Chapter 13

Choice under Uncertainty

and Game Theory
 Lecture Plan
 Objectives
 Risk and Uncertainty in Decision Making
 Game Theory
 Structure of a Game
 Strategies
 Nash Equilibrium
 Prisoners’ Dilemma
 Types of Games
 Game Tree
 Applications of Game Theory in Economics
 Summary
 Objectives

 To understand the intricacies of risk and uncertainty

in economic decision making.
 To explain the relevance of game theory in economic
theory.
 To understand dominated and dominant strategies.
 To understand determination of Nash equilibrium,
minmax and maxmin strategies.
 To illustrate the application of game theory concepts
in models of economics.
 Risk and Uncertainty in Decision Making
 Risk
 Decision maker (an individual or a firm) can assign mathematical
probabilities to the randomness which it is faced with, and thus
can insure against such risks.
 There can be more than one possible outcome, and probability
of each such outcome is known.
 Reason behind emergence of risk is lack of information.
 Uncertainty
 Randomness cannot be expressed in terms of specific
mathematical probabilities
 Randomness cannot be insured against.
 There can be more than one possible outcome and the
probability of each outcome cannot be ascertained.
 Knightian risk and uncertainty are one and the same
thing.
 Game Theory
 Started with a duopoly market structure by Augustin
Cournot in 1838.
 Formalized by John von Neumann and Oskar
Morgenstern
 Branch of applied mathematics
 Helps to study strategic situations in which decision
makers (players) optimize a variable not only on the
basis of their own preferences, but also on other
players’ decisions and reactions.
 A method of analyzing strategic interaction.
 Formally structures a situation in the form of a game
and studies the behaviour of conflict (competition) and
cooperation (collaboration) between players.
 Structure of a Game

 Players: participants in the game.

 Strategy: precise course of action with clearly defined
objectives.
 Strategy Profile: a set of strategies for each player that fully
specifies all the actions in a game.
 Payoff: net utility or gain to a player for any given counter
strategy of the other player
 Payoff Matrix: represents the set of outcomes for the game.
 Outcome: end result accruing to different players by opting for
different strategies of the game.
 Equilibrium: where no player can make its payoff better, and
all the other players continue to follow their optimal strategies.
 Strategies
 Pure and Mixed Strategies
 Specifies one and the same particular action at each decision
point in a game.
 Dominant and Dominated Strategy
 Optimum strategy taken by a player which maximizes its
outcomes, whatever is the strategy of opponents.
 If one player has a dominant strategy in a game, then all other
strategies are dominated strategies.
 Maxmin Strategy
 Maximizes among the worst case payoffs of a player.
 Assumes that all other players would inflict maximum harm to
him/her.
 Minmax Strategy
 A player minimizes the best case payoff of its rival.
 Psychology of player is to cause maximum loss to its opponent,
or rather to punish the opponent.
 Nash Equilibrium
• It is a strategy for each player such that no player has
the incentive to change its action unilaterally, given that
the other players follow the proposed action.
• It is the optimal collective strategy where no player has
anything to gain by changing his/her strategy.
• As per Nash equilibrium, both the players would try to
take the best possible action given the opponent’s
action.
• Any maxmin strategy profile confers to Nash
equilibrium.
• A minmax strategy by both players also leads to Nash
equilibrium.
 Prisoner’s Dilemma

 A model developed to explain the behaviour of two

players and the sets of outcome under certain conditions
with the story of two criminals arrested in a robbery.
 Each prisoner knows that if both confess, their
imprisonment will be 5 years but if only one confesses
and the other remains silent then the one who confesses
will get only 1 year of jail whereas the other will get 10
years.
 If both of them keep silent they will get only 2 years of
imprisonment
 Neither prisoner knows the choice of his accomplice.
 Each of them would try to minimize own jail term.
 Prisoner’s Dilemma
Prisoner B Stays Silent Prisoner B Confesses

Prisoner A Stays Both serve 2 years A serves 10 years

Silent Win-Win B serves 1 year
A Loses, B Wins
Prisoner A B serves 10 years Both serve 5 years
Confesses A serves 1 year Lose-Lose
A Wins, B Loses

• Nash equilibrium: Both prisoners would confess and serve 5

years.
• This dominant strategies equilibrium is a special case of Nash
equilibrium.
• If either A or B adopts maxmin or minmax strategy, the outcome in
both the cases would be the same.
 Types of Games
 Cooperative and Non Cooperative Games
 Cooperative games: entail cooperation among
players.
 Non cooperative games: no possibility of a tie up
among the players.
 Normal Form and Extensive Form Games
 Normal form: systematically lists each player’s
strategies and possible outcomes they derive from each
strategy, given the strategy of the opponent.
 Extensive form (or a game tree): gives the
chronological order in which players take their action at
that particular point of time, dependent on what they
know at that point.
 Types of Games Contd…

 Two Person Games and n Person Games

 On the basis of the number of players.
 Simultaneous Move and Sequential Move Games
 Simultaneous Game
 Both players act at the same time.

 second player is uninformed of the first player’s move,

thus making it effectively a simultaneous move.

 Sequential Game
 One player acts, followed by the other.

