Game Theory

1. Game Theory Mike ShorLecture 6 “Доверяй, Но Проверяй” (“Trust, but Verify”) - Russian Proverb (Ronald Reagan)

2. Repeated Interaction • Review • Simultaneous games • Put yourself in your opponent’s shoes • Iterative reasoning • Sequential games • Look forward and reason back • Sequentially rational reasoning • Outline: • What if interaction is repeated? • What strategies can lead players to cooperate?

3. The Prisoner’s Dilemma Equilibrium: $54 K Cooperation: $60 K

4. Prisoner’s Dilemma • Private rationalitycollective irrationality • The equilibrium that arises from using dominant strategies is worse for every player than the outcome that would arise if every player used her dominated strategy instead • Goal: • To sustain mutually beneficial cooperative outcome overcoming incentives to cheat (A note about tacit collusion)

5. Moving Beyond the Prisoner’s Dilemma • Why does the dilemma occur? • Interaction • No fear of punishment • Short term or myopic play • Firms: • Lack of monopoly power • Homogeneity in products and costs • Overcapacity • Incentives for profit or market share • Consumers • Price sensitive • Price aware • Low switching costs

6. Altering Interaction • Interaction • No fear of punishment • Exploit repeated play • Short term or myopic play • Introduce repeated encounters • Introduce uncertainty

7. Finite Interaction (Silly Theoretical Trickery) • Suppose the market relationship lasts for only T periods • Use backward induction (rollback) • Tth period: no incentive to cooperate • No future loss to worry about in last period • T-1th period: no incentive to cooperate • No cooperation in Tth period in any case • No opportunity cost to cheating in period T-1 • Unraveling: logic goes back to period 1

8. Finite Interaction • Cooperation is impossible if the relationship between players is for a fixedandknown length of time. • But, people think forward if … • Game length uncertain • Game length unknown • Game length too long

9. Finite Interaction (Theoretical Aside) • Unraveling prevents cooperation if the number of periods is fixed and known • Probabilistic termination • The “game” continues to the next period with some probability p: • Equivalent to infinite game • $1 next year is worth now • Value of future = { value if there is a future }  { probability of a future } • Effective interest rate:

10. Long-Term Interaction • No last period, so no rollback • Use history-dependent strategies • Trigger strategies: • Begin by cooperating • Cooperate as long as the rivals do • Upon observing a defection: immediately revert to a period of punishment of specified length in which everyone plays non-cooperatively

11. Two Trigger Strategies • Grim trigger strategy • Cooperate until a rival deviates • Once a deviation occurs, play non-cooperatively for the rest of the game • Tit-for-tat • Cooperate if your rival cooperated in the most recent period • Cheat if your rival cheated in the most recent period

12. Trigger Strategy Extremes • Tit-for-Tat is • most forgiving • shortest memory • proportional • credible but lacks deterrence Tit-for-tat answers: “Is cooperation easy?” • Grim trigger is • least forgiving • longest memory • MAD • adequate deterrence but lacks credibility Grim trigger answers: “Is cooperation possible?”

13. Why Cooperate (Against GTS)? • Cooperate if the present value of cooperation is greater than the present value of defection • Cooperate: 60 today, 60 next year, 60 … 60 • Defect: 72 today, 54 next year, 54 … 54 Firm 2

14. Payoff Stream (GTS) profit 72 cooperate 60 defect 54 t t+1 t+2 t+3 time

15. Aside: Discounting • Discounting: • Present-day value of future profits is less than value of current profits • r is the interest rate • Invest $1 today  get $(1+r) next year • Want $1 next year  invest $1/(1+r) today • Annuity paying $1 today and $1 every year has a net present value of $ 1+1/r

16. Aside: Infinite Sums • Why?

17. Calculus of GTS • Cooperate if • Cooperation is sustainable using grim trigger strategies as long as r < 50% • Or … as long as $1 invested today does not return more than $1.50 next period > > > > < PV(cooperation) 60…60…60…60… 60 + 60/r 6/r r PV(defection) 72…54…54…54… 72 + 54/r 12 6/12 = 50%

18. Payoff Stream (TFT) profit 72 cooperate 60 defect 54 47 t t+1 t+2 t+3 time

19. Calculus of TFT • Cooperate if • Much harder to sustain than grim trigger • Cooperation may not be likely PV(cooperation) PV(cooperation) 60…60…60…60… 60 + 60/(1+r) 13/(1+r) 13 r PV(defection) PV(defect once) 72…47…60…60… 72 + 47/(1+r) 12 12 + 12r 1/12 = 8.3% > and > > > > > <

20. Trigger Strategies • Grim Trigger and Tit-for-Tat are extremes • Balance two goals: Deterrence • GTS is adequate punishment • Tit-for-tat might be too little Credibility • GTS hurts the punisher too much • Tit-for-tat is credible

21. Optimal Punishment COMMANDMENT In announcing a punishment strategy: Punish enough to deter your opponent. Temper punishment to remain credible.

22. Axelrod’s Simulation • R. Axelrod, The Evolution of Cooperation • Prisoner’s Dilemma repeated 200 times • Economists submitted strategies • Pairs of strategies competed • Winner: Tit-for-Tat • Reasons: • Forgiving, Nice, Provocable, Clear

23. Main Ideas from Axelrod • Not necessarily tit-for-tat • Doesn’t always work • Don’t be envious • Don’t be the first to cheat • Reciprocate opponent’s behavior • Cooperation and defection • Don’t be too clever

24. Summary • Cooperation • Struggle between high profits today and a lasting relationship into the future • Deterrence • A clear, provocable policy of punishment • Credibility • Must incorporate forgiveness • Looking ahead: • How to be credible?