝑖 , 𝑠−𝑖 )
 𝑠−𝑖 = (𝑠1 , 𝑠2 , … . 𝑠𝑖−1 , 𝑠𝑖+1 , … 𝑠𝑛 )
 Then, u = (𝑢1 , 𝑢2 , … , 𝑢𝑛 ) is the set of all payoffs
Normal Form Representation of
Example 3: Prisoners’ Dilemma
Adam\Bob Deny Confess
Deny -1,-1 -3,0
Confess 0,-3 -2,-2

 𝐼 = {𝐴, 𝐵}
 𝑃𝑢𝑟𝑒 𝑠𝑡𝑟𝑎𝑡𝑒𝑔𝑖𝑒𝑠: 𝑆𝐴 = 𝐶𝑜𝑛𝑓𝑒𝑠𝑠, 𝐷𝑒𝑛𝑦 ; 𝑆𝐵 = 𝐶𝑜𝑛𝑓𝑒𝑠𝑠, 𝐷𝑒𝑛𝑦
 𝑆𝑡𝑟𝑎𝑡𝑒𝑔𝑦 𝑃𝑟𝑜𝑓𝑖𝑙𝑒: 𝑆 = 𝐶𝑜𝑛𝑓𝑒𝑠𝑠, 𝐷𝑒𝑛𝑦 , 𝐶𝑜𝑛𝑓𝑒𝑠𝑠, 𝐶𝑜𝑛𝑓𝑒𝑠𝑠 , 𝐷𝑒𝑛𝑦, 𝐶𝑜𝑛𝑓𝑒𝑠𝑠 , 𝐷𝑒𝑛𝑦, 𝐷𝑒𝑛𝑦
 P𝑎𝑦𝑜𝑓𝑓 𝑓𝑢𝑛𝑐𝑡𝑖𝑜𝑛𝑠:
 𝑢𝐴 𝐶, 𝐶 = −2; 𝑢𝐴 𝐶, 𝐷 = 0; 𝑢𝐴 𝐷, 𝐶 = −3; 𝑢𝐴 𝐷, 𝐷 = −1
 𝑢𝐵 𝐶, 𝐶 = −2; 𝑢𝐵 𝐶, 𝐷 = −3; 𝑢𝐵 𝐷, 𝐶 = 0; 𝑢𝐵 𝐷, 𝐷 = −1
 Game: 𝐺 = (𝐼, 𝑆, 𝑢)
 If S is finite, we can use a matrix to represent the game G
Example
 2 players (1 and 2) playing Rock, Paper, Scissors
 Rock wins over scissors, scissors wins over paper, paper wins over rock, otherwise draw.
 Winner gets 1, draw gets 0, loser gets -1.
 I=?
Example
 2 players (1 and 2) playing Rock, Paper, Scissors
 Rock wins over scissors, scissors wins over paper, paper wins over rock, otherwise draw.
 Winner gets 1, draw gets 0, loser gets -1.
 I = {1,2}
 𝑆1 =?
 S= ?
Example
 2 players (1 and 2) playing Rock, Paper, Scissors
 Rock wins over scissors, scissors wins over paper, paper wins over rock, otherwise draw.
 Winner gets 1, draw gets 0, loser gets -1.
 I = {1,2}
 𝑆1 = 𝑅, 𝑃, 𝐶 = 𝑆2
 S={RR, RP, RC, PR, PP, PC, CR, CP, CC}
 𝑢1 𝑠 = 𝑅𝑅 = 0; 𝑢1 𝑠 = 𝑅𝑃 = −1, 𝑢1 𝑠 = 𝑅𝐶 = 1, … .

1\2 R P C
R 0,0 -1,1 1,-1
P 1,-1 0,0 -1,1
C -1,1 1,-1 0,0
Assumptions
 Common Knowledge: For each player i, G is known.
 Rationality: Each player i tries to maximize ui given what he/she thinks the others will do.
 Common Knowledge of Rationality: Each player i knows that other players are rational, and that
the other players know that i is rational, and that i knows they are rational, and so on…
Exercise
 Represent example 1 in the normal form.
Some Classic Games:
Matching Pennies
 Two players simultaneously and independently select “heads” or “tails” by each uncovering a
penny in his hand.
 If their selections match, then player 2 must give his penny to player 1; otherwise, player 1 gives
his penny to player 2.
Coordination Game
 Both players obtain a positive payoff if they select the same strategy; otherwise they get nothing.
Stag Hunt Game
 “Pareto coordination” game or Stag Hunt Game: Two players go hunting. They can try to hunt a
stag (strategy A), or they can look for a hare (strategy B).
 If both try to hunt a stag (both choose strategy A), only then they can hunt it, in which case they
get larger share of meat. If one person looks for a stag and another looks for a hare, then they can
catch neither, and get 0. If both hunt a hare (both strategy B) then they can catch it but get a lower
share of meat.
Battle of Sexes
 Two friends have to decide whether to see a movie or go to the opera.
 Unfortunately, they work in different parts of the city and, owing to a massive outage of the
telephone system, find themselves incommunicado.
 They must simultaneously and independently select an event to attend.
 There is only one movie theater and only one opera venue, so the friends will meet each other if
they manage to coordinate their decisions.
 Both prefer to be together, regardless of which event they attend.
 However, player 1 prefers the opera and player 2 prefers the movie
Battle of Sexes
 Two friends simultaneously and independently select an event to attend.
 Both prefer to be together, regardless of which event
they attend.
 However, player 1 prefers the opera and player 2 prefers
the movie
Hawk And Dove/ Chicken
 Two players drive cars toward each other at top speed.
 Just before they reach each other, each chooses between maintaining course (H) and swerving
(D).
 If both swerve, they both save face and are satisfied.
 If only one swerves, then he is proved to be a wimp, whereas the other is lauded as a tough guy
with steely nerves.
 If both maintain course, they crash and are severely injured.
Next Class
 Extensive Form Games
 Mixed Strategies and Expected Payoffs