OUTLINE

A. Introduction.
B. Game Theory: Key concepts.
1. What is a game? Concepts and solutions.
2. Social dilemmas and altruism.
3. Negotiations and fairness.
C. Judging game solutions: efficiency and fairness.
 A. Introduction

• Previous models of choice in Unit 3 did not depend

on others’ decisions.
• Individuals motivated by self-interest can produce
outcomes that are beneficial for society e.g.
entrepreneurship, innovation (in Unit 1).

• However, self-interest can also be harmful to

society.
• Why do these problems arise?
• What can we do about it?
A. Introduction
• Garret Hardin’s “tragedy of the commons”, i.e. overexploitation
of communal resources –grazing, fish, air, and, now climate.
• Social dilemma – what is best for an individual may be worst for
society. Because people can free-ride on others’ efforts.
• Actually, humans have been managing commons for a long
time.
– Self-sacrifice
Belling the cat.
– Rules and
institutions
(tribunal de las
Aguas)
Elinor Ostrom
B.1. Game theory: Key concepts
• Strategic interaction – a situation in which my optimal decision
depends of what others’ do, and vice versa.
• Game – is a formal model of a strategic interaction. It accounts
for: players, strategies, and payoffs.
• Player – a participant in the game.
• Strategy – a detailed plan of action (it may even plan for
reactions to others’ actions in dynamic settings) for strategic
interactions.
• Payoff – the final utility the player obtains in the game as a
consequence of all the players’ strategies.
• Equilibrium – the analysts’ prediction for a solution of the game.
We will talk more about this later.
 B.1. A first game: the prisoners’ dilemma
• The pest control game.
• Players: Anil and Bala.
• Strategies: Grow (and sell) Rice or Cassava.
• Payoffs:
• Strategies are cheap and dirty, or expensive
and clean.
• But filth can be “shared”, if only one does it.
• Solution?
• Why is it a dilema?
• Other examples?
 B.1. Dominant and dominated strategies
• Solution: In general, you will need to think of
• Best responses: your strategy that gives the highest payoff
given the strategy chosen by the other player.
• In some games, like the invisible hand game this is easy.
• A dominant strategy: a strategy that is Best Response
independently of other player’s strategy.
• A dominated strategy: a strategy that is NOT a Best
Response independently of other player’s strategy.
• If dominant strategy exists: dominant strategy equilibrium
• One NEVER plays a dominated strategy
 B.1. Dominant and dominated strategies
• This is more general than two strategies.
• Game in the left (blue) has one dominant strategy, and two
dominated strategies.
• Game in the right (green) has NO dominant strategy, and
one dominated strategy. We will go back to that one.
Anil, Bala Rice Cassava Potato Anil, Bala Rice Cassava Potato

Rice 2,2 4,1 4,0 Rice 2,2 4,3 4,0

Cassava 1,4 0,0 1,0 Cassava 3,4 1,1 3,0

Potato 0,4 0,1 0,0 Potato 0,4 0,3 0,0

B.1. Coordination and Nash equilibrium
• Nash equilibrium: each individual plays best-response
to the strategies he/she expects others to use. And
expectations are correct.
• Two equilibria in this game.
• And a dominated strategy.

Anil, Bala Rice Cassava Potato

Rice 2,2 4,3 4,0

Cassava 3,4 1,1 3,0

Potato 0,4 0,3 0,0

B.2. Social dilemmas and altruism. The lottery
Anil’s indifference
curves (when
completely selfish)
12
Feasible
payoffs
10
Bala’s payoff (thousands of rupees)

frontier

Feasible
payoffs set
C B
0
0 10 12
Anil’s payoff (thousands of rupees)
B.2. Social dilemmas and altruism. The lottery
Anil’s indifference
Anil’s indifference
curves (when
curves (when
somewhat
completely selfish)
12 altruistic)
Feasible
payoffs
Bala’s payoff (thousands of rupees)

10 frontier

C
5

B
3

Feasible
payoffs set
A
0
0 6 7 10 12
Anil’s payoff (thousands of rupees)
B.2. Social dilemmas and altruism. The PD
  Bala: Bala:
IPC Terminator
Anil’s indifference curves (when
Anil: IPC 3,3 1,4
completely selfish) Anil: 4,1 2,2
Terminator

5
I,I = Both use IPC

I,T I,T = Anil uses IPC, Bala uses Terminator

4 T,I = Anil uses Terminator, Bala uses IPC
Bala’s payoff

I,I T,T = Both use Terminator

3

2
T,T Anil’s indifference curves
(when somewhat
1 T,I altruistic)

0
0 1 2 3 4 5
Anil’s payoff
B.2. Social dilemmas. A real dilemma
• A group of 10 randomly matched students.
• Each student is given 10£ and then they play the following
game:
– Each student chooses, in secret, and without communicating with others
to put any integer number (between 0 and 10) of their £’s in a box.
– Each one keeps for him or herself whatever amount they did not put in
the box.
– The amount in the box is multiplied by 4 and then divided equally among
all group members and given to them.
• Notice for every pound you give, 0.4 comes back to
you, and 0.4 to each other participant.
B.2. Social dilemmas. A real dilemma
Figure 7. Worldwide public good experiments: contributions
over 10 periods
16
Copenhagen
Dnipropetrov
14 s’k
Minsk
12 St. Gallen
Muscat
10 Samara
Contribution

