Game Theory

and
Externalities
 Game Theory
Game Theory is a framework for
hypothetical social situations among
competing players. In some respects,
game theory is the Science of Strategy, or
at least the optional decision making of
independent and competing actors in a
strategic setting. The key pioneers of the
game theory were mathematicians Jon
Von Neumann and John Nash, as well as
economist Oscar Norgenstern.
 Game Theory
The focus of the game theory is the
game, which serves as a model of an
interactive situation among rational
players. The key to game theory is the
one player’s payoff is contingent on the
strategy implemented by the other
player.
 Game Theory has wide range of
applications including psychology,
biology, war, politics, economics and
business.
 Theory
*Nash Equilibrium
 Nash equilibrium is one the fundamental concepts
in game theory. It conceptualizes the behavior and 
interactions between game participants to
determine the best outcomes. It also allows
predicting the decisions of the players if they are
making decisions at the same time and the decision
of one player takes into account the decisions of
other players.
 Nash equilibrium was discovered by American
mathematician John Nash. He was awarded Nobel
Prize in Economics in 1994 for his contributions to
the development of game theory.
Example of Nash Equilibrium
Imagine two competing companies: Company A and Company B. Both
companies want to determine whether they should launch a new 
advertising campaign for their products.

Company A should advertise its products because the strategy

provides a better payoff than the option of not advertising. The
same situation exists for Company B. Thus, the scenario when
both companies advertise their products is a Nash equilibrium.
 
 * Prisoner's Dilemma
> The prisoner's dilemma is a common situation analyzed in game theory
that can employ the Nash Equilibrium. In this game, two criminals are arrested
and each is held in solitary confinement with no means of communicating with
the other.
The prosecutors do not have the
evidence to convict the pair, so they
offer each prisoner the opportunity
to either betray the other by
testifying that the other committed
the crime or cooperate by
remaining silent.

The Nash Equilibrium in this

example is for both players to betray
each other. Even though mutual
cooperation leads to a better
outcome, if one prisoner chooses
mutual cooperation and the other
does not, one prisoner's outcome is
worse.
 Other Types of Game Theory
 Although there are many types (e.g. symmetric/asymmetric,
simultaneous/sequential, et al.) of game theories, cooperative and
non-cooperative game theories are the most common

Cooperative game theory

deals with how coalitions or
cooperative groups interact
when only the payoffs are
known. It is a game between
coalitions of players rather
that between individuals and
it questions how groups form
and how they allocate the
payoff among players. A
game is cooperative if the
players are able to form
binding commitments.
 Non-cooperative game theory deals with how rational economic
agents deal with each other to achieve their own goals. The most
common non-cooperative game is the strategy game, in which
only the available strategies and the outcomes that result from a
combination of choices are listed. A simplest example of a real-
world non-cooperative game is rock-paper-scissors.
 Externalities
Externalities are a form of market
failure. Externalities are defined as the
spillover effects of the consumption or
production of a good that is not reflected
in the price of the good. For example:
production of steel results in pollution
being released into the air, but the cost
of the pollution to the environment is not
reflected in the price of steel.
 Externalities
Private Cost- is the price of an activity to an
individual consumer or firm.
Social Cost- is the total cost of an activity
not just to the firm but the rest of the society
as well.
Private Benefit- is the benefit received by
an individual or a firm by consuming and
producing good respectively.
Social Benefit- is the total benefit to society
from an economic activity.
 
Types of Externalities
1. Negative Externalities of Consumption
When the consumption of a good result in social costs
being greater than private costs. They are over produced and
over consumed. For example, a smoker causing second-hand
smoke to people around him doesn’t pay for the cost to others
(social cost).

The optimal consumption should be Q* at P*, but it’s at Q

at P. policy to discourage the negative externality at
consumption- indirect taxes, negative advertising, bans.
 
Types of Externalities
2. Positive Externalities of Consumption
When the consumption of a good results in social
benefits being greater than private benefits. They are under
produced and under consumed. For example, a farmer
landscaping his land makes the countryside better to look
at and makes it more pleasant for everyone.

The optimal consumption should be Q* at P*, but it’s at

Q at P. policies to encourage positive externalities of
consumption- Government provision, positive advertising,
regulation encouraging consumption.
 
Types of Externalities
3. Positive Externalities of Production
When the production of a good results in private
benefits being greater than social benefits. They are under
produced and under consumed. For example, a vaccination
drive in your neighborhood would reduce the chance of you
getting infected.

The optimal production should be at Q* at P*, instead

it’s Q at P. Policies to encourage a positive externality of
production- subsidies, government provision, regulation
forming producers to produce.
 Solutions for Positive and Negative
Externalities
1. Government Solutions
Subsidies- are a form of support given to producers
that help reduce the cost of production which results in an
increase in production and consumption. Goods that
governments want to increase the consumption of are
subsidized. Subsidies should be provided for goods with
positive externalities.
Indirect Taxes- is a tax applied to the manufacture or
sale of goods and services. Indirect tax discourages
consumption of goods and services and is represented
by a decrease in supply. The government should impose
indirect taxes on products with negative externalities.
 Solutions for Positive and Negative Externalities
2. Private Solutions
Moral Codes- it guide individual’s behavior.
For example, littering. The like hood of being
fined by small, but moral codes provides an
incentive to refrain from littering.
Charities- channels donation from private
individuals towards fighting to limit behaviors or
promoting behaviors. For example, Donations
to help protect the Environment.