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
