Cyberlecture

This chapter introduces you to strategic thinking and how to use game theory to model economic behaviour. You will learn that making self-interested choices sometimes leaves you worse off than you would expect.

What is game theory?
Game theory is used to model strategic behaviour. There are three elements to each game:

• players
• actions or strategies from which the players can choose
• payoffs that result from the chosen strategies

Each player chooses her action, or strategy, independently, but keeping in mind that the other player has a strategy too.
      The game is presented in a payoff matrix, a table setting out the three elements of the game.
      Each player may have the same actions to choose from or different actions. In choosing which action to take, Player 1 will consider her payoff as a result of taking Action A when Player 2 takes Action C or when Player 2 takes Action D. Player 1 will choose the higher payoff. Player 1 will then consider her payoff as a result of taking Action B when Player 2 takes Action C or when Player 2 Action D. Player 2 goes through the same process.
      If a player chooses the same action regardless of the other's possible choices, that player has a dominant strategy.

What is Nash equilibrium?
Nash equilibrium occurs in a game when both players have a dominant strategy. In this case, neither player would change her actions even if the other player did change.
      An equilibrium occurs when both players choose an action that lands them in the same cell of the payoff matrix.

Practice Activity 1 Try answering some questions about a collusive behaviour game.

What is the Prisoner's Dilemma?
A game is classed as a prisoner's dilemma when both players simultaneously choose a dominant strategy that leaves them less well off than other strategies. This kind of game is common in all areas of behavioural science.
      Cartels – small groups of firms that collude to set higher-than-market prices for their output – often face a prisoner's dilemma. Each firm has an incentive to cheat on the collusive agreement, and sell more at a slightly lower price. As the cheating continues, firms undercut each other until they are all earning less profit.

For a glimpse inside the struggles of cartel members for relative market share, log on to WTRG Economics at http://www.wtrg.com/opecshare.html. The incentive in the oil industry to cheat on agreed shares is strong.

Economic Naturalist If farmers did not grow food we would all starve. So why aren't they well paid for their work?

What is a sequential game?
Games where actions are chosen first by one player and then by the next are called sequential games. A decision tree, or game tree, is used to analyze the game rather than a payoff matrix.
      In sequential games, Player 1 moves first, and Player 2 reacts to Player 1's move.
      Sequential games are solved from the end forward. First, Player 2 considers her payoffs as a result of Player 1's possible choices. She chooses the best payoff in each choice. Player 1 then chooses between her best choices, given Player 2's decision. This game is solved backwards because it is assumed that Player 2 knows how Player 1 will react to her strategy.

Practice Activity 2 Try answering some questions about a sequential game.

Visit Carnegie Melon's ConLab game theory site at http://www.cmu.edu/comlabgames/. You can play existing games or design new games using game trees to help you explore many problems in economics.

When are threats credible?
Players often make threats during games. Threats are credible when the player making the threat will gain from carrying it out. If the threatening player will be made worse off if she carries out the threat, other players will not believe her.
      Credible promises work like credible threats. A player making a promise is credible only if by keeping the promise she will make herself better off.
      Players face commitment problems when they cannot make credible promises or threats. They need a commitment device – some way of altering the incentives so that promises and threats become credible.

Are preferences important in game theory?
Most games assume that the players are strictly self-interested. If players are not completely self-interested, then the outcomes of real life games may not be the ones predicted by game theory.

Understanding Questions Do I understand this chapter? As a check to your understanding of the material in this chapter, you should be able to answer our questions.