4.

1: Social Interactions – Game Theory:

Terminology:
1) Social Dilemma = this occurs when we don’t take account of how our own personal
decisions (e.g. consumption) impact on other people’s wellbeing (or utility)
2) The Tragedy of the Commons = this occurs when a resource isn’t owned by anyone
in particular, it is easily overexploited and degraded when individuals act selfishly,
unless you control access in some way.
3) Strategic Interaction = when people are engaged in a social interaction, and are
aware of the ways in which their actions affect others, and vice versa
4) Strategy = a complete plan of action which describes the actions that an individual
will take throughout the course of the interaction
5) Games = models of strategic interactions and consist of players, feasible strategies,
payoffs (numerical outcome) and information
6) Game Theory = the study of these strategic interactions, which is widely used in
economics, biology, mathematics and other social sciences.
7) Simultaneous move game = move with same information e.g. rock, paper, scissors
8) Sequential move game = move one after the other after processing previous
information e.g. chess
9) Nash Equilibrium = the combination of strategies in a game such that neither player
has an incentive to change their strategies, given the strategy choice of their opponent
(mutual best response)
10) Dominant Strategy = sometimes there is one strategy which always provides a
player with a higher payoff, no matter what the other player does.
11) Dominant strategy equilibrium: An outcome of a game in which every player plays
his or her dominant strategy.
12) Zero-sum game: The players’ interests are in direct conflict with one another. For
example, in football, one team wins and the other team loses. If a win equals +1 and a
loss equals -1, the sum is zero
13) Non-zero sum game: The players’ interests are not always in direct conflict, so that
there are opportunities for both to gain. For example, when both players choose
“don’t confess” in Prisoner’s Dilemma (see below).
14) One-shot games: The play of the game occurs only once. Here, the players are likely
to not know much about each other. For example, tipping a waiter on your vacation
15) Repeated games: The play of the game is repeated with the same players.
16) Invisible Hand Game = whereby the NE is also the socially optimal outcome
without any interaction/prior information being given
17) Prisoners’ Dilemma = is one which exhibits: both players have a dominant strategy
& would do better in the outcome where they play their non-dominant strategy (also
called the dominated strategy) than they do in the Nash Equilibrium
18) Assurance game = where there are two Nash Equilibria where
both players play the same strategy, but both players strictly prefer
one Nash Equilibrium over the other. This game exhibits
multiple equilibria.
19) Battle of the sexes game = where there are two Nash Equilibria
where both players play the same strategy, but players prefer
different equilibria. This game exhibits conflicting equilibria.
4.2: Equilibrium in the Invisible Hand Game:

Basic Game and Solving for the Nash Equilibrium:

• NB! Use the Best Response Method!
• NE = (Sugar Cane, Maize)
• The Nash Equilibrium Outcome (NEO) is the payoffs
associated with the Nash Equilibrium [NEO = (4, 4)]
• The NE is a dominant strategy equilibrium, as both
players are playing their dominant strategy

How to solve:

• To predict the outcome of a game, we need another concept: best response.

• This is the strategy that will give a player the highest payoff, given the strategies the
other players select i.e. if Betty plays Mazie, then holding this strategy constant,
which strategy will Amandla play? She will play Sugar Cane as a payoff of 4 is
greater than a playoff of 1.
• We can represent players payoffs using a standard format called a payoff matrix. The
first number in each box is the reward received by the row player. The second number
is the column player’s payoff.

Assumptions Game Theorists Make:

• The payoffs are known and fixed

• All players behave rationally
• The rules of the game are common knowledge.
4.3 Prisoner’s Dilemma:

• Prisoners’ Dilemma = is one which exhibits: both players have a dominant strategy
& would do better in the outcome where they play their non-dominant strategy (also
called the dominated strategy) than they do in the Nash Equilibrium.
• Thus, under the Prisoner’s Dilemma, we end up with a social dilemma that results in
an undesirable outcome.

4.13 Is there always one NE?

• In reality this does not happen.
• The following Games proves this - assurance game and battle of the sexes:

Which Equilibrium?
• Well, actually it isn’t so easy to predict. At the end of the day, there is no way of
knowing which of the equilibria we will see. There is no guarantee that we end up in
the “better” Nash Equilibrium.
• This depends on a number of things: chance, history, social norms, and many more
4.4 Social preferences:
Altruism

A person who is willing to bear a cost in order to help another person is said to have altruistic
preferences. This is an example of social preferences (Preferences that place a value on what
happens to other people, even if it results in lower payoffs for the individual).

