MICROECONOMICS – III

GROUP ASSIGNMENT
GROUP 2 – GAME THEORY

Name: AYUSHI JOGI

Class/Div: TYBA – A
Roll no.: 016
Sap id: 40310190049

Topics selected:
1) PRISONER’S DILEMMA
2) ULTIMATUM GAME
INTRODUCTION
WHAT IS GAME THEORY?

Game theory is a theoretical framework for conceiving social situations among competing
players. In some respects, game theory is the science of strategy, or at least the optimal
decision-making of independent and competing actors in a strategic setting.

The key pioneers of game theory were mathematician John von Neumann and economist Oskar
Morgenstern in the 1940s. Mathematician John Nash is regarded by many as providing the first
significant extension of the von Neumann and Morgenstern work.

Game theory is the study of mathematical models of strategic interaction among rational
decision-makers. It has applications in all fields of social science, as well as in logic, systems
science and computer science. Originally, it addressed zero-sum games, in which each
participant's gains or losses are exactly balanced by those of the other participants. In the 21st
century, game theory applies to a wide range of behavioural relations, and is now an umbrella
term for the science of logical decision making in humans, animals, and computers.
PRISONER’S DILEMMA

The Prisoner's Dilemma is the most well-known example of game theory.

The Prisoner’s Dilemma is a simple game which illustrates the choices facing oligopolies. The
name ‘Prisoner’s Dilemma’ was first used in 1950 by Canadian mathematician, Albert W.
Tucker when providing a simple example of game theory.

THE SCENARIO:

Robin and Tom are prisoners:

They have been arrested for a petty crime, of which there is good evidence of their guilt – if
found guilty they will receive a 2-year sentence.

During the interview the police officer becomes suspicious that the two prisoners are also guilty
of a serious crime but is not sure he has any evidence.

Robin and Tom are placed in separate rooms and cannot communicate with each other. The
police officer tries to get them to confess to the serious crime by offering them some options,
with possible payoffs.

THE OPTIONS:

Each is told that if they both confess to the serious crime, they will receive a sentence of 3
years. However, each is also told that if he confesses and his partner does not, then he will get
a light sentence of 1 year, and his partner will get 10 years. They know that if they both deny
the serious offence, they are certain to be found guilty of the lesser offence and will get a 2-
year sentence.
THE PAYOFF MATRIX:

The dilemma is that their own ‘pay-off’ is wholly dependent on the behaviour of the other
prisoner. To avoid the worse-case scenario (10 years), the safest option is to confess and get 3
years. If collusion is possible, they can both agree to deny (and get 2 years), but there is a very
strong incentive to cheat because, if one denies and the other confesses, the best outcome of all
is possible – that is 1 year. Fearing that the other may cheat, the safest option is to confess.

TYPES OF STRATEGY:

MAXIMAX:

A maximax strategy is one where the player attempts to earn the maximum possible benefit
available. This means they will prefer the alternative which includes the chance of achieving
the best possible outcome – even if a highly unfavourable outcome is possible.

This strategy, often referred to as the best of the best is often seen as ‘naive’ and overly
optimistic strategy, in that it assumes a highly favourable environment for decision making.

The best pay-off for Robin from confessing is 1 year (with Tom denying), and the best pay-off
from denying is 2 years (with Tom denying) – so the best of the best is to confess (1 year).
MAXIMIN:

A maximin strategy is where a player chooses the best of the worst pay-off. This is commonly
chosen when a player cannot rely on the other party to keep any agreement that has been made
– for example, to deny. In the Prisoner’s Dilemma, the worst pay-off to Robin from confessing
is to get 3 years (with Tom confessing), and the worst pay-off from denying is 10 years (with
Tom confessing) – therefore the best of the worst is to confess.

In this case, both the maximin and maximax strategies would be to confess. When this occurs,
it is said to be the dominant strategy.

DOMINANT STRATEGY:

A dominant strategy is the best outcome irrespective of what the other player chooses, in this
case it is for each player to confess – both the optimistic maximax and pessimistic maximin
lead to the same decision being taken.

HOW DOES THIS RELATE TO A FIRM’S BEHAVIOUR?

In general, game theory suggests that firms are unlikely to trust each other, even if they collude
and come to an agreement such as raising price together.

Consider the hypothetical example of two Airlines and return ticket prices to New York.

In this case, for both Airlines, the aggressive maximax strategy is £140m from a low price and
£120m from a high price, so a low price gives the maximax pay-off.
In terms of the pessimistic maximin strategy, the worst outcome from a low price is £100m,
and from a high price is £70m – hence a low price provides the best of the worst outcomes.

Again, lowering price is the dominant strategy, and the only way to increase the pay-off would
be to collude and increase price together. Of course, this requires an agreement, and collusion,
and this creates two further risks – one of the airlines reneges on the agreement and ‘rats’, and
the competition authorities investigate the airlines, and impose a penalty.

HOW CAN YOU USE IT?

The prisoner’s dilemma can be used to aid decision-making in a number of areas in one’s
personal life, such as buying a car, salary negotiations and so on.