Zurich
8 Boston
Bonn
6 Chengdu
Seoul
4
Riyadh
Nottingham
Athens
2
Istanbul
Melbourne
0
1 2 3 4 5 6 7 8 9 10
Period
B.2. Social dilemmas. The rules of the game
• You may think that if public good experiment is true, climate
change will not be mitigated, and we are doomed.
• Maybe not, check what happens if costly punishments allowed.
And we will see that people like to punish!
Cooperation with, and without, punishment opportunities
Without punishment: periods 1-10 With punishment: periods 11-20
14

12

10
Average contributions

0
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
Period
B.3. Negotiations and fairness
• When there is a social dilemma, people may sit and talk
(remember Kyoto protocol). So we need to understand
the negotiation process. Like the one you did!
• Experiment
• Anne and Betty find a 10£ note in the street.
• And they play the following game to divide the note:
– Anne proposes to give Betty an (integer amount)
between 0 and 10, and Anne keeps rest.
– Betty says yes or no to proposal.
– If Yes, proposal implemented.
– If No, 10£ stay in the street.
B.3. Negotiations and fairness
 B.3. Negotiations and fairness
• First, let us use this to introduce the game tree: a
graphical representation of a dynamic game.
• Nodes (except final): decision makers have to choose
• Edges: actions at the decision nodes.
• Final nodes: payoffs Proposer

Offer (5,5) Offer (8,2)

Responder Responder

Accept Reject Accept Reject

(5,5) (0,0) (8,2) (0,0)

B.3. Negotiations and fairness
• As before start from a purely self-interested person.
• The mínimum acceptable offer is 1, as 1 > 0.
• This is anticipated by proposer who, being self
interested, maximizes her money proposing 9.
• But, what if preferences are different?
• Perhaps there is a social norm that unearned money
has to be shared.
• And violations of the norm anger us, and we want to
punish the violator.
• Punishment which makes us feel good!
B.3. Negotiations and fairness
• Then it is a BAD idea to offer 1!!
• For the Kenyan farmers:
• Expected payoff of offering 40%:
• = 96% chance of keeping 60% = 0.96 x 0.60 = 58%
• Expected payoff of offering 30%:
• = 52% chance of keeping 70% = 0.52 x 0.70 = 36%
• Turns out, 40% is best. With students, it is 30%
• Curiously, Modal offers!
• You need to learn this, even if you want to be hard-
nosed manager!!
C. Judging game solutions: efficiency
• Pareto efficiency:
An allocation is efficient if there is no other allocation
where all are at least as well and someone improves.
5
Outcomes better for both than I,T
I,T
4 Outcomes better for both than T,I
Bala’s payoff

I,I
3 Outcomes better for both than I,I

2 Outcomes better for both than T,T

T,T
I,I = Both use Integrated Pest Control (IPC)
1 T,I
I,T = Anil uses IPC, Bala uses Terminator
T,I = Anil uses Terminator, Bala uses IPC
0
T,T = Both use Terminator
0 1 2 3 4 5
Anil’s payoff
 C. Judging game solutions: fairness
• Substantive fairness.
– Equality in material and non-material outcomes
– "Life, Liberty and the pursuit of Happiness" .
• Procedural fairness.
– Institution is unbiased.
– No one is privileged (but wait, perhaps compensation is needed),
participation is voluntary (The Hunger Games), good behaviour rewarded.
• One operationalization: The veil of ignorance.
– An institution is fair if we accept it before knowing which role we will play.
 C. Judging game solutions: Inequality
Lorenz curve: Shows the
extent of inequality and
allows comparison of
distributions.
Gini coefficient: Measure of
inequality, approximated as
the deviation of the Lorenz
curve from the perfect
equality line.
Ranges from 0 (perfect
equality) to 1 (maximum
inequality).
 C. Judging game solutions: Inequality

Piracy was surprisingly fair

and democratic – unlike in
the British Navy, pirates on
The Rover distributed their
spoils relatively equally
between crew members.
 C. Judging game solutions: Inequality
Redistributive government
policies (income tax and
transfers) can result in a
more equal distribution of
disposable income.
Differences in inequality in
disposable income across
countries depends on the
effectiveness of these
policies.
 C. Judging game solutions: Inequality
• Before 1973, land
distribution in West Bengal
was highly unequal - a few
landowners owned all the
land.
• Sharecroppers usually
gave half their crop to the
landowners.
• Income inequality – 73%
rural poverty rate in 1973.
 C. Judging game solutions: Inequality
• Land tenure reform
allowed farmers to keep a
greater share of their crop,
and protected them from
eviction.
• Not Pareto efficient BUT
decreased income
inequality.
• Work motivation and
agricultural productivity
also improved.
 Wrapping up
1. Social interactions can be modeled as games
• Players choose best responses to others’ strategies
2. Social dilemmas e.g. prisoners dilemma can be resolved
by social preferences, peer punishment, or binding
agreements
• The rules of the game also matter for outcomes
3. Multiple Nash equilibria can cause coordination problems
• Economic and political institutions can help achieve
socially optimal outcomes
4. Institutions have to be judged on efficiency and fairness
 In the next unit
• The role of institutions: firms and
markets

• How firms work: owners, managers,

and employees

• Why unemployment is a feature of the

way labour markets function