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Semester II, AY2013-2014

NUS Business School


BSP1005 Managerial Economics

Lecture Notes 9
GAME THEORY AND STRATEGIC THINKING I:
Introduction and Game Theory in Static Settings

By Jo Seung-Gyu
1

Recommended Readings (later, if not now.)


-

Dixit, A. and B. Nalebuff (2008), The Art of Strategy, Norton, W.W. & Company
Dixit, A. and B. Nalebuff (1991), Thinking Strategically, Norton, W.W. & Company
David M. Kreps (1990), Game Theory and Economic Modelling, Oxford Univ. Press

Outline

Introduction, Motivating Examples


and Fundamentals of a Game
Strategic Thinking in Static Games
Introduction
Pre-Nash Equilibrium Concepts
o Dominant Strategy Equilibrium
o Iterated Dominance Equilibrium
o Maximin Strategy Equilibrium
Nash Equilibrium
Application: Rational Pigs

Game: situation in which players (participants) make


strategic decisions that take into account each others
actions and responses
3

Introduction

Opening Question:
What is the difference between the following two problems?
I want to choose the best jazz bar to refresh tonight.
I want to choose the best jazz bar while avoiding my
ex-girlfriend.

Strategic thinking is the focus of game theory.

Introduction cont.
Game theory was developed in the early 1940s (in connection with
war strategies during the cold war era) and is concerned with the
formal study of rational decisions in strategic situations where conflict
interfaces with mutual dependence. Such situations are common both
within firms and in market actions among firms as well as in everyday
life.
price wars (e.g. collusion vs competition?) or trade wars (e.g.
managed trade vs free trade)
You broke up with your girl (boy) friend a week ago. And you
want her back. Should you call ahead or wait for her (his) call?
What is the winning strategy? More importantly, what matters
in your decision?
In these situations, players have their own objectives possibly in
conflict - but also share a mutual dependence.

Motivating Examples
Example 1: A Robbery at an LA Branch of Hanmi Bank
Source: http://www.koreadaily.com/news/read.asp?art_id=855394

(June 11, 2009)

The robbery was successful in stealing US$ 3,500 after a written


threat of
Give me the money or we all die
Which part of the note was the key to the successful robbery?

Example 2: Fruit Price War in Singapore (from the reading)


At two Ang Mo Kio fruit shops,
customers have been queuing to buy
fruits which were going for as little as
$1 for 30 apples.
After the 5-day long price war, two fruit
shops lost $30,000 and $50,000,
respectively.

Issues
Why is it a dilemma?
How to get out of the
dilemma?

Example 3: 2006-2009 Semiconductor Industry Chicken Game


DRAM output and prices
Brief History:
2006.10

Impact on Operating Profit

Elpida (Japanese): First to produce


70 nano DRAM chips
2007. 01 Elpida and Powerchip (Taiwan)
agree to JV
2007. 11. Elpida: announced JV with Nanya and
ProMos (to beat Samsung), invested
$10bln in facilities
2008. 01 DRAM prices plunge
2008. 05. Taiwanese chip-makers: 13-17% loss
(started the chicken game, yet the
worst losers)
2009. 12
- German Qimonda reports bankruptcy
- Elpida: Reduced DRAM production
- Four (Powerchip, Promos, Nanya, - - Qimonda)
under government bailout
- Hynix: expanded production but eventually
negotiating rescue plan with KDB
- Only Samsung maintained its
market share.
2012, 01
- SK took over Hynix
- Elpida reported bankruptsy
- Samsung and Hynix become dominant
players, while old rivals all lost their footing.

Semiconductor Industry cont.


How can the situation be seen?

Issues:
How can you be the ultimate winner?

FUNDAMENTALS OF A GAME

A Game Framework is composed of the following elements:


o Players: A set of rational, payoff-maximizing competitors
firms, governments or any other decision groups
o Strategies: Set of actions players choose as a game plan
o Payoffs: Value associated with each possible outcome of the game
(expected) economic profits, utility or national welfare etc

10

FUNDAMENTALS OF A GAME cont.

