Microeconomics II

Game Theory and Its Applications

PROF. SWAGATA BHATTACHARJEE
Microeconomics So Far..
 Single Person Decision Making: Consumer Theory
 Aggregating individual demands into Market Demand
 Producer Theory
 Aggregating individual firm’s supply schedules into Market Supply
 Competitive Market Equilibrium
 Assumptions:
Microeconomics So Far..
 Single Person Decision Making: Consumer Theory
 Aggregating individual demands into Market Demand
 Producer Theory
 Aggregating individual firm’s supply schedules into Market Supply
 Competitive Market Equilibrium
 Assumptions:
 Large number of buyers and sellers
 Complete Information
 Individual decision has no impact on the market outcome
 No strategic interaction
Microeconomics So Far..
 Single Person Decision Making: Consumer Theory
 Aggregating individual demands into Market Demand
 Producer Theory
 Aggregating individual firm’s supply schedules into Market Supply
 Competitive Market Equilibrium
 First and Second Fundamental Theorems of Welfare Economics
Microeconomics So Far..
 Single Person Decision Making: Consumer Theory
 Aggregating individual demands into Market Demand
 Producer Theory
 Aggregating individual firm’s supply schedules into Market Supply
 Competitive Market Equilibrium
 First Fundamental Theorems of Welfare Economics:
Every CE is Pareto Optimal
 Second Fundamental Theorems of Welfare Economics:
Every Pareto Optimal allocation can be induced as a CE
What’s Next….
 Strategic Interactions!

 Most often, in our daily lives, our own individual decisions alone do not yield to a specific
outcome.

 In any context with multiple people involved, one person’s decision affects another person’s
well-being, either positively or negatively.

 These situations of interdependence are called Strategic settings.

 Here, in order for a person to decide how best to behave, s/he must consider how others around
him/her choose their actions.
What’s Next….
 Strategic Interactions!

 In Strategic settings, in order for a person to decide how best to behave, s/he must consider
how others around him/her choose their actions.

 Eg: a game of chess. Each player has to anticipate the reaction of the opponent and choose
the best move considering this.

 Eg: a group project. A successful project depends on how well the members coordinate their
efforts

 Eg: a political contest. If a politician wants to win an election, she should pick a campaign
strategy that competes favorably with her opponent’s strategy.
Game Theory
 Game theory is a methodology of formally studying situations of strategic interdependence/
interactions.

 Game Theory gives a mathematically precise and logically consistent structure.

 With the right theoretical tools in place, we can study behavior in a variety of contexts and come
to better understand and predict the outcomes of economic and, more generally, social
interaction.
Uses of Game Theory
 Developed during the Cold War period (1950-80s) primarily in order to model the strategic
competition between the dominant countries

 Political Science/ Political Economics

 Predict wartime strategies
 Political campaign strategies in the democratic elections
 International relations
Uses of Game Theory
 Industrial Organization:

 Should a firm acquire a new firm? Should two competitors merge?

 How should the market operate if there is a dominant firm and many smaller firms?
 How to determine the optimal advertising strategies?
 Is it possible for multiple dominant firms to collude? How to detect illegal collusion?
Uses of Game Theory
 Industrial Organization:

 Should a firm acquire a new firm? Should two competitors merge?

 How should the market operate if there is a dominant firm and many smaller firms?
 How to determine the optimal advertising strategies?
 Is it possible for multiple dominant firms to collude? How to detect illegal collusion?

 Contract Theory/ Managerial Economics

 Within a firm, how best to motivate the employees so that they do not shirk even when it is not possible to track
their exact effort?
 Designing optimal incentive schemes for long and short term employment
 Collaboration between firms: how best to design the contract
 Where we can not write any legally enforceable contract, how do organizations operate?
Uses of Game Theory
 Network Theory
 How people form connections? In a society/ social media platform, what is the network structure that is
expected to emerge?
 Given any existing network structure, how to transmit information? Suppose, in a village government
wants to raise awareness about the hazards of using bio fuel. How can they design the optimal way to
transmit this information?
Uses of Game Theory
 Network Theory
 How people form connections? In a society/ social media platform, what is the network structure that is
expected to emerge?
 Given any existing network structure, how to transmit information? Suppose, in a village government
wants to raise awareness about the hazards of using bio fuel. How can they design the optimal way to
transmit this information?

 Information Economics
 A company is hiring for a position. How should they choose candidates matching the exact requirement
when the candidates have no relevant experience? How should the candidates signal their ability?
 If you are buying a used car, you have less information about the car than the owner. What happens in
such cases?
 How to disseminate information?
A Game
 A game is a multi-person strategic interaction context defined by its structure, which includes:

 The players: independent decision makers (Players)

 e.g. a game of chess has 2 players

 The rules: specifies the order of players’ decisions, their feasible decisions at each decision point (action) at each
decision point.
 e.g. different pieces in chess has different moves and at any given point, a subset of the moves are available to
choose from. The players alternate in moving pieces on the game board.

 The information: what each player knows at each decision point.

 E.g. players observe each other’s moves, so each knows the entire history of play as the game progresses

 How players’ decisions jointly determine the outcome.

 E.g. a player who captures the other player’s king wins the game, and otherwise, a draw is declared

 Players’ preferences over outcomes (or probability distributions of outcomes)

 E.g. each player prefers a win over a draw over a loss (generally)
Example 1
 Two companies share a market, in which they currently make $5,000,000 each.
 Both need to determine whether they should advertise.
 For each company advertising costs $2,000,000 and captures $3,000,000 from the competitor
provided the competitor doesn’t advertise.
 What should the companies do?
Example 2
 Three legislators vote whether they allow themselves a raise in salary of $2000 per year.
 Since voters are observing the vote, there is some loss of face for a legislator to vote for a raise.
 Let’s assume that the legislators estimate that loss of face is worth $1000 per year.
 What happens if all three vote at the same time?
Example 3
 Adam and Bob have robbed a bank and been arrested. They are interrogated separately.
 Adam and Bob have the option to confess or to remain silent.
 The police have little evidence, and if both remain silent they will be sentenced to one year on a
minor charge.
 Therefore the police interrogators propose a deal: if one confesses while the other remains silent,
the one confessing goes free while the other is sentenced to three years.
 However, if both talk, both will still be sentenced to two years.
 Each questioned in a separate cell without knowing what the other is doing.
 What will Adam and Bob do?
Example 3: Adam and Bob
Adam\Bob Deny Confess
Deny -1,-1 -3,0
Confess 0,-3 -2,-2

 This is a “normal form” representation of this game.

 Players: Adam and Bob
 Actions: Confess and Deny
 Row player (Adam)’s payoff is the first entry, column player’s (Bob’s) is the second one
 Rule of the game: simultaneous move
How to Use Game Theory
To “Model” Your Everyday World
 A model is an abstract, often mathematical, version of reality.
 You can formulate many real life instances around you as a model, that is, a game.
 This is abstract, but is supposed to yield some insight into the particular real-world situation.
 It is important not to confuse the model with reality—in reality there are many other factors that
affect the situation.
 But if we can use game theory to predict the outcome of a “model”, then we can extrapolate it to
predict the real life situation.
A Thought Exercise
 Think of any real life context, try to formulate it (model it) as a game.
 In particular, specify the players, the rules, the order of the plays, the information, how the
outcome is determined, and the players’ preferences.
Next Class
 A primer on decision making under uncertainty
 Representation of Games