WIRTSCHAFTSUNIVERSITÄT WIEN

DEPARTMENT OF STRATEGY AND INNOVATION

INSTITUTE FOR MARKETS AND STRATEGY

SBWL Strategy and Data

Strategic Thinking and Analysis I

Lecture I-4

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 Organization
 A game is defined by: Players, Strategies, Payoffs, Info
 Game payoffs are utility payoffs. They depend on the
preferences of players, and are not necessarily equal to
$$$ payoffs.
  We have to know the preferences of players!
Otherwise we are solving the wrong game.
• Experiments:
– Experiment 8: Dictator game
– Experiment 9: Ultimatum game
– Experiment 10: Repeated Ultimatum game
– Experiment 11: Market game

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 Recap

 Which ways are there to write down a game?

 What is a Nash equilibrium?

 What is a subgame perfect equilibrium?

 How can we find Nash equilibria?

 How can we find subgame perfect equilibria?

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 Experiment 8
 Dictator game
a) Is this a “game” in the sense of game theory? Discuss
shortly.
b) What is the optimal strategy of person A?

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 Experiment 8
 Extensive Form 100

A Offer x (100-x, x)

0.1

 Player A maximizes his $$$ payoff by choosing the lowest

possible x

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 Experiment 8
 Dictator game
• It is a game: there are players, there are strategies (at
least for one player), there are outcomes.
• However, the game is not interactive. It is not really a
strategic situation. It is an individual decision situation.
So maybe it is not a game at all. ;-)
 Solution
• As the game is not interactive, the equilibrium just
involves person A (the “dictator”) maximizing his
outcome. If E$ payoffs represent utility, he should only
give the minimal amount to person B, E$ 0.10, and
keep the rest for himself.
  Nash equilibrium: A chooses E$ 0.10
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 Experiment 8
 Data
c) Analyze the data set of experiment 8. Describe what
you observe. Provide an explanation if you find
differences between behavior and optimal strategy.

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 Experiment 8

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 Experiment 9
 Ultimatum game
a) What kind of game is this: sequential or
simultaneous?
b) Assume that person A can only make offers of either
0.10, 25, 50, or 75. Write down the possible strategies
of A and B. (Don’t forget that B’s strategies are
conditional on what A did.) Solve for all Nash
equilibria of the game.
c) Which of the Nash equilibria you found are subgame
perfect? Use the rollback technique (backward
induction) to find them. Name all subgame perfect
NEs.

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 Experiment 9
 Normal form: 15 Nash equilibria
Proposer
0.10 25 50 75
0.10r, 25r, 50r, 75r 0 , 0* 0 , 0* 0 , 0* 0 , 0*
0.10r, 25r, 50r, 75a 0,0 0,0 0,0 75* , 25*
0.10r, 25r, 50a, 75r 0,0 0,0 50* , 50* 0,0
0.10r, 25r, 50a, 75a 0,0 0,0 50* , 50* 75* , 25
0.10r, 25a, 50r, 75r 0,0 25* , 75* 0,0 0,0
0.10r, 25a, 50r, 75a 0,0 25* , 75* 0,0 75* , 25
0.10r, 25a, 50a, 75r 0,0 25* , 75* 50* , 50 0,0
Responder

0.10r, 25a, 50a, 75a 0,0 25* , 75* 50* , 50 75* , 25

0.10a, 25r, 50r, 75r 0.1*, 99.9* 0,0 0,0 0,0
0.10a, 25r, 50r, 75a 0.1*, 99.9* 0,0 0,0 75* , 25
0.10a, 25r, 50a, 75r 0.1*, 99.9* 0,0 50* , 50 0,0
0.10a, 25r, 50a, 75a 0.1*, 99.9* 0,0 50* , 50 75* , 25
0.10a, 25a, 50r, 75r 0.1*, 99.9* 25* , 75 0,0 0,0
0.10a, 25a, 50r, 75a 0.1*, 99.9* 25* , 75 0,0 75* , 25
0.10a, 25a, 50a, 75r 0.1*, 99.9* 25* , 75 50* , 50 0,0
0.10a, 25a, 50a, 75a 0.1*, 99.9* 25* , 75 50* , 50 75* , 25
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 Experiment 9
 Extensive Form 100
(100-x, x)
accept

A Offer x B

reject
(0, 0)
0.1
Solve backwards

 Player B: For any possible x, B should choose accept

 Player A: Given B’s best reply function (accept any x), A
should offer the minimal amount
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 Experiment 9
 Ultimatum game
 A Take-it-or-leave-it offer

 Only one subgame perfect Nash equilibrium (assuming

both players are only interested in E$):
• Proposer gives minimal amount, E$ 0.10
• Responder accepts any proposal (larger than zero).