Cooperative vs Non-cooperative Games


Collusion is attractive but illegal.
Therefore, we only study non-cooperative games

11

FUNDAMENTALS OF A GAME cont.


Order of Decision Making and Game Forms
Simultaneous Movement
Static
Normal Form Games

vs

Sequential Movement
Dynamic
Extensive Form Games

What matters is the information or knowledge, not the physical order of


players movements .
Example:
Voting Game- Voters move sequentially but is a simultaneous-moving
game.

12

FUNDAMENTALS OF A GAME cont.

Information/Knowledge
Mutual Knowledge:
I know A is true and you know A is true
Common Knowledge:
I know A is true.
You know A is true.
I (You) know (I) you know A is true.
I (You) know you (I) know I (You) know . A is true.
Example

Take the exam or not?


Note: Game theory distinguishes perfect information from imperfect, and
complete information from Incomplete it goes beyond our level.
13

Outline
Introduction, Motivating Examples and
Fundamental of a Game

Strategic Thinking in Static Games


Introduction
Pre-Nash Equilibrium Concepts
o Dominant Strategy Equilibrium
o Iterated Dominance Equilibrium
o Maximin Strategy Equilibrium
Nash Equilibrium
Application: Rational Pigs

14

Introduction
Static Games in Normal (or Strategic) Form
The normal or strategic forms are usually presented through a game
matrix highlighting the following three key aspects of the strategic
situation:
The players and their identities
The feasible strategy set for each player
The payoffs associated with each strategy profile
Players make decisions without knowing what others did, thus
simultaneous movement game.

15

Example: PRISONERS DILEMMA GAME

Two NUS students stole a book from the library.


After investigation, the district attorney gathered some information about the two
suspects as partners in the crime. He holds them in separate cells and they cant
communicate. Each is asked to choose after given the following game rules, which
is a common knowledge.
There are four possible outcomes depicted in the matrix below. The entries are
prison sentences, with As sentence first. (Plea-bargain incentive is considered.)

Are the followings clear to you in


the game?
Players:
Strategies
Payoffs

16

Outline
Introduction, Motivating Examples and
Fundamental of a Game
Strategic Thinking in Static Games
Introduction
Pre-Nash Equilibrium Concepts

o Dominant Strategy Equilibrium


o Iterated Dominance Equilibrium
o Maximin Strategy Equilibrium
Nash Equilibrium
Application: Rational Pigs

17

DOMINANT SRATEGY EQUILIBRIUM

Prisoners dilemma game revisited:

Question: Would you confess or deny?


If a player has a strategy which gives her better payoffs than her other
strategies for each of possible choice by the other player, it will be safe to
assume that she will play such strategy (without the need to consider about
the other players choices).
Rational choice leads the two players to both play defect (i.e. confess) even
though each player's individual reward would be greater if they both played
cooperatively (i.e. deny). This is why its a dilemma.
They end up doing something that hurts them both.

18

Formalization:
Concept of Dominance:

The strategy s* is a dominant strategy if it is a players optimal choice no


matter what the other players do.
His inferior strategies are called dominated strategies, which a rational
player would not choose.
When every player has a strictly dominant strategy, the outcome of the
game is called a dominant-strategy equilibrium.
Example:
In the prisoners dilemma game, (Confess, Confess) shares such
property for both players, and thus constitutes a dominant strategy
equilibrium.

COMMANDMENT

If you have a dominant strategy, use it.


Expect your opponent to use her dominant strategy if she has one.

19

Examples of Prisoners Dilemma Game


Pricing Game:

You can charge high or low. All charging a high price would be the
best for both, but Charge Low is a dominant strategy.
Real Life Example:
Fruit price war in Ang Mo Kio (Singapore): Two shops lost
$30,000 and $50,000 over 5 days of price war.
20

Examples of Prisoners Dilemma Games cont.


