Chapter 14
GAME THEORY,
STRATEGIC
DECISION
MAKING, AND
BEHAVIORAL
ECONOMICS
McGraw-Hill/Irwin
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
14-2
Today’s lecture will:
• Explain why game theory is more flexible
•
•
•
than standard models of market behavior.
Provide an example of prisoner’s dilemma
game.
Explain what is meant by Nash
equilibrium.
Demonstrate how the prisoner’s dilemma
can be applied to an oligopoly of two
firms.
McGraw-Hill/Irwin
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
14-3
Today’s lecture will:
• Distinguish between a dominant strategy and
a mixed strategy.
• Give two examples of seemingly irrational
•
behavior that behavioral economists are
attempting to explain and include in their
economic models.
Explain why the standard model remains
relevant even if the findings of behavioral
economists are true for many, and even most,
individuals.
McGraw-Hill/Irwin
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
14-4
Game Theory and the
Economic Way of Thinking
• Game theory is formal economic
•
•
reasoning applied to situations in which
decisions are interdependent.
Game theory is a very flexible tool that
allows us to develop more precise models
of situations that involve strategic
interactions.
Game theory models are not as broad as
the standard models.
McGraw-Hill/Irwin
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
14-5
Prisoner’s Dilemma
B Confesses
A 5 years
B Does Not Confess
A Goes Free
A Confesses
B 5 years
A 10 years
A Does Not
Confess
McGraw-Hill/Irwin
B Goes Free
B 10 years
A 6 months
B 6 months
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
14-6
MC
$800
Price
Price
Firm and Industry Duopoly
Cooperative Equilibrium
ATC
$800
700
700
600
575
500
600
400
400
300
300
200
200
100
100
Monopolist
solution
Competitive
solution
500
0
1 2 3 4 5 6 7 8
Quantity (in thousands)
Firm's cost curves
McGraw-Hill/Irwin
MC
D
0
MR
1 2 3 4 5 6 7 8 9 10 11
Quantity (in thousands)
Industry: Competitive and monopolist solution
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
14-7
Firm and Industry Duopoly
Equilibrium When One Firm Cheats
P
MC ATC
$800
MCATC
$800
P
$900
800
700
700
700
600
550
500
600
550
500
600
550
500
A
A
400
300
300
200
200
200
100
100
100
1 2 3 4 5 6 7
Quantity (in thousands)
Non-cheating firm’s loss
McGraw-Hill/Irwin
0
1 2 3 4 5 6 7
Quantity (in thousands)
Cheating firm’s profit
B
A
Non- Cheating
400 cheating firm’s
300 firm’s output
output
400
0
C
0
1 2 3 4 5 6 7 8
Quantity (in thousands)
Cheating solution
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
14-8
Payoff Matrix of Strategic
Pricing Duopoly
B Cheats
A
B Does Not Cheat
A +$200,000
0
A Cheats
B
0
A -$75,000
A Does Not
Cheat
McGraw-Hill/Irwin
B +$200,000
B -$75,000
A +$75,000
B +$75,000
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
14-9
Formal Game Theory
Assumptions
• Players are fully forward looking.
• Players always behave in a manner
•
that gives them the highest payoff.
Players expect all other players to
behave in the same manner.
McGraw-Hill/Irwin
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
14-10
Different Games
in Game Theory
• Cooperative games – games in which
•
•
players can form coalitions and can
enforce the will of the coalition on its
members
Sequential games – players make
decisions one after another, chess, for
example
Simultaneous move games – players make
their decisions at the same time as other
players, for example, the prisoner’s
dilemma
McGraw-Hill/Irwin
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
14-11
Strategies of Players
in Game Theory
• Backward induction – you begin with a
•
•
desired outcome and then determine the
decisions that could have led you to that
outcome
Dominant strategy – a strategy that is
preferred by a player regardless of the
opponent’s move, prisoner’s dilemma, for
example
Mixed strategy – a strategy of choosing
randomly among moves, for example,
rock, paper, scissors
McGraw-Hill/Irwin
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
14-12
An Example of Strategy:
The 2/3rds Game
•
•
•
•
Each player chooses a number between 0 and
100, and the person who chooses 2/3rds of the
average wins.
If people choose randomly, the average would be
50, 2/3rds of which is 33, so the person choosing
33 would win.
If other people reason the same way, and choose
33, then the winning number is 22, 2/3rds of 33.
If the rollback reasoning continues, the winning
number gets smaller and smaller, and the Nash
equilibrium is zero.
