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GAME THEORY, STRATEGIC DECISION MAKING, AND BEHAVIORAL ECONOMICS

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GAME THEORY, STRATEGIC DECISION MAKING, AND BEHAVIORAL ECONOMICS

Chapter 14

- 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.

- 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 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.

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

- 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.

- 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

- 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

- 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 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.

- 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 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.

- 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 – 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?

- 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.

- 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.

- 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.

- 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.