Extensive Form Games with Perfect Information: Illustrations

1. Chapter 6 Extensive Form Games With Perfect Information (Illustrations)

2. Extensive Form Games with Perfect Information: Illustrations • Ultimatum Game • Two people using the following procedure to split $k. Person A offers person B some positive $x less than or equal to k. If B accepts, A and B get k-x and x respectively. If B does not accept, neither gets any money. Each person only cares about their own payoff. • Players: A and B • Strategies: Player A: an offer between 0 and k. Player B: Accept or Not accept. • Payoffs: (k-x,x) or (0,0)

3. Extensive Form Games with Perfect Information: Illustrations • Subgames: Every possible offer by person A is a subgame. If the offer, x, is a continuous variable (ie, offers of fractions of cents are possible), then this game has an infinite number of subgames. • In the subgame following an offer x>0, the optimal response of player B is to accept. (not accepting yields a payoff of zero). • In the subgame following an offer x = 0, player B is indifferent between accepting and not accepting.

4. Extensive Form Games with Perfect Information: Illustrations • So what should player A do? If player B accepts all possible offers (including x = 0), then clearly offering x = 0 and attaining payoffs of (k,0) is our subgame perfect Nash equilibrium. If player B accepts all offers except x=0, then there is NO subgame perfect Nash equilibrium ! Offering $1 is dominated by offering $0.50. Offering $0.01 is dominated by offering $0.005. And so on.

5. Extensive Form Games with Perfect Information: Illustrations • So does this result violate our theorem that all finite games have a Nash equilibrium, possibly in mixed strategies? No, because even though there are a finite number of players, there are an infinite number of strategies.

6. Extensive Form Games with Perfect Information: Illustrations • Suppose the smallest unit of currency was a cent and player B always rejects an offer of x = 0, then x=0.01 would be the offer in a subgame perfect Nash equilibrium. • We could also complicate things further by allowing player B to make counteroffers. This will be developed in chapter 16 on repeated games. • Experiments in the ultimatum game: pg 183. Experimentally, many people reject offers that would give them positive amounts of money but that they deem unfair. Why? Lack of understanding of the game? Irrationality? Preference for “fairness”?

7. Extensive Form Games with Perfect Information: Illustrations • Exercise 185.1. Two people use the following procedure to allocate two desirable identical indivisible objects. • One person proposes an allocation (both objects go to person 1, both go to person 2, one goes to each), which the other person then either accepts or rejects. In the event of rejection, neither person receives either object. Each person cares only about the number of objects she obtains. • Construct an extensive game that models this situation and find its subgame perfect equilibria. • Does the game have any NE that are not SPE? • Is there any outcome that is generated by a NE but NOT by any SPE ?

8. Extensive Form Games with Perfect Information: Illustrations Oligopoly: market structure characterized by a few firms that recognize their strategic interdependence. Middle ground between monopoly and perfect competition. Duopoly: special case of oligopoly with 2 firms competing strategically with each other in the market(s) for the good(s) they both produce. Dynamic Quantities: Firm A is the leader and firm B is the follower. In period 1, firm A chooses its quantity and in period 2, firm B observes firm A's choice and then chooses its own quantity. Called "Quantity Leadership" or "Stackelberg in Quantities." • Who has more power in this setting? Dynamic Prices: Firm A is the leader and firm B is the follower. In period 1, firm A chooses its price and in period 2, firm B observes firm A's choice and then chooses its own price. Called "Price Leadership" or "Stackelberg in Prices." • What will be the feature of an equilibrium set of prices in this setting? Simultaneous Quantities: Firm A and firm B set their quantities at the same time given their beliefs about what the other firm will do. Called Cournot competition. • What will be the feature of an equilibrium in this setting? Simultaneous Prices: Firm A and firm B set their prices at the same time given their beliefs about what the other firm will do. Called Bertrand competition. • What will be the feature of an equilibrium in this setting? Collusion: a situation where firms jointly determine their prices or quantities to maximize joint profits. When firms get together and attempt to set prices and outputs so as to maximize total industry profits, they are known as a cartel. • OPEC.

9. Extensive Form Games with Perfect Information: Illustrations Stackelberg’s Model of Duopoly. • Firms move sequentially choosing quantities of production. Firm A chooses first and B chooses second, having observed firm A’s choice. Both firms seek to maximize their individual profits given their costs, Ci(qi). Total quantity is Q = qA + qB. Demand is P(Q). • At t=1, A chooses qA. At t=2, B chooses qB, At t=3, payoffs realized. • Who has more power in a game like this? (eg, which firm will end up with a higher level of profits if their costs are identical?) What are the strategies of the two firms (formally) ? • Example 6.2.2. Page 188 • Comparing Cournot, Bertrand, and Stackelberg. • Next Time!