McGraw-Hill/Irwin
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
14-13
Informal Game Theory and
Behavioral Economics
• Informal game theory is often called
•
behavioral game theory because it
relies on empirical observation, not
deductive logic alone, to determine
the likely choices of individuals.
Informal game theory examines how
people actually think and behave and
is, therefore, empirically based.
McGraw-Hill/Irwin
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
14-14
Auction Markets
• Standard sealed bid auction – the person
•
•
who bids the highest gets the good
Vickrey auction – a sealed bid auction
where the highest bidder wins but pays
the price bid by the next highest bidder.
Vickrey auctions result in higher bids
because people are more likely to bid their
willingness to pay.
McGraw-Hill/Irwin
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
14-15
Behavioral Economics
• Behavioral economics uses informal game
•
•
theory to explore rationality and the nature
of individuals’ utility functions.
Behavioral economists use experiments in
which people actually play formal games.
The trust game is used to explain altruistic
behavior.
McGraw-Hill/Irwin
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
14-16
The Trust Game
•
•
•
•
•
In the trust game the first player is given $10 and the
choice of keeping it all for himself or investing some
portion of it, which will triple and be given to the
other player.
The other player, the trustee, can keep the tripled
amount or return some to the first player.
Acting purely in self-interest, the Nash equilibrium
is for the first player to keep the entire $10.
However, experimental evidence shows that on
average, individuals invest about $5 and, on
average, the trustees return a little less than the
investment.
The results suggest that people want to trust and
reward trust.
McGraw-Hill/Irwin
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
14-17
Loss Aversion and
Framing Effects
•
•
•
•
•
Loss aversion – preferences are not independent
of endowment
People tend to want to keep what they have
regardless of their preference before acquiring
the item.
Framing effects – the tendency of people to base
their choices on how the choice is presented
An early-bird special is a better advertisement
than a surcharge for peak- time meals.
Would you choose option A of saving 200 of 600
lives or option B that will end lives of 400 of 600?
McGraw-Hill/Irwin
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
14-18
The Importance of the
Standard Model
• Even though people don’t always act
•
as the standard economic model
predicts, the standard model and its
assumptions are still relevant.
“Money is left on the table” by
people who act irrationally to be
taken by those who behave
rationally.
McGraw-Hill/Irwin
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
14-19
Summary
• Game theory is a flexible approach that is
•
•
useful when decisions are interdependent.
In the prisoner’s dilemma game both players
have a dominant strategy that leads to a jointly
undesirable outcome.
A payoff matrix provides a summary of each
player’s strategies and how the outcomes of
their choices depend on the actions of the
other players.
McGraw-Hill/Irwin
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
14-20
Summary
• A Nash equilibrium is an equilibrium of a
•
•
game that results from a noncooperative game when each player
plays his or her best strategy.
Decisions that face a duopoly can be
modeled as a prisoner’s dilemma game.
A dominant strategy is preferred
regardless of one’s opponent’s move. A
mixed strategy is choosing randomly.
McGraw-Hill/Irwin
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
14-21
Summary
• Behavioral economics examines deviations
•
•
between formal game theoretical predictions
and actual outcomes of games.
Loss aversion and framing effects are
examples of findings in behavioral
economics that challenge the standard
model’s predictions.
The standard model remains relevant
because it only takes a few people to realize
that money has been left on the table for the
money to be taken.
McGraw-Hill/Irwin
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
14-22
Suppose that Ford and Chevrolet are each considering offering a $1000 rebate
on their cars. Currently, without a rebate, they split the market evenly, and each earns profits of
$2 million per week. However, if Ford offers a rebate and Chevy doesn’t, they will win Chevy customers,
and their profits will increase to $3 million and Chevy’s will fall to $1 million. Conversely, if Chevy offers
the rebate and Ford doesn’t, Chevy profits increase to $3 million and Ford’s will fall to $1 million. If both
companies offer a rebate, neither will win new customers and profits for each will fall to $1.5 million.
Review Question 14-1: Construct a payoff matrix showing Ford (F) and Chevrolet’s strategies and
all of the outcomes.
Ford has a rebate
C
Chevy has a
rebate
$1.5
Ford has no rebate
C $3
F $1.5
C $1
F $1
C $2
Chevy has no rebate
F $3 million
B $2
Review Question 14-2: What is the dominant strategy?
The dominant strategy is for each firm to offer a rebate.
McGraw-Hill/Irwin
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.