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 Experiment 9
 Only one subgame perfect Nash equilibrium

 As we have seen, there are more (not subgame perfect)

Nash Equilibria
 Each outcome can be reached in a Nash equilibrium

 Example for (not subgame perfect) NE:

• Proposer offers 75
• Responder accepts any offer above or equal to 75, and
rejects everything below

•  The proposer’s strategy is a best response to the

responder’s strategy, and the responder’s strategy is a
best response to the proposer’s strategy.
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 Experiment 9
 Data
d) Analyze the data set of experiment 9. Describe how
participants in the experiment behave. Compare the
behavior to the prediction of the subgame perfect
Nash equilibrium, and explain differences if you find
some.
e) Compare the behavior of person A in experiment 9 to
the behavior of person A in experiment 8, both in
theory and in the data. What explains the
differences? Do you think that E$ payoffs are the right
way to describe “outcome utilities” in this game?

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 Experiment 9

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 Experiment 9

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 Experiment 9

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 Experiment 10
 Repeated Ultimatum game
a) Find the subgame perfect NE of the 10-times repeated
game using rollback.

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 Experiment 10
 The subgame perfect Nash equilibrium (SPNE) of the repeated
game (repeated with the same players) corresponds to playing
the one-shot SPNE in each repetition.
 Why? Backward induction!
• In the very last repetition, i.e. last proposal, last response,
what is the SPNE of the game?
• The unique one-shot SPNE! That means, behavior in the very
last round is completely independent of any behavior before.
• Thus, in the second-to-last round, as behavior has no impact
on how players will behave in the last round, the game is
again played like the one-shot game.
• The same is true for the third-to-last round, etc. etc., until
we arrive at the first round.

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 Experiment 10
 Subgame perfect Nash equilibrium (SPNE) of the repeated
game:
• Proposer: Offer minimum amount in each round.
• Responder: Accept any amount (larger than zero) in each
round.

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 Finitely repeated games
 Theorem:
• If a game G has a unique subgame perfect Nash
equilibrium, then there exists a unique subgame
perfect Nash equilibrium in the finitely repeated game
G(T) in which the subgame perfect Nash equilibrium of
the game G is played in each repetition.

• Proof: We find the SPNE of the T times repeated game

by rollback. The SPNE solution for the last repetition T
will be the SPNE of the one-shot game. So play in the
second-to-last repetition T-1 cannot change what
comes after in T. As a result, the SPNE solution for the
second-to-last repetition T-1 will also be the SPNE of
the one-shot game. Etc. etc. until the first repetition.
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 Finitely repeated games: Example
 Extensive Form of UG 10
(10-x1+10-x2 , x1+x2)
repeated twice accept

A Offer x2 B
10 accept
reject
(10-x1+ 0 , x1+0)
0.01
A Offer x1 B 10
accept ( 0 + 10-x2 , 0+x2)
reject
0.01 A Offer x2 B
reject ( 0 + 0 , 0+0)
0.01

Solve backwards

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 Finitely repeated games: Example
 Extensive Form of UG 10 Subgame 1
(10-x1+10-x2 , x1+x2)
repeated twice accept

Subgame 3 A Offer x2 B
10 accept
reject
(10-x1+ 0 , x1+0)
0.01
A Offer x1 B 10 Subgame 2
accept ( 0 + 10-x2 , 0+x2)
reject
0.01 A Offer x2 B
reject ( 0 + 0 , 0+0)
0.01
 SPNE solution in SG 1 and SG 2 will be exactly the same (here: x2=0.01, accept all).
  Solution in SG 1 and SG 2 does not depend on what happened before in SG 3.

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 Finitely repeated games: Example
 Extensive Form of UG
repeated twice

10
Subgame 3 (10-x1+SG1_payoff , x1+ SG1_payoff)
accept

with SG1 payoffs equal to SG2 payoffs!

A Offer x1 B

reject
0.01 ( 0 +SG2_payoff , 0 + SG2_payoff)

 SPNE solution in SG 1 and SG 2 will be exactly the same (here: x2=0.01, accept all).
  Solution in SG 1 and SG 2 does not depend on what happened before in SG 3.
  Solution in SG 3 will be exactly like solution of one-shot game with no SG 1/ SG
2 afterwards.
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 Finitely repeated games
 Theorem:
• If a game G has a unique subgame perfect Nash
equilibrium, then there exists a unique subgame
perfect Nash equilibrium in the finitely repeated game
G(T) in which the subgame perfect Nash equilibrium of
the game G is played in each repetition.