In sports: Weight-Reduction and Sudden Death
Sudden death in weight-class sports like boxing or
wrestling is not a news. And an intentional weightreduction in an unnatural level is often a reason.
In high-school wrestling, for example, participants
intentionally lose unnaturally large amounts of weight so
as to compete against lighter opponents. In doing so, the
participants are clearly not at their top level of physical
and athletic fitness and yet often end up competing
against the same opponents anyway, who have also
followed this practice (mutual defection). Yet if a
participant maintains their natural weight (cooperating),
they will most likely compete against a stronger opponent
who has lost considerable weight.
The result is a reduction in the level of competition and
occasional sudden death

Analogy:
-

Over-weight in Sumo?

21

Examples of Prisoners Dilemma Games cont.


In Human (or Animal) Behavior: The Survival of the Fittest?

During my trip to Moscow last spring, I noticed substantially many ladies are
wearing high very high heels. I asked a local lady why and the returning
answer was:
After the revolution, there were fewer males than females. And there
was a competition among ladies to look attractive High heel was
one answer.
22

Examples of Prisoners Dilemma Games cont.


Pseudo-Prisoners Dilemma on TV Quiz Show: Shafted
(Wikipedia) Shafted was a British quiz show that had a slight resemblance to The Weakest Link as
it was based on answering questions and eliminating fellow contestants.
The show begins with six players. In the first round, they each must declare how much money (up
to 25,000) they would like to start with. This is important as you need a large amount of money to
bet on the questions during the show. The person who asked for the biggest amount of money is
removed from the show before they answer a single question.
Then, the remaining five contestants answer incomplete questions that they must bet on. After all
players have placed their bets, the question is completed and whoever staked the most money can
answer it. If their answer is correct, then they get the money they bet added onto their score and if
they answer incorrectly, then the money is taken away. After a certain number of questions (equal
the number of players still in the game), the person with the most money decides who they want to
remove from the game. Then after the contestant is voted out, all the contestants are given the
same amount of money as the leader and the process continues until there are two contestants left.
The final round takes the form of a type of Prisoner's Dilemma. The two remaining players stand
opposite each other behind podia. They are playing for the amount of money the leading player
ended the main game with. Then each of the players is asked if they wish to "share" or to "shaft".
This is how it works:
23

Shafted cont.
Suppose the two finalists were playing for 150,000.
If both players decided to shaft, then both players would walk away emptyhanded.
If one decided to share and the other decided to shaft, then the person who
shafted would win all the money.
If they both decided to share, they split the money and would each get 75,000
in this case.
.
share
shaft
share

50%, 50%

0%, 100%

shaft

100%, 0%

0%, 0%

The tag-line delivered by the presenter of the show is


Their fate will be in each other's hands as they decide whether to share or
to shaft".

24

Shafted cont.
Now, lets get live through the YouTube Video and see how two contestants
play the game over 217,000!!
First half of the episode:
http://www.youtube.com/watch?v=X6rwrr-opEs
Second half:
http://www.youtube.com/watch?v=OmcRvtSCows

25

Outline
Introduction, Motivating Examples and Fundamentals of
a Game
Strategic Thinking in Static Games
Introduction
Pre-Nash Equilibrium Concepts
o Dominant Strategy Equilibrium

o Iterated Dominance Equilibrium


o Maximin Strategy Equilibrium
Nash Equilibrium
Application: Rational Pigs

26

ITERATED DOMINANCE EQUILIBRIUM


Dominant strategy equilibrium was about which strategy will be
played for sure?
If the dominant strategy equilibrium exists, it is easy to solve.
But few games have the dominant strategy equilibrium.
Then what if there is no dominant strategy equilibrium?
Then, as an alternative, we can ask what strategies will not be
played?

The rationale behind is clear: you wouldnt play a strategy


when there is some other strategy which always does better
regardless of the rivals choices.

We call such a strategy a dominated strategy.


If dominated, you wont adopt that strategy and you would delete it out
of your option. Iteratively deleting such dominated strategies can
although not always give us a unique outcome called iterated
dominance equilibrium.

27

ITERATED DOMINANCE EQUILIBRIUM cont.


