Eric Shapiro Gill AP Macroeconomics Tuesday, May 31, 2011 Economic Theory Paper (Game Theory)

Until John von Neumann published his groundbreaking book The Theory of Games and Economic Behavior in 1944, the use of mathematical devices to solve economic problems was very restricted. Economic problems simply had not been articulated in such a way as to inspire contributions from creative mathematicians. John von Neumann was not the first to suggest a theory of games, but he was the first to successfully come up with a theory of mixed strategy in two-player constant-sum games: his celebrated minimax theorem. This was an extraordinarily insightful theory, and without its important insights game theory may never have seen any light at all. Game theory sprung from the necessity of a consistent and workable model of conflicts of interest. Without it, few reliable conjectures could be made as to the outcomes of certain situations. Game theory does not encompass all possible problems involving conflicts of interest, and no mathematical theory possibly could. It is a mathematical model and as such it is not guaranteed to yield accurate predictions every time. Like all models, game theory is a tool used to make predictions about the world given limited information. In any conflict of interest, two or more individuals with certain personal preferences are placed in a situation in which they have some control over the variables which determine the outcome. In some cases the individuals preferences are not the same. Or else chance events, as well as other individuals who may or may not be affected by the outcome of the situation, might influence the final result. Individuals may execute their choices simultaneously or in turn, and the situation might occur only once or it may be repeated over a long span of time. These robust classes of situations are called games and the individuals are called players. It is the realm of game theory to formulate principles to guide intelligent action on the part of each player.

Shapiro 2 As the methods of game theory merely model reality, there are certain assumptions which are made which may or may not be true of a certain situation. The first is that each player strives to maximize his utility. (Utility is a well-defined concept with a set of assumptions of its own, but suffice it to say utility is a numerical measure of relative satisfaction and that all players do not necessarily glean the same utility from corresponding outcomes.) Game theory also assumes that each player is fully aware of what every other player is trying to achieve. The final assumption is that all players act rationally, always choosing the best possible strategy to maximize his utility. This last assumption lends itself to the astonishingly important concept of equilibrium. If every player is attempting to maximize his payoffs (how much utility he gets from the outcome) then there must be some combination of strategies which leads to the best possible outcome for each player. This combination of strategies is known as the games equilibrium, although in more complicated games it is possible that there will be two or more equilibria. The concept of Nash equilibrium (named after famous mathematician and economic theorist John Forbes Nash, who proposed it) is a more specific example of this in which no player can change his strategy without worsening his own payoffs while the other players keep their own constant. In other words, a strategy set is in Nash equilibrium if each players chosen strategy is the best response to all possible actions of the other players. Identifying Nash equilibria is simplest when games are represented in their normal, or strategic, forms. For a two-player game, these generally look something like this: Player 2 Strategy A Player 1 Strategy A Player 1 Strategy B Player 2 Strategy B

1,1 -1 , 1

1 , -1 0,0

In its strategic form the strategy combinations of the players and their respective payoffs are easily analyzed. The payoffs of the row player are represented first, those of the column player second. Unless otherwise noted, positive payoffs are more desirable. A Nash equilibrium exists if the first number of a cell is the maximum in that column and the second

Shapiro 3 number of the same cell is the maximum of that row. For the payoff matrix above, the Nash equilibrium is for both players to choose Strategy A, because neither can change his strategy in a manner which increases his payoff. In the case presented above, the globally optimal strategy is stable, as it is a Nash equilibrium. There are cases, however, in which both players can feasibly improve their outcomes if they cooperate. The Prisoners Dilemma is the classic example of this, in which the globally optimal strategy is unstable and the Nash equilibrium is a Pareto-inefficient, or suboptimal: Player 2 Cooperates Player 1 Cooperates Player 1 Doesnt Cooperate Player 2 Doesnt Cooperate

3,3 5,0

0,5 1,1

The Nash equilibrium in a Prisoners Dilemma is for both players not to cooperate, as this is the only stable solution. In other words no matter what Player 2 does, Player 1 can always do better by choosing not to cooperate and vice versa. Unless there is some form of penalty or guarantee in play which provides some incentive for the players to cooperate (and which is for some reason not factored into the payoff matrix) both players will choose not to cooperate and settle for a lower payoff. The two examples above are non-zero-sum games. A zero-sum game is one in which one players gain exactly balances the other players loss (the sum of all payoffs is zero). The zero-sum game is a special case of a constant sum game, and constant sum games can be reduced to zero-sum games by subtracting half of the constant sum from each payoff in the matrix. For instance, the constant-sum game represented by the payoff matrix Player 2 Strategy C Player 1 Strategy A Player 1 Strategy B Player 2 Strategy D

1,5 4,2

5,1 2,4

Shapiro 4 can be expressed equivalently and without any loss of information as this zero-sum game by applying the above algorithm (subtracting 3, which is half of the constant sum 6, from each payoff): Player 2 Strategy C Player 1 Strategy A Player 1 Strategy B Player 2 Strategy D

