ae 1 Introduction (Gane THEORYIS ABOUT Wnist HAPFENS when people—or genes, or nations— Inceract. Here are some examples: Tennis players deciding whether to serve to the let or right side of the court; dhe only bakery in town offering a dis: counted price on pasties just before it loses: employees deciding how hard to work when the boss is away, an Arab rug seller deciding how cuicky to lower his price when haggling with 2 tourist; rival drug firms investing in a zace to reach patent; an ecommerce auction company learning which fea ‘ures to ade to its website by rial and error: real estate developers guessing, ‘when a downtrodden urban neighborhood will spring back to life; San Fran ‘isco commuters deciding which route to work will be quickest when the Bay Bridge is closed; Lamelara men in Indonesia deciding whether to join the ay’s whale hunt, and how to divide the whale if they catch one, aisline ‘workers hustling t get 2 plane away from the gate on time; MBAs decid. ing what their degree will signal to prospective employers (and whether {quitting alter the fist year of their tworvear program to join a dotcom sarcup signals guts or stupidity); a man framing 2 memento from when hae first met his wife, s a gift on their first official date a year later (they're happily marsied now!}; and people bidding for artor oil leases, or for Knick Iknacks on eBay. These examples illustrate, respectively, ultimatum games Coakery, Chapter 2), gift exchange (employees, Chapter 2), mixed equillb- suum (tennis, Chapter 8), Tunisian bazaar bargaining (rug seller, Chapter 4), patent race games (patents, Chapter 5), learning (e-commerce, Chap- ter 6), stag hunt games (whalets, Chapter 7), weaklink games (airlines, Chapter 7), orderstatisuc games (developers, Chapter 7), signaling (MBAs and romance, Chapter 8), auctions (bidding, Chapter 9) 12 Intvoduation In al of these stations, a person (or frm) muss anticipate what oth ers will do and what others will infer rom the ponent toe setene game is a mathematical x43) ofthe crucial feaioree of tone atesoone A game consists of the “stategcs each of several “plore have wade cise rules forthe order in which players cheese seareges the nformnton they have when they choose, and how they rate the decisbing to a ig) of esuling outcomes. An appendis to Uns chapter deeribes We bee tmathematis of game theory and gies some references for farines reading Game theory has avery clear paternity Many of ts main festonee noes snuodaced by von Nevmanm and Morgenstern n 1944 Colsene eoeg workin the 1920 by von Neumann, Borel, and Zermelo) A few yous hac, John Nash proposed a "solition” to the problem of how tatoral play would pay now ealled Nash equilibrium Nash's ides, bated ok the es oF quibram napa system wastha players wouldadjust her searsgne unt no player could Bene fom changing. Al players ae thet chet strategies thacar best (uttymaximizing) esponcestoal theatherclone sorateges. Important steps n the 19603 were the realization tha tony in repeated sequences of oneshot games could difer substan hog 'ehavior in oneshet games, and theories in which player can have pore information about her values (or "ype'), proved al players kage tre Probables of wha those types might be. In 1094 Nash, John Haren, and Remhard Selten (an actve experimenter) shared the Nobel ne Economic Science for their patnbresking contibudons Tn the pas fy year, game theory has gradually Become a standard language in economicsand sinereasingly wsedin ether social sccm (od in biology). In economics, game theory s used to analyte behavior of feos {hat worry about what their competitors will do.! Game theory is also good for understanding how workers behave in firms (such a te reacion of or alespeopleoincentive contrac), the spread of sada conventions sch as langage and fashion, and which genes or cultural peuees oot Spread The power of game theorists generltyand mathematical precision The same basic ideas are used to analyze all the gamestchis bergaining for rugs romance. yhalehunting-described in the fas paragraph of tg ehaprer Game theory i also boldly precise Suppose ai Arts og cell «an alway buy more rugs cheap, an inerested tours values the sags somewhere benveen $10 sod $1000, and the sles has & good idea of Lae ame inary coer ap bere ingle mencphwich pee wo wiry owt cite fis sensi wil obec he anap pon a -peretape wa ‘ofrm cinch omptcstwr aban Gane tr wot coe 2 Introduction 3 Impatient the tourists but inc sure how much the tours kes a particular rug Then game theory ells you excl what price the seller should sartout {ay and exactly how quickly he should cat the price as the tourist hems and hraws. In experimental recreations of this kind of sugselling, the cheory is halfright and balésrong it’s wong about the opening prices sellers state, but the rate at which experimental sellers érop their prices over ume is amazingly cose to the rate that game theory predicts (see Chaprer 4) tis important to disunguish games from game theory. Cames area tax ‘onomy of strategic situations, a tough equivalent for social science ofthe periodic table of elements in chemistry. Analytical game theory is math fmatical derivation of what players with efferent cagnitive capabilities are Jikelyo doin games? Game theory soften highly mathematical (which has Iumited is spread outside economies) and is usually based on invospecton and guesses rather than careful observation of how people actually pain games. This book aims to corzeet the imbalance of theory and facts br de seribing hundreds of experimentsin which people interact strategically The results are used to create behavioral game theory Behavioral game theory's bout what players actualy do. ILexpands aaytical theory by adding emo- tion, mistakes, limited foresight, doubss about how smart others are, and Jearning to analytical game theory (Colman, in press, gives a more philo- sophical perspective). Behavioral game theoty is one branch of behavioral economies, an approach to economics which uses paychotogiel regularity to suggest ways to weaken rational assumptions and extend theory (see Camerer and Loewenstein, 2003) ‘Because