• Proof: We find the SPNE of the T times repeated game

by rollback. The SPNE solution for the last repetition T
will be the SPNE of the one-shot game. So play in the
second-to-last repetition T-1 cannot change what
comes after in T. As a result, the SPNE solution for the
second-to-last repetition T-1 will also be the SPNE of
the one-shot game. Etc. etc. until the first repetition.
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 Finitely repeated games
 Note:
• If a game has only one NE, then this must be the
unique SPNE of the game.
• So when repeating the game, playing this NE in each
repetition is the only SPNE of the repeated game.

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 Experiment 10
 Data
b) Analyze the data set of experiment 10. Describe the
behavioral pattern you observe. Is there a change in
behavior over time, in the different rounds?

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 Experiment 10

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 Experiment 10

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 Experiment 10

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 Experiment 10

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 Experiment 10

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 Experiment 11
 2-Proposer Ultimatum Game
a) What kind of game is this: sequential or simultaneous?

b) Find all subgame perfect NEs of the single round game. Hints:
• Assume that person C is indifferent if both offers are exactly the
same, and will choose randomly between both offers in this case.
• Use rollback. That is, first solve for person C’s optimal strategy
given what A and B have done.
• Then, inspect the resulting 2-player game between players A and B,
assuming an optimal reaction by player C. Solve using a normal
form version of the game (use 0.01, 1, 2, 3, 4, 5, 6, 7, 8 as possible
choices for A and B).

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 Experiment 11
8 8
accept a (10-a,0,a)

Offer a Offer b acc. b (0,10-b,b)

A B C

reject both
0.1 0.1 (0, 0, 0)
Solve backwards
 For any a or b, player C should never reject both (strictly dominated
strategy).
 Player C should accept a if a>b, and accept b if b>a, and is indifferent
otherwise.
  simultaneous subgame between players A and B, given player C’s
best reply function
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 Experiment 11
 This is a mixed sequential/simultaneous game.
• Players A and B decide simultaneously.
• Player C decides thereafter.

 Rollback: start with player C.

• If interested in money, Player C should accept the
proposal which offers her more money.
• She is indifferent when both offers are the same.

  Players A and B face a simultaneous game.

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 Experiment 11

B's
B's offer
payoff
A's
payoff 0.01 1 2 3 4 5 6 7 8
4.995 9* 8 7 6 5 4 3 2
0.01
4.995 0 0 0 0 0 0 0 0
0 4.5 8* 7 6 5 4 3 2
1
9* 4.5 0 0 0 0 0 0 0
0 0 4 7* 6 5 4 3 2
2
8 8* 4 0 0 0 0 0 0
0 0 0 3.5 6* 5 4 3 2
3
7 7 7* 3.5 0 0 0 0 0
0 0 0 0 3 5* 4 3 2
A's offer 4
6 6 6 6* 3 0 0 0 0
0 0 0 0 0 2.5 4* 3 2
5
5 5 5 5 5* 2.5 0 0 0
0 0 0 0 0 0 2 3* 2
6
4 4 4 4 4 4* 2 0 0
0 0 0 0 0 0 0 1.5 2*
7
3 3 3 3 3 3 3* 1.5 0
0 0 0 0 0 0 0 0 1*
8
2 2 2 2 2 2 2 2* 1*

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 Experiment 11
 The subgame perfect Nash equilibrium of the game is:
• Player A: Offer a price of 8.
• Player B: Offer a price of 8.
• Player C: Accept A’s offer if a>b, accept B’s offer if b>a,
and choose randomly otherwise.

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 Experiment 11
 Data
c) Analyze the data set of experiment 11 and compare
behavior in the experiment to your equilibrium
analysis above. Is there a change in behavior over
time?
d) Compare theoretical predictions and behavior
between experiment 11 and experiments 9/10. What
do you think drives the differences?

