Lecture 1 - Some Games Econ 106G Spring 2013

Some Games
The scal cli
If congress cannot agree on a dierent course of action, the Bush tax cuts expire for everybody on January 1st 2013 Democrats want tax cuts to expire, particularly on the wealthy (above $200k) Republicans want to maintain tax cuts for everybody Both sides have to agree on how to reform the taxes In August 2012 Senate democrats propose to let tax cuts expire above $200k On December 18th House republicans propose to let tax cuts expire above $1m On January 2nd Senate makes nal proposal to let tax cuts expire above $400k Faced with the choice to let tax cuts expire above $400k or for everybody, House agrees to proposal

Pre-Existing Health Conditions

Blue Cross is selling health insurance to an economics professor and can choose between a high, medium and low price The professor can be healthy or sick and he can decide whether or not to buy the insurance If the professor does not know whether he is healthy or sick he prefers to buy the insurance if the price is medium or low, but not if it is high If Blue Cross knows this, it chooses the medium price and the professor buys the insurance If the professor has a pre-existing condition and knows whether he is healthy or sick, the situation changes If he is healthy, he only buys the insurance if the price is low If he is sick, he buys the insurance at any price Now the insurance faces a problem if it charges the medium price, because the professor will only buy it if he is sick This phenomenon is called adverse selection 1

Assuming that the low price is too low to cover for the risk, the insurance chooses the high price and the professor purchases the insurance only if he is sick If the insurance could oer dierent policies for professors with/without pre-existing conditions, it would oer a low price if the professor is healthy, and a high price if he is sick.

Crying it out
A two-year old girl wants to take her doll with herself into the bathtub Her father is concerned that the doll might fall apart either in the bathtub, or later in the dryer However, he is willing to concede if having her doll with her is very important to his daughter The girl can cry as long as she chooses to get her way The father can force his way as long as he is willing to The longer the girl cries, the more her father becomes convinced that having the doll is very important The longer the father holds out, the more the girl becomes convinced that the father will not concede this time

The Sex-Ratio
Why is there a roughly even number of men and women on the world? Darwin s theory of evolution by mutation and selection predicts that genetic traits that enhance the tness of an individuum will spread through the population Assume that the ratio of women to men there are ve men for each woman
w m

was not equal to 1 but, say,

w m

= 0:2, so

Every woman has N = 12 kids, 2 daughters and 10 sons Every man has a chance of daughters and 2 sons
1 5

of mating with a woman and thus in expectation has 0:4

Note that women are much more productivethan men So, every woman will in expectation have 8 granddaughters and 40 grandsons She has 12 children, 2 daughters and 10 sons Each of the 2 daughters has 2 daughters and 10 sons for a total of 4 granddaughters and 20 grandsons

 Each of the 10 sons has 0:4 daughters and 2 sons for a total of 4 granddaughters and 20 grandsons Consider a dominant mutation that leads to an equal number of 6 girls and 6 boys She still has 12 children, 6 daughters and 6 sons Each of the 6 daughters has 6 daughters and 6 sons Each of the 6 sons has 1:2 daughters and 1:2 sons Thus, the total number of grandchildren is 6 granddaughters and 43:2 grandsons ... Thus, after only two generations the mutation is leading to strictly more granddaughters and grandsons Eventually the mutation will spread over the entire population 6+6 1:2 = 36 + 7:2 = 43:2

What is Game Theory?

Denition 1 Game theory is a tool to analyze interaction among a group of rational, strategic agents. A more descriptive term would be "Interactive Decision Theory". Let us elaborate on the key terms in this denition: Interaction in a Group: In each example there are at least two players and each player s payo from the game depends not only on her own action but also on the other players actions. However, the presence of multiple players in a problem does not make it a game. Consider the situation of going to a restaurant with a group of friends. If everybody orders and pays for their own food, this is just a collection of decision problems. If, however, the bill is split evenly within the group, the decisions become interactive and we can use game theory to study the situation. Rational, strategic Agents: Players are assumed to have well-dened payos over the outcomes of the game and try to secure themselves the highest payo. In choosing one s own action a player tries to guess the other players actions and choose an action that secures herself a high payo given this guess. This implicitly assumes that players understand the game and know that the others also understand the game. Tool to analyze: Game theory cannot tell us whether it is a good idea for president Obama to allow insurances to discriminate based on pre-existing conditions, or for a father to let his daughter have her doll. Rather, game theory provides us with a rigorous language to analyze the strategic considerations faced by these people. If our game-theoretic models are su ciently close to the real situation that is being modeled, our game-theoretic results can be useful in both positively, by predicting how people will act, and normatively, by indicating how we can improve our actions. 3

(Brief) History of Game Theory

1838 Cournot analyzed oligopolistic quantity competition applying a version of Nash Equilibrium 1944 John von Neumann and Oskar Morgenstern: Theory of Games and Economic Behaviorfocused on two-player zero-sum games 1950 John Nash develops the Nash equilibrium 1970s - present: Application of game theoretic concepts to various areas of economics 1994 Nobel prize to Nash, Harsanyi, Selten 2005 Nobel prize to Aumann and Schelling 2007 Nobel prize to Hurwicz, Maskin and Myerson 2012 Nobel prize to Roth and Shapley

Economic Applications
Game theory has pervasive implications in several areas of economics Industrial Organization: Price setting; Quantity setting; Product Choice; Entry into an Industry; Exit from an Industry Trade: Setting of Taris and Quotas Labor: Eort choice of worker; Promotion tournaments Public Finance: Tragedy of the commons Political Economy: Choice of optimal election platform

PrisonersDilemma
Two prisoners are charged of a serious crime. If they both C ooperate and do not confess, they will be released after one year of investigation. If they both D efect and confess, they will both be sent to prison for three years. If only one of them D efects but the other one C ooperates, the defector gets out of prison for free, while the cooperator receives a sentence of ve years. Every prisoner wants to mimize her own time in prison.

2 1 C D C 1, 1 0 , 5
4

D 5, 0 3, 3

In a variation of the PrisonersDilemma, prisoner 2 is scrupulous and prefers to cooperate with prisoner 1, as long as 1 cooperates as well. Thus the payo matrix is given by

2 1 C D
Think about for next class: Would you cooperate or defect in the prisonersdilemma? Would you cooperate or defect in the variation of the prisonersdilemma if you were prisoner 1? If you were prisoner 2?

C 1, 1 0 , 5

D 5, 2 3, 3

Fiscal Cliff
1

Accept

S
0

H
x 1 Accept

Reject

H
0

S
y Reject 1 Accept

S
0

S
x Reject

Pre-Existing Health Conditions 1

Blue Cross
High Medium

Prof.

buy no buy no buy no

Low

Pre-Existing Health Conditions 2

Chance

Blue Cross
High Medium

Prof.

buy no buy no buy no buy

Healthy

Low

High Sick Medium Low

no buy no buy no

Pre-Existing Health Conditions 3

Chance

Blue Cross
High Medium

Prof.

buy no buy no buy no buy

Healthy

Low

High Sick Medium Low

no buy no buy no

Crying it out
concede

concede

F
cry cry

concede

F
cry Hold out accept

F G
accept Hold out

G
accept

Hold out