Game Theory

Developed to explain the optimal strategy in two-person interactions. Initially, von Neumann and Morganstern
Zero-sum games

John Nash
Nonzero-sum games

Harsanyi, Selten
Incomplete information

An example: Big Monkey and Little Monkey

Monkeys usually eat ground-level fruit Occasionally climb a tree to get a coconut (1 per tree) A Coconut yields 10 Calories Big Monkey expends 2 Calories climbing the tree. Little Monkey expends 0 Calories climbing the tree.

An example: Big Monkey and Little Monkey

If BM climbs the tree
BM gets 6 C, LM gets 4 C LM eats some before BM gets down

If LM climbs the tree

BM gets 9 C, LM gets 1 C BM eats almost all before LM gets down

If both climb the tree

BM gets 7 C, LM gets 3 C BM hogs coconut

How should the monkeys each act so as to maximize their own calorie gain?

An example: Big Monkey and Little Monkey

Assume BM decides first
Two choices: wait or climb

LM has four choices:

Always wait, always climb, same as BM, opposite of BM.

These choices are called actions

A sequence of actions is called a strategy

An example: Big Monkey and Little Monkey

Big monkey Little monkey w w c w c c

0,0 9,1 6-2,4 7-2,3 What should Big Monkey do? If BM waits, LM will climb BM gets 9 If BM climbs, LM will wait BM gets 4 BM should wait. What about LM? Opposite of BM (even though well never get to the right side of the tree)

An example: Big Monkey and Little Monkey

These strategies (w and cw) are called best responses.
Given what the other guy is doing, this is the best thing to do.

A solution where everyone is playing a best response is called a Nash equilibrium.

No one can unilaterally change and improve things.

This representation of a game is called extensive form.

An example: Big Monkey and Little Monkey

What if the monkeys have to decide simultaneously?
Big monkey Little monkey w 0,0 w c w c c

9,1 6-2,4 7-2,3

Now Little Monkey has to choose before he sees Big Monkey move Two Nash equilibria (c,w), (w,c) Also a third Nash equilibrium: Big Monkey chooses between c & w with probability 0.5 (mixed strategy)

An example: Big Monkey and Little Monkey

It can often be easier to analyze a game through a different representation, called normal form
Little Monkey c Big Monkey c v 5,3 9,1 v 4,4 0,0

Choosing Strategies
In the simultaneous game, its harder to see what each monkey should do
Mixed strategy is optimal.

Trick: How can a monkey maximize its payoff, given that it knows the other monkeys will play a Nash strategy? Oftentimes, other techniques can be used to prune the number of possible actions.

Eliminating Dominated Strategies

The first step is to eliminate actions that are worse than another action, no matter what.
Big monkey w Little monkey 0,0
Little Monkey will Never choose this path.

w c w

c c

w 9,1

c 4,4

9,1 6-2,4 7-2,3

Or this one

We can see that Big Monkey will always choose w. So the tree reduces to: 9,1

Eliminating Dominated Strategies

We can also use this technique in normalform games:
Column a a Row b 5,3 0,0 9,1 b 4,4

Eliminating Dominated Strategies

We can also use this technique in normalform games:
a a b 9,1 5,3 b 4,4 0,0

For any column action, row will prefer a.

Eliminating Dominated Strategies

We can also use this technique in normalform games:
a a b 9,1 5,3 b 4,4 0,0

Given that row will pick a, column will pick b. (a,b) is the unique Nash equilibrium.

Prisoners Dilemma
Each player can cooperate or defect
Column cooperate cooperate Row defect 0,-10 -8,-8 -1,-1 defect -10,0

Prisoners Dilemma
Each player can cooperate or defect
Column cooperate cooperate Row defect 0,-10 -8,-8 -1,-1 defect -10,0

Defecting is a dominant strategy for row

Prisoners Dilemma
Each player can cooperate or defect
Column cooperate cooperate Row defect 0,-10 -8,-8 -1,-1 defect -10,0

Defecting is also a dominant strategy for column

Prisoners Dilemma
Even though both players would be better off cooperating, mutual defection is the dominant strategy. What drives this?
One-shot game Inability to trust your opponent Perfect rationality

Prisoners Dilemma
Relevant to:
Arms negotiations Online Payment Product descriptions Workplace relations

How do players escape this dilemma?

Play repeatedly Find a way to guarantee cooperation Change payment structure

Tragedy of the Commons

Game theory can be used to explain overuse of shared resources. Extend the Prisoners Dilemma to more than two players. A cow costs a dollars and can be grazed on common land. The value of milk produced (f(c) ) depends on the number of cows on the common land.
Per cow: f(c) / c

Tragedy of the Commons

To maximize total wealth of the entire village: max f(c) ac.
Maximized when marginal product = a Adding another cow is exactly equal to the cost of the cow.

What if each villager gets to decide whether to add a cow? Each villager will add a cow as long as the cost of adding that cow to that villager is outweighed by the gain in milk.

Tragedy of the Commons

When a villager adds a cow:
Output goes from f(c) /c to f(c+1) / (c+1) Cost is a Notice: change in output to each farmer is less than global change in output.

Each villager will add cows until output- cost = 0. Problem: each villager is making a local decision (will I gain by adding cows), but creating a net global effect (everyone suffers)

Tragedy of the Commons

Problem: cost of maintenance is externalized
Farmers dont adequately pay for their impact. Resources are overused due to inaccurate estimates of cost.

Relevant to:
IT budgeting Bandwidth and resource usage, spam Shared communication channels Environmental laws, overfishing, whaling, pollution, etc.

Avoiding Tragedy of the Commons

Private ownership
Prevents TOC, but may have other negative effects.

Social rules/norms, external control

Nice if they can be enforced.

Taxation
Try to internalize costs; accounting system needed.

Solutions require changing the rules of the game

Change individual payoffs Mechanism design

Coming next time

How to select an optimal strategy How to deal with incomplete information How to handle multi-stage games