Altruistic preferences as indifference curves

• The horizontal axis represents the amount of money that Anil keeps for himself, and
the vertical one the amount that he gives to Bala.
• The choice among points on the feasible frontier is called a zero-sum game (A game
in which the payoff gains and losses of the individuals sum to zero, for all
combinations of strategies they might pursue).
• So, if we represent Anil’s losses as negatives and Bala’s gains as positives then at
every point on the feasible frontier the sum of their gains and losses will be zero.
• Anil’s preferences can be represented by indifference curves, showing combinations
of the amounts for Anil and Bala that are equally preferred by Anil. Let us look at the
two cases below:

1.Indifference curves when Anil is self-interested

If Anil does not care at all about what Bala gets, his indifference curves are straight lines. He
is indifferent to whether Bala gets a lot or nothing. He prefers curves further to the right,
since he gets more money.
Anil’s best option is A, where he keeps all the money.
2. Anil’s indifference curves when he is somewhat altruistic

When Anil derives utility from Bala’s consumption – i.e. he is happier if Bala is richer, he
has downward-sloping indifference curves so he may prefer an outcome where Bala gets
some of the money.
His best feasible option is point B.

4.5 Altruistic preferences in the prisoners’ dilemma

In this example, Bala and Anil found themselves in a prisoners’ dilemma where their choice
of pest control insecticide implied a free ride (Benefiting from the contributions of others to
some cooperative project without contributing oneself) on the other farmer’s contribution to
ensuring clean water.
If Anil cares about Bala’s wellbeing as well as his own, the outcome can be different.
Note that in this case, the two axes in the figure represent Anil and Bala’s payoffs. The four
points are the feasible outcomes associated to the strategies. Let us consider again the two
cases below:

1.Anil’s indifference curves if he doesn’t care about Bala

(T, I) is Anil’s preferred outcome. He prefers (T, I) to (I, I), so he chooses T if Bala chooses
I. If Anil is completely selfish, T is unambiguously his best choice. Anil benefits at the
expense of Bala.
His dominant strategy is Terminator.

2. Anil’s indifference curves when he cares about Bala

(I, I) is Anil’s most preferred outcome. If Bala chooses I, Anil should choose I. Anil should
also choose I if Bala chooses T, since he prefers (I, T) to (T, T) (higher indifference curve).
His dominant strategy is IPC.
If Bala feels the same way, then the two would both choose IPC, resulting in that outcome
that both of them prefer the most.

>> If people care about one another, social dilemmas are easier to resolve.
Unit 4.6: Public Goods, Free Riding and Repeated Interaction
Public good: A resource that’s available to everyone and does not get depleted after each
person’s use. Even if only some people pay for the resource, everybody gets to use it.
Public goods game (PG game): Like a prisoner’s dilemma game, but with more than two
players. If everyone co-operates, they will be better off than if everyone does not co-
operate. However, if one person free-rides (doesn’t contribute) off of the other players’
contributions, that person will always have the best outcome. This (free riding) is the
dominant strategy
Altruism: Social preference which puts the other players’ well-being above personal gains.
Altruistic approach could help solve the PG game dilemma, BUT, this approach is less likely
to work the larger the community of players is.
Repeated Games
You will likely have to interact with the other players in a PG game again in the future. Real
life is not a one-shot game! ‘Player A’ might be more mindful now about how his decision
impacts the other players if he knows that the tables could turn in future and the other
players may then choose their dominant strategies, resulting in everyone being worse off.

Unit 4.8: Behavioural Experiments in The Lab and in The Field

Although Altruistic preferences by players or the repeated games concept are ideal,
experimental economics reveals how people actually behave in real life.
Experimental Economics: Uses controlled laboratory/ field experiments to determine real-
life behaviour.
Laboratory experiment: Where subjects come in (often to a computer lab) and record their
real reactions to scenarios presented. Easier to control as you design the software exactly to
your specifications
Field experiment: Where economists observe people’s reactions to certain scenarios out in
the real world. Very limited control over the real world. You can only change a certain
aspect of an environment and observe how behaviours change. E.g. Introducing a new late
submission penalty for tutorials and seeing how students react
Note: Experiments are thought to be more effective than surveys in determining one’s
behaviour as one cannot control the decision-making environment in which preferences are
revealed in a survey and people may not always reveal 100% truth in their answers to
surveys. Especially with more complex, challenging questions.
Experiments use monetary incentives to get people’s truest reactions

Experiments are designed to be as realistic as possible while maintaining a

controlled environment
 Experiments measure what you actually do rather than what you say you would do

