1. McGraw-Hill/Irwin Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. GAME THEORY, STRATEGIC DECISION MAKING, AND BEHAVIORAL ECONOMICS GAME THEORY, STRATEGIC DECISION MAKING, AND BEHAVIORAL ECONOMICS Chapter 14

2. 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.

3. 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.

4. 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.

5. McGraw-Hill/Irwin Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. 14-5 Prisoner’s Dilemma A Does Not Confess A Confesses B Confesses B Does Not Confess A 5 years B 5 years A Goes Free A 10 yearsA 6 months B 6 months B Goes Free B 10 years

6. McGraw-Hill/Irwin Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. 14-6 Firm and Industry Duopoly Cooperative Equilibrium Price 575 $800 700 600 500 400 300 200 100 0 Firm's cost curves 1 2 3 4 5 6 7 8 Quantity (in thousands) MC ATC $800 700 600 500 400 300 200 100 0 1 2 3 4 5 6 7 8 9 10 11 Monopolist solution MR D Competitive solution MC Industry: Competitive and monopolist solution Quantity (in thousands)

7. McGraw-Hill/Irwin Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. 14-7 Firm and Industry Duopoly Equilibrium When One Firm Cheats P P 600 500 0 $800 700 400 300 200 100 550 1 2 3 4 5 6 7 A MC ATC Quantity (in thousands) Non-cheating firm’s loss P 600 500 0 $800 700 400 300 200 100 550 1 2 3 4 5 6 7 A MC ATC Quantity (in thousands) Cheating firm’s profit 600 500 0 $900 800 700 400 300 200 100 550 A B C 1 2 3 4 5 6 7 8 Quantity (in thousands) Cheating solution Non- cheating firm’s output Cheating firm’s output

8. McGraw-Hill/Irwin Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. 14-8 Payoff Matrix of Strategic Pricing Duopoly A Does Not Cheat A Cheats B Cheats B Does Not Cheat A 0 B 0 A +$200,000 A -$75,000A +$75,000 B +$75,000 B +$200,000 B -$75,000

9. McGraw-Hill/Irwin 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.

10. 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

11. 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

12. 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.

13. 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.

14. 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.

15. 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.

16. 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.

17. 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?

18. 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.

19. McGraw-Hill/Irwin Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. 14-19Summary 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.

20. McGraw-Hill/Irwin Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. 14-20Summary A Nash equilibrium is an equilibrium of a game that results from a non- cooperative 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.

21. McGraw-Hill/Irwin Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. 14-21Summary 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.

22. 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. Chevy has no rebate Chevy has a rebate Ford has a rebateFord has no rebate C $1.5 F $1.5 C $3 C $1C $2 B $2 F $3 million F $1 Review Question 14-2: What is the dominant strategy? The dominant strategy is for each firm to offer a rebate.