Then the following thinking process applies:
Check if a player has a dominant strategy.
Check if a player has a dominated strategy.
Eliminate the dominated strategies
Reduce the size of the game
Iterate the above procedure until you cannot proceed further

Example:
FirmA

FirmA

Middle
Bottom

FirmA

Top
Middle
Bottom

Left
3, 6
5, 1
6, 0

FirmB
Center Right
7, 4 10, 1
8, 2 14, 6
6, 2
8, 5

(Middle, Right) is the


only outcome that
survives the Iterated
Dominance, thus
iterated dominance
equilibrium.

FirmB
Left Center Right
5, 1
8, 2 14, 6
6, 0
6, 2
8, 5

FirmB
Right
Middle 14, 6
Bottom 8, 5

FirmB
Right
FirmA

Middle

14, 6
28

Outline
Introduction, Motivating Examples and Fundamental of
a Game
Strategic Thinking in Static Games
Introduction
Pre-Nash Equilibrium Concepts
o Dominant Strategy Equilibrium
o Iterated Dominance Equilibrium

o Maximin Strategy Equilibrium


Nash Equilibrium
Application: Rational Pigs

29

MAXIMIN STRATEGY EQUILIBRIUM

Players may sometimes play conservatively to avoid a bad outcome.


When this bad outcome is a really bad one, you cannot blame them,
can you?
Such risk-averse players may believe others are not necessarily
rational. Then they would be willing to tradeoff between risk and return.
In doing so, their objective is to choose the strategy associated with the
best out of the worst outcomes.

A strategy of Player A that guarantees A the best outcome if the other


player plays the strategy that is worst for A, that is, the maximum out of
the minimum payoffs, is called As maximin strategy.

30

MAXIMIN STRATEGY EQUILIBRIUM cont.


Example:

Top

Left
10, 4

Player B
Right
8, 15

A's Min

100

Player A
Bottom

100, 5

20, 10

B's Min

10

RIGHT is a dominant strategy for player B. Given this, player A will choose
BOTTOM. (This is the only Nash equilibrium of the game, as to be seen later.)
However, what if player A doubts player Bs rationality? That is, what if
player A thinks there is a slight chance for player B to choose LEFT?
-

Then player A may choose Top in fear of the disastrous outcome of (-100,
5). By doing this, A can guarantee herself 8, regardless of Bs choices.

Such risk-averse attitude may force the players to choose the strategies to
maximize among the guaranteed minimum payoffs. Player A will choose Top
since it guarantees her the higher minimum payoff than Bottom. By the same
token, Player B will choose Right. This may justify (TOP, RIGHT) as a possible
game outcome, which we call maximin strategy equilibrium (outcome).
31

MAXIMIN STRATEGY EQUILIBRIUM cont.

Usefulness of Maximin Strategy Concept:


Given the above game structure, player B might have an incentive to
fake her rationality. Sometimes, you may want to create a fog for your
own good.
Skepticisms of Maximin Strategy Concept:
Very little justification for an equilibrium concept for a rational player:
- The concept may sound practical, particularly when the damage from
the bad outcome is fatal. But how bad is fatal? Would you still behave
conservatively when (Bottom, Left) gives (-1, 5) or (4, 5) instead of (100, 5)?
Furthermore, It is not always self-enforcing.
In sum, this concept may be acceptable for a risk-averse behavior but
inconsistent and fragile as an equilibrium concept.
32

Outline
Introduction, Motivating Examples and Fundamental of
a Game
Strategic Thinking in Static Games
Introduction
Pre-Nash Equilibrium Concepts
o Dominant Strategy Equilibrium
o Iterated Dominance Equilibrium
o Maximin Strategy Equilibrium

Nash Equilibrium
Application: Rational Pigs

33

NASH EQUILIBRIUM
For the majority of games, modelers use the Nash
equilibrium (named after a Princeton Mathematician
and 1994 Nobel laureate John F. Nash).
This is the most important and most frequently
encountered equilibrium concept, albeit it contains its
own imperfectness.

