1. 01.16.01Lecture Notes in Game Theory1 Game Theory Applications: Lecture 2 u Galina Albert Schwartz Galina Albert Schwartz u Department of Finance u University of Michigan University of Michigan u Business School Business School

2. 01.16.01Lecture Notes in Game Theory2 How to find me: My office: D3270A (Davidson Hall) My e-mail: galka@umich.edu My office hours: Mon., 10am - 12pm & Th., 1pm - 3pm, or by appointment

3. 01.16.01Lecture Notes in Game Theory3 Lecture 2 : Terminology & Examples of Basic Games u Dixit, Chapters 1 & 2 (mostly 2) u Definitions –strategy –outcome –equilibrium –payoff –expectations –rationality

4. 01.16.01Lecture Notes in Game Theory4 The Major Definition u Dixit, p. 29 second paragraph from the bottom u Our definition of the rules of the game –list of players –strategies available to each of them –payoffs of each player for all possible combinations of all player strategies –each player is a rational maximizer

5. 01.16.01Lecture Notes in Game Theory5 Definitions: u Strategy is a set of the choices available for the players, (Dixit, p. 25) u Payoff is a number associated with each possible outcome of the game (Dixit, p. 26) (and Expected payoff) u Equilibrium - each players strategy is a best response to the strategies of others, p. 30

6. 01.16.01Lecture Notes in Game Theory6 What Do We Assume about the Game? u Rationality implies: –consistency in the ranking of the payoffs –ability to calculate what is in his best interest u Common knowledge of the rules of the game

7. 01.16.01Lecture Notes in Game Theory7 What is Rationality? u Rationality does not imply: –the same values for everyone –impossibility of altruism[could be incorporated in payoff] –short-term rationality [irrational from immediate perspective may be valuable as a long-term strategy] »example: prices: introductory prices & predatory prices. Interaction between the two

8. 01.16.01Lecture Notes in Game Theory8 Classification of the Games u Dixit, Chapters 1 & 2 (mostly 2) –constant-sum games  zero-sum games –bargaining games –brinkmanship –sequential moves games –simultaneous moves games –cooperative games (we will not address) [i.e. games with a possibility of enforceable joint-action agreements]

9. 01.16.01Lecture Notes in Game Theory9 Classification of the Games (cont.) u Dixit, Chapters 1 & 2 (mostly 2) –non-cooperative games –non-repeated games (one-shot games) –repeated games –repeated but with different opponents –dynamic games (evolutionary games) [or, are the rules fixed or permit manipulation?]

10. 01.16.01Lecture Notes in Game Theory10 What is more important: How or Why? u How (cases) u Why (theory) u Apply game theory to –explain –predict –advise (prescribe) u Why is needed to advice (prescribe)

11. 01.16.01Lecture Notes in Game Theory11 Lewis, Chapter 2: Never Mention Money. Game 1 u Never Mention Money: Does it makes any sense? –Yes, it does. [The required answer actually makes perfect sense.] Emotions matter! I.e.: –the people [excitement by the high- caliber people] –the challenge –the thrill of the deal

12. 01.16.01Lecture Notes in Game Theory12 Lewis, Chapter 2: Never Mention Money. Game 2 u Why analysts’ job has super-long hours? –from a production point: inefficient –Prisoners dilemma? [A small part of the explanation] [But a cutthroat business competition is a Prisoner’s dilemma] –Major purpose - to deter cheats [time constraint on physical implementation, and design of the cheating mechanism]

13. 01.16.01Lecture Notes in Game Theory13 Lewis, Chapter 2: Never Mention Money. Game 3 u Interviewing with Solomon Brothers. –Why intellect is not checked sometimes? »It is implied to be sufficient –Why education (the knowledge) is irrelevant, but still is required? »signals interests »signals ability »majoring in economics: permit direct comparison

14. 01.16.01Lecture Notes in Game Theory14 Lewis, Chapter 2: Never Mention Money. Game 3 (cont) –Why to intimidate? »Speed (and quality) or responses in unfamiliar situation are tested –Why no explicit offer? »Nobody could turn it down »Importantly: impossible to state that you turned Solomon down –No explicit salary offer. To underpay? »No, to screen. A quest for the able ones (who do not fear the risk & confident in abilities)

15. 01.16.01Lecture Notes in Game Theory15 Summary of Today u Definition of the Game p. 29 u The definition of Nash Equilibrium, p. 30 u Lewis, Chapter 2: examples of the games

16. 01.16.01Lecture Notes in Game Theory16 To Do: your preparation to 01.18.01 u Read: Dixit, chapter 2 u Read: Lewis, chapters 2 & 3 u Next time: we will explain what is the absolutely necessary component of the Greenspan’s strategy [and any other Central Banker’s strategy] Please, prepare your guesses of the ’absolutely necessary component’