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Lecture 1

Lecture 1

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Published by: Prashant Patel on Dec 06, 2012
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Lecture I-II: Motivation and Decision Theory
Markus M. M¨obiusFebruary 4, 2003
1 Motivating Experiment: Guess the average
Setup:
Each of you (the students in this course) have to declare an integerbetween 0 and 100 to guess ”2/3 of the average of all the responses”. Moreprecisely, each student who guesses the highest integer which is not higherthan 2/3 of the average of all responses, will receive a prize of 10 Dollars.
This game can be solved by iterated dominance. However, being smaris not enough. Those who bid 
0
typically lose badly. You have to guess how ’dumn’ all the other students in the class are. Even if everyone is supersmart,but has low confidence in the smartness of others, the winning value can be quite high. In our class we got a winning bid of 17 and 1 person walked away with 10 Dollars.
2 What is game theory?
Definition 1
Game theory is a formal way to analyze interaction among a group of rational agents who behave strategically.
This definition contains a number of important concepts which are dis-cussed in order:
Group:
In any game there is more than one decision maker who isreferred to as player. If there is a single player the game becomes a decisionproblem.
Interaction:
What one individual player does directly affects at leastone other player in the group. Otherwise the game is simple a series of independent decision problems.1
 
Strategic:
Individual players account for this interdependence.
Rational:
While accounting for this interdependence each player choosesher best action. This condition can be weakened and we can assume thatagents are boundedly rational. Behavioral economics analyzes decision prob-lems in which agents behave boundedly rational. Evolutionary game theoryis game theory with boundedly rational agents.
Example 1
Assume that 10 people go into a restaurant. Every person pays  for her own meal. This is a decision problem. Now assume that everyone agrees before the meal to split the bill evenly amongst all 10 participants. Now we have a game.
Game theory has found numerous applications in all fields of economics:1.
Trade:
Levels of imports, exports, prices depend not only on your owntariffs but also on tariffs of other countries.2.
Labor:
Internal labor market promotions like tournaments: your chancesdepend not only on effort but also on efforts of others.3.
IO:
Price depends not only on your output but also on the output of your competitor (market structure ...).4.
PF:
My benefits from contributing to a public good depend on whateveryone else contributes.5.
Political Economy:
Who/what I vote for depends on what everyoneelse is voting for.
3 Decision Theory under Certainty
It makes sense to start by discussing trivial games - those we play againstourselves, e.g. decision problems. Agents face situations in which they haveto make a choice. The actions of other agents do not influence my preferenceordering over those choices - therefore there is no strategic interaction goingon. Proper games will be discussed in the next lectures.A decision problem (
A,
) consists of a finite set of outcomes
A
=
{
a
1
,a
2
,..,a
n
}
and a preference relation
. The expression
a
b
should be interpreted as”b is at least as good as a”. We expect the preference relation to fulfill twosimple axioms:2
 
Axiom 1
Completeness. Any two outcomes can be ranked, e.g.
a
b
or 
b
a
.
Axiom 2
Transitivity implies that if 
a
b
and 
b
c
then 
a
c
.
Both axioms ensure that all choices can be ordered in a single chain withoutgaps (axiom 1) and without cycles (axiom 2).Although the preference relation is the basic primitive of any decisionproblem (and generally observable) it is much easier to work with a consistentutility function
u
:
A
because we only have to remember
n
real numbers
{
u
1
,u
2
,..,u
n
}
.
Definition 2
A utility function 
u
:
A
is consist with the preference relationship of a decision problem 
(
A,
)
if for all 
a,b
A
:
a
b
if and only if 
u
(
a
)
u
(
b
)
Theorem 1
Assume the set of outcomes is finite. Then there exists a utility  function 
u
which is consistent.
Proof:
The proof is very simple. Simple collect all equivalent outcomes inequivalence classes. There are finitely many of those equivalence classessince there are only finitely many outcomes. Then we can order theseequivalence classes in a strictly increasing chain due to completenessand transitivity.Note that the utility function is not unique. In fact, any monotonictransformation of a consistent utility function gives another utility functionwhich is also consistent.We can now define what a rational decision maker is.
Definition 3
A rational decision maker who faces a decision problem 
(
A,
)
chooses an outcome 
a
A
which maximizes his utility (or, equivalently, for each 
a
A
we have 
a
a
).
Remark 1
When there are infinitely many choices we want to make sure that there is a continuous utility function. This requires one more axiom which makes sure that preferences are continuous. For that purpose, one has to define topology on the set of outcomes. We won’t deal with that since we won’t gain much insight from it.
3

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