Unit 4.7: Public Good Contributions and Peer Punishment

PG games are typically run in lab experiments. The focus of such experiments is to see how
much a participant is willing to contribute into a public pot which shares the total
contribution equally whether or not one had initially contributed. i.e. will participants still
contribute where they have a potential of getting back less than they’ve actually put in?
Bearing in mind that if everyone were to contribute, each participant would be better off
because the total amount is multiplied.
Essentially, if everyone contributes, everyone will be better off. But if only Person A free-
rides, Person A will be better off than everyone else. So, Person A is always incentivised to
free-ride
Results of the experiment

• Initially participants contribute a lot

• Gradually over time, there is a downward trend in contributions and less money is
contributed each round.
(People stop contributing when they see others stop contributing. Altruism isn’t
sufficient)
• Punishments were then introduced (at a small cost to the ‘punisher’) where they
could fine those who were not contributing. Participants took up the offer (even
though they had to pay for it, so it isn’t the most economically rational option) and
punished non-contributors. This resulted in increased contributions in the following
round.
• This shows how much people value reciprocity. People are willing to spend their own
money (by paying to punish someone) in order to stop other people from violating
the group as a whole.
4.9 Cooperation, negotiation, conflicts of interest, and social norms

Cooperation means participating in a common project in such a way that mutual benefits
occur. Examples in which players acting independently can achieve a cooperative outcome
include; the invisible hand, the repeated prisoner’s dilemma, the public goods game.

People commonly resort to negotiation to solve their economic and social problems. But
negotiation does not always succeed, sometimes because of conflicts of interest over how the
mutual gains to cooperation will be shared.

Negotiation: Sharing mutual gains

Everyone’s preferences are individual. They may be influenced by social norms, but they
reflect what people want to do as well as what they think they ought to do. These preferences
are such as; altruism, fairness and reciprocity.

4.10-4.11: The ultimatum game

• Two-person one-shot game. The subjects’ preferences and motives are investigated by
observing the choices they make.
• The subjects of the experiment are invited to play a game in which they will win some
money. How much they win will depend on how they and the others in the game play.
• One player is randomly assigned as the Proposer and the other as the Responder.
Subjects remain anonymous.
• The proposer is given some amount of money, say R30 and they can make any split
including keeping it all, or giving it all away. The responder is aware of the amount to
be split.
• After observing the offer, the Responder accepts or rejects it. If the offer is rejected,
both individuals get nothing. If it is accepted, the split is implemented.
• This is a game about sharing the economic rents that arise in an interaction.
• The ultimatum game is a sequential move game, in which players do not choose their
strategies at the same time, and players that choose later can see the strategies already
chosen by other players.
Solving sequential move games

Consider the game tree below;

• The Proposer has to think about how the Responder will behave before they decide
what offer to make. This introduces the concept of backward induction.
• Given (x, y) in the game tree, x represents the proposer’s payoff and y the
responder’s.
• Starting with when the proposer offers R1: by accepting the offer, the responder gets
R1 and by rejecting they’ll get R0. So, since R1 is better than R0, they will accept the
offer. So, we can prune off the “reject” node.
• Doing the same for the 50:50 split, we see that the responder will also accept the offer
and we can prune off the reject node as well.
• The proposer then compares R29 to R15 and picks R29/ offer R1 and prune off the
50:50 split.
• We can then see that the equilibrium of this game is for the Responder to accept either
the R1 offer, or the R15 offer, and the Proposer should offer R1.

• In the ultimatum game, it is clear that the Proposer has to think about how the
Responder will behave before they decide what offer to make e.g. if the Proposer
thinks the Responder will reject R1, then it definitely isn’t in the Proposer’s best
interest to make an offer of R1.
• In general, with more choices open to the Proposer, the equilibrium prediction tells us
that the Proposer will offer the smallest possible amount to the Responder, and
actually the Responder will accept this offer (as well as any other offer made to
them).
• Social norms – i.e. what we consider to be normal behaviour in society = proposer
will adapt their behaviour to maximise their payoff, but still keeping in mind that they
must act within societal norms.
• This means they want to make an offer that maximises the payoff they expect to get –
i.e. their expected payoff.
Example of calculating expected payoffs for the Proposer in an ultimatum game:

• Maximised expected payoffs = calculated risks (advantageous to take risks)

• In reality = absolutely no way to know whether people were doing this calculation

• Multiple Responders:
• We change the rules of the game slightly: now, the Proposer makes an offer, and both
Responders must choose what to do. If one of them chooses to accept, then the split is
actioned. If both accept, one is chosen randomly to get the split.
• When a second Responder is introduced, people reject lower offers less frequently =
you are now in competition with another person, and so rejecting a low offer
(perhaps to punish the Proposer) no longer guarantees punishment.