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 Experiment 11

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 Experiment 11

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 Experiment 11

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 Experiment 11
 Thus, the competition between proposers turns the
game around. Though they have Ultimatum power, they
will compete their offers up.
 Note: even if players are “fair minded” we will have this
result. The distribution is unfair anyway (at least one gets
nothing), so it’s better if it’s to my advantage than to my
disadvantage.
 In the Ultimatum game, both proposer and responder
are “monopolists”. Without any of them, there are no
gains to realize.
 In this game, proposers are exchangeable. The responder
alone is a monopolist.
  In a negotiation between rational players, you can
only get in value what makes you distinct from your
next replacement.
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 Experiment 11
 Compare to:
• Markets: profit of seller = lowest costs among sellers
who are not able to trade, minus own costs
• Markets: profit of buyer = own value minus highest
value among buyers who do not trade
• Auctions: profit of auction winner = own value of good
minus price (price = highest value among bidders who
are not successful – that’s where they stop bidding)
• Coalitions: share of pie = Shapley value = value the
coalition member brings in compared to an alternative
coalition which excludes that member
 You are “priced” at your opportunity costs – the value of
the next best alternative foregone as the result of making
the decision to deal with you
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 Experiment 11

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 Game theory
 Until now:
• “Traditional” as-if assumption: selfish and rational
• In markets, theory which assumes that players are
selfish and rational does a pretty good job. Real market
behavior appears as if traders are selfish and rational.
 Today:
• Games in which those assumptions seem not be valid.
•  Games are defined by utility payoffs, and utility
might not be equal to income.
• Behavioral Game Theory: Non-egoistic preference
(Altruism and spite, Fairness, Reciprocity)

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 Selfishness
 Usual assumption in economics:
• Everything can be expressed in monetary terms:
everything can be bought, everything has a value
• People are selfish with respect to money, and never
satisfied: the more, the better
 That means:
• In a game, every outcome can be expressed as a
monetary term y which represents the equivalent
monetary payoff of a player
• Utility u(y) of the player is only a function of income y
• The higher y, the higher u(y): u’(y)>0

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 Selfishness

"Greed is good. Greed

is right. Greed works.
Greed cuts through,
clarifies, and captures
the essence of the
evolutionary spirit."

Gordon Gekko

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 Selfishness
 Greed works, greed clarifies.
• See our experiments on competitive markets,
analyzed in lecture 2.
 But greed leads the monopolist to use his power, leads to
unfair distributions if power is unequally distributed.
• See our experiments on monopolies etc.,
analyzed in lecture 3.
 Greed has limits, or is responded to.
• See the Dictator giving and Ultimatum rejections,
analyzed today.
 Greed can lead to less efficient outcomes.

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 Other-regarding preferences
 “Standard” models in economic theory assume (often as a
simplification) that players are selfish $$$ income
maximizers: the homo œconomicus.

 But if that’s the case:

• Nobody should give anything in the Dictator game.
• Nobody should reject in the Ultimatum Game.
• Nobody should give anything in the Ultimatum Game.

 People have many more preferences than just maximizing

money. Simply assuming selfish money-maximizers might
be simplifying too much.
 Especially in bargaining and negotiations, it is incredibly
important to know what the preferences of others are …
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 Dictator and Ultimatum Game

80
71

60

40
29
21 21
20 17 17
13
4 4 4
0 0 0 0
0
0 1 2 3 4 5 6

dictator ultimatum

(Forsythe, Horowitz, Sefton & Savin, 1994)

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 Rejections in Ultimatum
 High and low stakes

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 Behavioral game theory
 Behavioral game theory
• What are the motives of
people? Can we build
models that better
explain our observations?
• What does that mean for
our strategic analysis?
 Social preferences: my
utility does not only depend
on my, but also on other’s
wellbeing: ui=f(yi, y-i)
 Preferences vs. Cognition

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 Other-regarding preferences

1759
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 Altruism and spite

y
+

− +
− x

 x = how important is my wellbeing to me?

 y = how important is the other person’s wellbeing to me?
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 Social preferences
 Expected utility theory
• Utility function over money: only own income ui=f(yi)
• When applied to games: implies selfishness.

 Social preferences
• Utility function not just over own income, but over something
more, a social component: ui=f(yi, X )

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 Modeling inequality aversion
 My utility depends on
• my own income
• my relative standing (i.e. my income compared to what the
others earn on average)
 ui=f(yi, øy-i) with øy-i = (ji yj)/(n-1)
 Social component:
• I don’t like to be worse off than others and I don’t like to be
better off than others  inequality aversion
• δui/δyi> 0  I like more money more, but
• δui/δøy-i < 0 if yi < øy-i  if I am (already) worse off than others,
I dont’t like them to have more, and
• δui/δøy-i > 0 if yi > øy-i  if I am better of than others,
I would like them to have more.