The dominance concept was about What strategies would a rational player always
play or never play?
In contrast, Nash equilibrium is motivated by the question What properties must a
game equilibrium have?
The Core idea suggested by John Nash was:
-

No player should have an incentive to deviate from the equilibrium, once


it is reached.
(That is, a players strategy choice should be self-enforcing with the other
players strategy choice. Each players chosen strategy should be optimal
given that every other player chooses the equilibrium strategy.)

Lets look through examples below:

34

Example: Stag Hunt Game


The French philosopher Jean-Jacques Rousseau described a situation in which two
individuals go out on a hunt (The Social Contract, 1762).
Each can individually choose to hunt a stag or hunt a rabbit. (It highlights the social benefit
from coordinating the choices.)
Hunter B
Stag

Rabbit

Stag

5, 5

0, 1

Rabbit

1, 0

1, 1

Hunter A

Note that the dominance concept does not help us.

Nashs suggestion is:


o

Put yourself in your rivals shoes. That is, choose your best response to each
of your rivals potential choices
Blue Hunter As best response
Green Hunter Bs best response

Nash equilibrium is a solution of mutual best response. That is, it should


satisfy the players best responses at the same time.

We have Two Nash in this game: (Stag, Stag) and (Rabbit, Rabbit)
Naturally, neither player has an incentive to deviate.

35

Finding a Nash Equilibrium: Easy Algorithm

When a game does not have any dominant or


dominated strategies, or when the iterated
deletion of dominated strategies does not yield a
unique outcome, cell-by-cell inspection is used.
Simply put, each cell of the game box is checked,
each time asking "does either player have
incentive to change her strategy unilaterally" or
"are both players playing a best response."
The problem with this approach is that it can take
quite a while. If there are two players, one with N
strategies and the other with M, we need to
check NxM cells which, for many games, can be
quite large. For example, if each of two players
has 5 strategies, we need to check 5x5=25 cells..
Below, you will learn a simpler technique for conducting cell-by-cell inspection. This
method, called "strategy-by-strategy inspection" (or Dot-Algorithm, as I name it
myself) requires only N+M inspections, and is less likely to result in mistakes
36

Finding a Nash Equilibrium: Easy Algorithm - cont


Consider a two-player game with five strategies for each player:

Player 1

A
B
C
D
E

F
9,9
7,8
5,6
3,9
1,2

G
7,1
5,2
3,3
1,9
9,8

Player 2
H
5,6
3,6
1,8
9,4
7,7

I
3,4
1,4
9,7
7,9
5,6

J
1,1
3,3
1,5
5,9
3,7

Use dots (or underlines or circles) to specify player 1s best response and
player 2s best response.

Player 2
F
G
H
I
J
A
9,9
7,1
5,6
3,4
1,1
B
7,8
5,2
3,6
1,4
3,3
Player 1 C
5,6
3,3
1,8
9,7
1,5
D
3,9
1,9
9,4
7,9
5,9
E
1,2
9,8
7,7
5,6
3,7

You can see there are three Nash: (A, F), (E, G) and (D, J)
-

Check if they are self-enforcing, i.e., if neither has an incentive to deviate.


37

A Beautiful Mind and Nash Equilibrium


Now, lets see a movie clip from A Beautiful Mind
to check your understanding.
Movie Clip: A Beautiful Mind
In the movie, "A Beautiful Mind," John Nash gets
the idea for Nash equilibrium in a student hangout
where he is sitting with three buddies.
Five women walk in, four brunettes and a stunning
blonde. Each of the four buddies starts forward to
introduce himself to the blonde. Nash stops them,
though, saying, "If we all go for the blonde, we will
all be rejected and none of the brunettes will talk to
us afterwards because they will be offended. So
let's go for the brunettes."
The next thing we see is the four buddies dancing
with the four brunettes and the blonde standing
alone, looking unhappy. Nash then runs to his
professor to discuss his new idea of Nash
equilibrium and how individual pursuit of payoff
maximization does not lead to optimal results.

Lets take Russell Crowes line of


If we all go for the blonde, we will
all be rejected and none of the
brunettes will talk to us afterwards
because they will be offended as
a genuine part of the game rules.
Is the result in the story a Nash
equilibrium? Why or why not? If
not, what would be Nash
equilibrium for the situation?
38

NASH EQUILIBRIUM IN MIXED STRATEGY


(Its an advanced topic. We may have to skip on this section or we will just go over the
concept.)

