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GAME THEORY, STRATEGIC DECISION MAKING, AND BEHAVIORAL ECONOMICS. Chapter 14. 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.
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GAME THEORY, STRATEGIC DECISION MAKING, AND BEHAVIORAL ECONOMICS Chapter 14
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.
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.
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.
Prisoner’s Dilemma B Does Not Confess B Confesses A Goes Free A 5 years A Confesses B 5 years B 10 years A 10 years A 6 months A Does Not Confess B 6 months B Goes Free
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.
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
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
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.
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.
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.
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.
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.
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?
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.
Summary • 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.
Summary • 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.
Summary • 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.
Ford has a rebate Ford has no rebate C $3 C $1.5 Chevy has a rebate F $1.5 F $1 C $1 C $2 Chevy has no rebate B $2 F $3 million 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. Review Question 14-2: What is the dominant strategy? The dominant strategy is for each firm to offer a rebate.