 Dislike of inequality might be asymmetric: inequality to my

disadvantage hurts more than inequality to my advantage
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 Modeling inequality aversion
 Dictator Game  Ultimatum Game
(80,20) B (80,20)
A A ( 0, 0) UB ?
UA ? B UA ?
(50,50)
(50,50) ( 0, 0)
UB ?
 For A, up yields a  For B, accepting yields higher
higher payoff payoff than rejecting
 But up also yields  But the involved inequality might
higher inequality be so “painful” that the overall
 So if the inequality in utility is lower than getting zero
up is to high, and and having equality
therefore too painful, A  A anticipates that some B might
might choose down reject plus his own discomfort
with 80/20 (as in Dictator )
 Thus, more people choose down
in Ultimatum than in Dictator
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 Modeling intentions and reciprocity
 My utility depends on
• my own income
• how nice I think the other was to me, and how nice I
think I was to the other guy
 ui(yi, Nj->i, Ni->j) = f(yi) + Nj->i · Ni->j ·R with
– Ni->j = 1 if i thinks he was kind to j, and -1 otherwise
– Nj->i = 1 if i thinks j was kind to him, and -1 otherwise
– R = the strength of reciprocal feelings
 Nj->i · Ni->j = 1 if both i and j are kind, or if both are unkind,
 Nj->i · Ni->j = -1 if i and j behave differently
  player i likes to reciprocate in-kind

 Beliefs: what does i think about j’s intentions?

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 Modeling intentions and reciprocity
 Dictator Game  Ultimatum Game
(80,20) B (80,20) N
BA ?
A
NAB ? A B
( 0, 0) NAB ?
(50,50) N ?
(50,50) BA
( 0, 0)
 If A chooses up this is  For both actions of A, if B
unkind to B, if A accepts, this is kind to A, if B
chooses down, this is rejects, this is unkind to A
kind to B  If A chooses up this is unkind to
 But B has no choice, so B, if A chooses down, this is kind
no intention (Nj->i = 0), to B
so reciprocity cannot  Thus, if reciprocity is strong
play a role, and only enough, there might be two new
payoffs count Nash equilibria:
  Reciprocity cannot up/reject (unkind/unkind), and
explain giving down/accept (kind/kind)
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 Reciprocity
 Gift exchange in the labor market
• Principal-Agent relationship: Employer pays wage, but
cannot observe worker’s effort
average effort
level
0,6
0,52
0,5 0,45
dominant
0,4
worker 0,34
strategy
0,3

0,2 0,17 0,18

0,1

0
30-44 45-59 60-74 75-89 90-110
wage

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 Summary: Social preferences
 In all these models of social preferences:
• Utility maximization
• Tradeoff between own wellbeing and other (social)
motivations
 Thus
• We have to look how outcomes are expressed in games.
• Social preferences might distort these outcomes if they
are just given in monetary terms.
• This might change the game completely.
 If
• game payoffs are properly expressed in utility
• people are still rational (able to maximize utility)
 then we can still use standard game theory tools to analyze
interactions.
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 Summary: Social preferences
 Important note:
• Incentives play still a role!!!
• More money is still better than less money – everything
else equal! – “ceteris paribus”
• If incentives change into one direction, behavior
changes in the same direction.
  Traditional game-theoretical analysis, even when
assuming egoism, still sheds light on the incentive
environment in which participants make decisions.
  One can assume that firms behave much less other-
regarding to each other than individuals, so when
analyzing strategic business situations, profits are still a
good approximation of utility outcomes.

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 Economist effect
 Marwell & Ames 1981
• “Economists free ride, does anyone else?”
 Frank, Gilovich & Regan 1993/1996, Rubinstein 2006,
Brosig, Heinrich, Riechmann, Schöb & Weimann 2007
• Economists behave significantly more “rational”/selfish
in the sense of game theory than non-economists.
 Education or self-selection? Do you behave differently after
you sat in an economics course on strategic behavior?
 Carter & Irons 2001: experiment on cooperation
• Freshmen, senior economists, and non-economists
• Result: Freshmen = senior economics < non-economists
• “Economists are born, not made.”
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 Take-aways
 A game is defined by: Players, Strategies, Payoffs, Info
  We have to know the preferences of players! Otherwise
we may solve the wrong game.
 Utilities over game outcomes might depend on other’s
payoffs or intentions.

 + Repeated games theorem: If a game has a unique SPNE,

then SPNE in the finitely repeated game is to play the
single-round SPNE in each repetition.

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 Experiments

 Now experiments ...

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