-2 , 2 1 , -1

2 , -2 -1 , 1

A Nash equilibrium exists in all zero-sum games, although it is not always easy to find. For instance, there does not at first glance appear to be any sort of Nash equilibrium for the above game. This is where von Neumanns Minimax Theorem comes into play! The Minimax Theorem states that for all zero-sum games a Nash equilibrium exists, and that it can be found by employing mixed strategies. A mixed strategy is one in which players employ an aspect of randomness (such as rolling a die) in order to determine which course of action to take. Players employ their strategies with predetermined probabilities in order to minimize their maximum losses. These probabilities are found in a simple case such as the one above by solving a single system of equations. In more complicated cases, or cases with a multitude of players, differential equations and more complicated devices must be used to find these probabilities. In the payoff matrix above, we assume that there is a probability p with which Player 1 should employ Strategy A and a probability (1 p) with which he should employ Strategy B. Because expected values can be calculated by summing the products of probability and payoff, assuming Player 2 chooses Strategy C, the expected payoff for Player 1 can be represented by the expression (p) (-2) + (1 p) (1). If player 2 chooses Strategy D, the expected payoff for Player 1 is (p) (2) + (1 p) (-1).

Shapiro 5 Setting these two expressions equal and solving for p reveals that p is equal to 1/3. This means that, if the game is played repetitively, Player 1 should choose Strategy A one-third of the time in order to maximize his payoffs in the long run. If the game is played only once then Player 1 would still be wise to, for instance, roll a die in order determine how to proceed. The same algorithm can be applied to determine with what frequency Player 2 should execute Strategy C. It turns out that in this game Player 2 should choose Strategy C and Strategy D with equal frequencies. Game theory extends into much more intricate and convoluted realms, such as analyzing games with an arbitrary number of players, infinite pure strategy sets or games in which coalitions are formed and are thus played cooperatively. However, this brief coverage of game theorys basic properties is sufficient to see how it can be applicable to the macroeconomy. Consider the following scenario, proposed by Tcha: There are two firms in the market, and they can choose to operate independently (Strategy I) or form a cartel (Strategy C). If they form a cartel, they agree to limit production, hence increasing price, so they both gain 8. If they both operate independently, they both gain 4. If they agree to form a cartel, thus increasing the price, but one firm betrays the other by producing more than agreed, then that firm gains a lot while the other loses a lot. Payoffs in this example are arbitrarily chosen.

Firm 2 Strategy C Firm 1 Strategy C Firm 1 Strategy I

Firm 2 Strategy I

8,8 10 , 1

1 , 10 4,4

Utilizing game-theoretical techniques, it can be shown that this situation is a form of Prisoners Dilemma in which the Nash equilibrium is Pareto-subdominant. The two firms are likely to each employ Strategy I, in which case neither receives the optimal payoffs. Another example of a macroeconomic use for game theory is in analyzing free trade and protection. Consider, for instance, a game between the United States and Japan, each of whom can choose free trade (Strategy F) or protection of their domestic markets (strategy P). If they

Shapiro 6 both choose free trade, both countries gain by trade. If they both choose protection, there is no gain for either country. If only one country chooses protection, they will gain by protecting their domestic market while still trading in the other country's market. This presents another Prisoners Dilemma. The only way in which the countries are likely to reach Pareto-efficiency is if they cooperate or negotiate penalties for reneging on their agreement. As previously mentioned, game theory is by no means a perfect tool and thus its predictions will certainly not always be correct, especially if the players are not informed enough to act in their own best interests. It does, however, present a useful tool set for evaluating economic situations and developing solutions to them. Game theory is used extensively by economists to this day, and new developments in the theory are still being made by analyzing the results of human behavior through experimentation and incorporating them mathematically into the theory.

Shapiro 7 Works Cited

Blaug, Mark. Economic Theory in Retrospect. 5th ed. 1962. Cambridge: Cambridge University Press, 1996. Print.

Luce, R. Duncan, and Howard Raiffa. Games and Decisions. 1957. Mineola: Dover Publications, 1985. Print.

Neck, Reinhard. "Dynamic Game Theory and Models of International Macroeconomic Policy." Recent Advances in Applied Mathematics: 37-42. Web. 31 May 2011. <http://www.wseas.us/e-library/conferences/2010/Harvard/MATH/MATH-002.pdf>.

Niehans, Jrg. A History of Economic Theory: Classic Contributions 1720-1980. Baltimore: The John Hopkins University Press, 1990. Print.

Tcha, MoonJoong. "Applications of Game Theory to International Trade." UCSB Economics. First Step Communications, 2003. Web. 31 May 2011. <http://www.econ.ucsb.edu/~verani/IIT_New/game_theory.html>.