For example, assume you are in the market for a new car and you walk into a car dealership.
The utility or payoff, in this case, is a non-numerical attribute (i.e., satisfaction with the deal).
You want to get the best possible deal in terms of price, car features, etc., while the car salesman
wants to get the highest possible price to maximize his commission.

Cooperation in this context means no haggling; you walk in, pay the sticker price (much to the
salesman’s delight), and leave with a new car. On the other hand, defecting means bargaining.
You want a lower price, while the salesman wants a higher price. Assigning numerical values
to the levels of satisfaction, where 10 means fully satisfied with the deal and 0 implies no
satisfaction, the payoff matrix is as shown below:
What does this matrix tell us? If you drive a hard bargain and get a substantial reduction in the
car price, you are likely to be fully satisfied with the deal, but the salesman is likely to be
unsatisfied because of the loss of commission (as can be seen in cell b).

Conversely, if the salesman sticks to his guns and does not budge on price, you are likely to be
unsatisfied with the deal while the salesman would be fully satisfied (cell c).

Your satisfaction level may be less if you simply walked in and paid full sticker price (cell
a). The salesman in this situation is also likely to be less than fully satisfied, since your
willingness to pay full price may leave him wondering if he could have “steered” you to a more
expensive model or added some more bells and whistles to gain more commission.

Cell (d) shows a much lower degree of satisfaction for both buyer and seller, since prolonged
haggling may have eventually led to a reluctant compromise on the price paid for the car.

ULTIMATUM GAME:
The Ultimatum Game, introduced by Werner Guth and colleagues (1982), is a simple, take-it-
or-leave-it bargaining environment. In ultimatum experiments two people are randomly and
anonymously matched, one as proposer and one as responder, and told they will play a game
exactly one time. The proposer is endowed with an amount of money and suggests a division
of that amount between herself and her responder. The responder observes the suggestion and
then decides whether to accept or reject. If the division is accepted, then both earn the amount
implied by the proposer’s suggestion. If rejected, then both the proposer and responder earn
nothing for the experiment.
The key result of ultimatum experiments is that most proposers offer between 40% and 50%
of the endowed amount, and that this split is almost always accepted by responders. When the
proposal falls to 20% of the endowment it is rejected about half of the time, and rejection rates
increase as the proposal falls to 10% and lower. As discussed by Camerer (2003, Chapter 2),
ultimatum game results are highly robust to a variety of natural design manipulations (e.g.,
repetition, stake size, degree of anonymity and a variety of demographic variables).
An important exception to the robustness results is reported by Hoffman and Spitzer (1985),
who show that offers become significantly smaller, and rejections significantly less frequent,
when participants compete for and earn the right to propose. An explanation is that this
procedure changes the perception of “fair” and draws attention to the importance of context in
personal (as compared to market) exchange environments. Effects might also stem from
varying the degree of anonymity among the subjects, or between the subjects and the
experimenter (Hoffman et al., 1996).
A key focus of recent ultimatum game research has been to understand why responders reject
low offers. Economic theory based on self-interested preferences suggests responders should
accept any positive offer and consequently, proposers should offer the smallest possible
positive amount.

When ultimatum game is applied as an economics experiment, typically, it will be played only
once so that the reciprocation and negotiation is not an issue. The first game was played in
1982, at Humboldt university in Berlin, Germany with the support of three professors, such as
Werner Guth. 12 students took part in a fun game theory experiment called Ultimatum Game.

In order to prevent the interaction between the two players, which will affect the result, the
experiment adopted a double-blind method. Neither the proposer nor the responder knows who
the other is. After the experiment rules were announced, the proposer had one day to think
carefully and come up with the proposal to be given to the experimented. Then the
experimented handed over the proposal to the responder, who decided to refuse of accept it.

According to the principle of benefit maximization, the equilibrium point of the game is very
clear. For respondents who make decisions, no matter how many, if not zero, accepting will
always have more benefits. Thus they should always accept except for the case of zero.

Since, the responder can accept anything more than zero, the proposer will give the other a
small sum of money for his own benefit. That's according to traditional economics. However,
the experiment results showed that the players relied more on their fairness ideas rather than
the maximization of their gains to determine the result of the game.

The tendency of fairness distribution in the experiment is not consistent with the hypothesis of
"economic man" in traditional economics.

Thus, the Ultimatum game became the primary experiment in behavioural economics.

To sum up, the ultimatum game challenged the forever accuracy of traditional economics and
serves as a footstone of behavioural economics.
REFERENCES:

• https://www.investopedia.com/articles/investing/110513/utilizing-prisoners-dilemma-
business-and-economy.asp
• https://www.sciencedirect.com/topics/neuroscience/ultimatum-game
• https://www.nature.com/articles/s41598-017-05122-5
• https://www.fte.org/the-ultimatum-game/
• https://www.britannica.com/science/game-theory/The-prisoners-dilemma
• https://www.youtube.com/results?search_query=ultimatum+game+economics
• https://en.wikipedia.org/wiki/Prisoner%27s_dilemma
• https://www.economicsonline.co.uk/Business_economics/Prisoners_dilemma.html