the language of game theory is both rich and ersp it could ‘unify many parts of socal science. For example, trust studied by social psichologiss, sociologists, philasophers economists interested in economic Sevelopment, and others. But what 1 ust? This shppery concept can be precisely defined in 2 game: Would you lend money to somebody who ‘doesn’t have t pay you back, but might feel morally obliged to da so? you ‘would, you tust her If she pays you back, she is wasevorthy This definition fives a way to measure Uns, and has been used in experiments in many places (including Bulgaria, Sou Asia, and Kenva; see Chapter $) “The spread of game theory outside of economics has suffered believe from the misceeeption that you need to know alt of fancy math to apply it-and from the fat that most predictions of analytical game theory are not ‘well grounded in observation. The need for empirical regularity to inform abe presen thsbooknonrsho ‘onceopern” generat en pie ct ake ‘seaing graces tons too hey ton gs a sl do Caopert ae ey ‘Seng eens4 J Induction {game theory has been recognized many times. n the opening pogesof thei seminal book, von Neumann and Morgenstern (1944, p. 4) wrote the empirical Background of economic scence is definitely inadequate. Our knowledge of the relevant facts of economics is incomparably smaller chan Giat commanded in physics at the time when mathemati zation of that subject was achieved... I¢ would have been absurd in physics to expect Kepler and Newoon withouc Tycho Brahe—and there 's no reason to hope for an easier development in economics. ‘This book is focused on experiments a¢ empirical background. Game sheory has also been tested using data that nanually occur in Held seuings (particularly in clearly structured situations such a auctions). But exper ‘mental contol is particularly useful because game theory predictions often depend sensitively on the choices players have, how they value outcomes, ‘what they know, the order in which they move, and so forth. as Crayford 2997, p 207) explains: Behavior in games ie matoriously sensitive to details ofthe environment, 50 that rategic models carry a heavy informational burden, which is often compounded in the field by an inabibiy to observe all relevance variables, Important advances in experimental technique aver the past three decades allow 2 control that often gives experiments decisive advantage in identifying the relationship between behavios and env Fonment,... For many questions, (experimental daca are} the most Jmipartant source of empitical information we have, and (they are) un- likely to be less reliable than casual empiricist or introspection Of course, its imporant 10 ask how well the results of experiments with {mosty) college stadens playing for a couple af hours for modest fi nancial stakes generalize to workers in firms, companies creating corporate strategy, diplomats negotiating, and so forth, But these doubis abown gen- ezalizability are a demand for more elaborate experiments, nota dismissal of the experimental method per se. Experimenters have studied a few di mensions of generalizabiliy—particularly the effects of playing for more money, which are usually small. But more ambitious experiments with teams cf players, complex eniconments, communication, and overlapping gener ations would enhance generalizability further, and people should do more of them, >see Sehnteans Soper (000, LD What le Game Tron Good For? 5 1.1 What Is Game Theory Good For? 1s game theory meant t predict what people do, to give them advice, or ‘what The theorists answer s that game theory is none of the above—itis SSmaply “analytical” a body of answers to mathematical questions about what players wth various degrees of rationality will do. If peaple don’t play the ‘vay theory ays, their behavior has not proved the mathematics Wrong, any snare than fling dhaccashiers sometimes give the wrong change disproves, arithmetic. In practice, however, she tools ef analyical game deory are vied predict, and also wo explain (or “postdcr™*) and prescribe. Auctions are 2 zo0d example ofall three ses nf game theory. Based on precise assumptions about the rus ofthe auction and the way in which bidders value an object, sich a3 an oil lease oF & painting, auction theory then derives how much rational bidders wal pay ‘Theory can help explain why some types of auction are more common dan osters For exaniple, in Sevondprice” or Viekrey auctions the high bidides buys the object being auctioned ata price equal tthe seandhighest bid. Under some ccndisons these auctions shoud in aheary, raise more revenue for sellers than traditional frseprice auetions in which the high bidder pays what she bid. But second-price auctions are rare (see Lacking Reilly, 2000). Why? Game theory offers an explanation: Since the high bidder paysa price other than what she bid in asecondiprice auction, sich auctions are vulnerable to manipulation by the seller (who can sneak in an ficial bid to force the high bidder to pay more) How well does auction eocy predict? Test with Geld data are prob. lemavie: Because bidders’ valuations are usvally hidden, iti dificult to tell whether they ae bidding optimally alhough same prediciens can be tested. Formunately, there are many cacefsl experiments (See Kagel, 199 Kagel and Levin, n press) The results ofthese experiments are mixed. In privarevalue auctions in which each player has her own personal value for the object (and doesn't care how much others value it), people bid remark ably close to the amounts they ate predited to, eve when the function ‘mapping values into isis nonlinear and counterintuitive? In commonvalue auctions the vale of the object is exsentially the same for everyone, but i uncertain. Bidding for leases op ofl acts an exainple—different oil companies would al vale the oi) in the same way Dutaren’ ture bow much eis there In these auctions players who are moxt optimistic about the value of the object tend to bid the highest and win “ear Soins cece. hw in of anette seat hw an nan or flied ae and" nares an are pig nrg pales 188) "Sex Chand Fl (188 and he aed mech nein Chap