What is the common feature of the following situations?

Sports:
Law Enforcement:
Olympic Games:

Penalty Kicks in Soccer


DUI checking points
Random drug testing

If opponent knows what I will do, I will always lose!


What would you do then?
RANDOMIZE!
By randomizing just right, you can avoid getting outguessed and taken
advantage of

Definition: For any given set of pure strategies, mixed strategies are
rules that tell a player with what percentage to play each pure strategy.

39

NASH EQUILIBRIUM IN MIXED STRATEGY cont.

Example: Consider the tennis game between Nadal and Federer.


-

Nadal is serving to Federer and is deciding between down the line (DL)
and cross court (CC).

Payoffs represent the winning chance (%) for each player.


DL

Federer
CC

DL

50, 50

80, 20

CC

90, 10

20, 80

Nadal

Notes:
-

Is it clear that you will lose if you get outguessed?


Is it clear that there is no Nash equilibrium in pure strategies?
Randomizing is a solution.

Finding Nash equilibrium in mixed strategy goes beyond our level, so well skip.

40

Outline
Introduction, Motivating Examples and Fundamental of
a Game
Strategic Thinking in Static Games
Introduction
Pre-Nash Equilibrium Concepts
o Dominant Strategy Equilibrium
o Iterated Dominance Equilibrium
o Maximin Strategy Equilibrium
Nash Equilibrium

Application: Rational Pigs

41

APPLICATION: RATIONAL PIGS

Two rational pigs, one big (called Napoleon) and the other small (called
Pinkie), are put in a cage. There is a button at one end of the cage and food
dispenser at the other end which dispenses 10g of food when button is
pressed.
Now if the pigs want food, they need to press the button; the pig that pressed
the button must run to the food dispenser while the other pig has started to eat.
Napoleon, being big and dominant, can eat all the food remaining once it
reaches the dispenser. So Pinkies only chance to eat is when she reaches
food before Napoleon, yet still need to subordinate to Napoleon once he
arrives. Pressing the button and running to the food dispenser involves calorie
expenditure, which costs 2g to each pig.
42

RATIONAL PIGS - cont.

If Pinkie presses the button, Napoleon eats all 10g.

-------- (10, -2)

If Napoleon presses the button, Pinkie can eat 7g before


Napoleon arrives.
---------

(1,7)

If both press the button, Pinkie can run faster (given


Napoleons fat shape) and eat 3g.

----------

(5,1)

If neither presses, no food of course

----------

(0,0)

Question: Who is going to press the button?

43

RATIONAL PIGS - cont.


The payoff matrix for the pigs:

So, who is going to press the button?

Why?

Lesson:
At times, a weakness can be a strategic strength and vice versa.
-

Often quoted as Judo Economics


44

RATIONAL PIGS - cont.


Business Analogy of the Pig Games: OPEC Game
The first quarter oil prices in 2013 are 10% lower than a year before.
OPEC members share a common incentive to produce less, and agree on the tight
production quotas.
Saudi Arabia (SA) is a stronger player than the rest of OPEC due to its relatively large oil
reserves and low production costs.

Once agreed, an individual member has a unilateral incentive to disobey the agreed
quota and produce more to take advantage of the supported oil price.

If the rest of OPEC obeys, Saudi Arabia also has an incentive to cheat.

But if the rest of OPEC do not obey its cartel quota (and produced too much), it is still
in the Saudi's interest to keep to its cartel quota (since SAs share is too big and SA
had better support the oil price by reducing its own production)

disobeycartelquota
Saudi
Aribia
obeycartelquota

RestofOPEC

disobeycartelquota
Obeycartelquota
LOW,LOW

MODERATE,VERYHIGH

VERYHIGH,VERYLOW

HIGH,HIGH

Highlight
SAs strength in market
power may turn into the
weakness in strategic power.

45

Next week, well be discussing dynamic games


and strategic moves.

46

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