 The second player knows the move adopted by the first

player, and takes its decision contingent on that taken

by the first player.
 Types of Games Contd…

 Constant Sum, Zero Sum and Nonzero Sum Games

 Constant sum games: Total benefit of the players is a constant
 Zero sum games: Total benefit of the players is equal to zero. A
gain for one participant is always equal to the loss of another.
 Nonzero sum game: Total benefit of the players added together
is more than zero or the constant.
 Symmetric and Asymmetric Games
 Symmetric games: Payoffs do not depend on the players of the
game, but on the strategies of the game.
 Strategies are such that if the players are interchanged

without changing the payoff matrix, the game remains the

same.
 Asymmetric games: Do not have do not have identical strategies
for both set of players .
 Cournot Model
 A simultaneous move game where the firms strategically
choose outputs such as to maximize profits.
 Model of oligopoly where firms choose output on the basis of
the assumption that the rival firms would not change its
output.
 Firms know that their choice of quantity is dependent on what
the rival firms choose.
 Once quantities are chosen, the prices are determined.
 If both firms fight with each other, then they earn duopoly
profits.
 If they form a cartel, each firm earns greater profits.
 Given the structure of the game and the players’ rivalry, they
end up in a suboptimal equilibrium.
 Bertrand Model

 Developed by Joseph Bertrand in 1883.

 A simultaneous move game where the firms choose prices
simultaneously.
 If one firm sets its price higher than the other firm it will not get
a single buyer since both the firms are selling homogeneous
products.
 The low priced firm will get the entire market share and thus
enjoy maximum profits.
 Each firm has the incentive to cut prices.
 There is exactly a single Nash equilibrium, where both the
firms set their price at marginal cost.
 Bertrand Model Contd…

 Demand faced by the firm “i” is given by Di ( Pi , Pj )

 Price of its rival firm is given by j.
 Each firm have a cost function given as: C ( q ) = cq i
If j charges a higher price, “i” gets entire
 D( Pi ) if Pi < Pj market.

1 If j charges a price equal to i then both the
Di ( Pi , Pj ) =  D( Pi ) if Pi = Pj
2 firms equally share the market.
0 if Pi > Pj If “j” charges a price lower than i then the
demand for the product of i is zero.
 Each firm wants maximum profits, given what it predicts what the other firms
will do.
 D( Pi ) ( Pi − c) if Pi < Pj
 Nash equilibrium
1
π i =  D( Pi ) ( Pi − c) if Pi = Pj
2
Pi = Pj= MC
0 if Pi > Pj
 Price Determining Game
Price of A (Pj)

Collusive
Equilibrium
90

50
Nash
Equilibrium

O
50 90 Price of B (Pi)
 Stackelberg Game
 A sequential move game. These types of games are
known as Follow the Leader games.
 One firm chooses the output is known as the leader . The
second firm (the follower firm) observes the first firm’s
quantity and then chooses its own output.
 Once the two firms choose respective quantities, prices
are determined.
 This technique first considers optimal strategy of the
player and its best response which takes moves that are
last in the game.
 Predicting the future action of the last player, second last
player proceeds takes best move and process continues
backwards in time determining for each player best
response, until the beginning of the game is reached.
Summary
 Game theory is a mathematical tool that helps to study strategic situations in which
players optimize a certain variable not only on the basis of their own preferences, but
also on the other players’ decisions and reactions.
 As per Knight’s definition of risk, game theory falls in the category of analyzing risk, as
through this method mathematical probabilities are assigned to situations.
 The “payoff” of a strategy is the net utility or gain to a player for any given counter
strategy of the other player.
 A pure strategy specifies one and the same particular action at each decision point in a
game; a mixed strategy would have randomness in the actions of the player at various
decision points in a game.
 Dominant strategy is the optimum strategy taken by a player which maximizes its
outcomes, whatever is the strategy of its opponents. If one player has a dominant
strategy in a game, then all other strategies are dominated strategies.
 Maxmin strategy maximizes among the worst case payoffs of a player. A minmax
strategy is one in which a player minimizes the best case payoff of its rival.
 Nash equilibrium proposes a strategy for each player such that no player has the
incentive to change its action unilaterally, given that the other players follow the
proposed action.
 Cooperative games entail cooperation among the players; in non cooperative games
there is no possibility of a tie up among the players.
 Summary

 Prisoner's Dilemma" talks of the importance of cooperation. Each player gains when
both cooperate, but if only one of them cooperates, the defector will gain more. If both
defect, both lose but less than the "cheated" cooperator.
 The normal form game systematically lists each player’s strategies and the possible
outcome from each strategy; an extensive form game (or a game tree) gives the
complete plan of action of the players over a period of time.
 In a simultaneous game, both players act at the same time; in a sequential game one
player acts, followed by the other.
 In constant sum games, the total benefit of the players, given each strategy, is a
constant and the players have to share the profit; in zero sum games, the total benefit
of the players, given each strategy, is equal to zero.
 The Cournot game is a simultaneous move game where the firms strategically choose
outputs such as to maximize profits.
 The Bertrand model is a simultaneous move game where the firms choose prices
simultaneously. There is exactly a single Nash equilibrium, where both the firms set
their price at marginal cost.
 The Stackelberg game is a sequential move game different from the Cournot or the
Bertrand game. Equilibrium determined in this model is known as backward induction
in the game theory.