Lady Shri Ram College for Women, New Delhi

To Comply Or To
Defy
A game theory model analyzing the present Greek crisis

Nidhi Mardi
2/1/2015
SECTION A: A BRIEF HISTORY OF THE GREEK CRISIS

Most of Europes history bears testimony to numerous wars. The countries at war tend to do less
or no business with each other, making Europe a continent of trade barriers and stifled economic
growth. It was only after the catastrophic aftermath of World War II that the need of unifying
Europe, in order to bring about stable economic growth was felt.

The Maastricht Treaty and Formation of European Union:

In order to realize this dream of an integrated Europe, the Maastricht Treaty was signed on 7th
February, 1992 by 27 European countries, forming the European Union. Member nations of the
European Union could practice hassle free trade. However, the only problem which persisted
was that of different currencies. This too was resolved by the treaty. The main highlights of the
Maastricht treaty are:-
a) Adoption of a common currency i.e. Euro, by the member nations. Any country in the EU
should not have its inflation higher than 1.5 percentage points of the average of the inflation
rates of three best performing EU countries. The ratio of annual government deficit to
GDP must not be more than 3% at the beginning of a fiscal year.
b) The ratio of government debt to GDP must not exceed 60% at the end of the fiscal year. The
nominal long-term interest rate must not be higher than 2 percentage points from that of three
best performing nations in order to maintain price stability within the Euro zone if and when
new members join.

The Crisis:

Recently, some Euro zone countries-Italy, Greece, Spain, Portugal and Ireland have failed to
comply with the terms of the treaty, their debt to GDP ratio being much more than 60%. The
inability of these countries to repay or refinance their debt has led to what is called the European
Sovereign Debt Crisis.

Countries adopting the Euro not only discontinued their native currencies but also their monetary
policies allowing European Central Bank to take charge. But they still had different fiscal
policies- a key reason behind the debt crisis. Before the Euro, Greece had to pay a high interest
rate of 18% to borrow money. The figure came down to 3% after it adopted the Euro. Lenders
now started to believe that if Greece defaults on its loans, Germany would step in for its rescue
as both share a common currency. Humongous credit now enabled Greece and other countries to
borrow more thereby increasing their deficit spending. Countries continued to accumulate dept
and repay it with borrowed money. But, this continued only till the time when credit was
available, i.e till 2008. After the Great Recession, due to unavailability of credit the Greek
economy found it difficult to function. It now looked up to Germany for credit which reluctantly
agreed for a bailout provided that Greece adopted strict austerity measures. But there was no
system in place to prevent this from happening again posing a great threat to the stability of the
Euro.
SECTION B: THE CURRENT SITUATION- AN INTRODUCTION TO
THE GAME

To understand the ongoing global financial crisis, politics of the euro needs to be looked at, and
it is necessary to look at its causes. In 1981, Greece became a part of the prestigious European
Union and adopted the Euro in 2001, thereby replacing the drachma, two years after the
Eurozone was created. Critics questioned whether the inclusion of a weaker member will affect
the euro project. It became apparent in 2004, when the Greek government admitted that it was
never eligible to join the Eurozone as the Greek budget deficit had never been below 3% since
1999, as the EU rules demanded.

Through 2004 to 2015, Greece applied several austerity measures to recover from its impending
deficit. In 2009, George Papandreou became the prime minister and he admitted that the Greek
economy was in intensive care, as European finance ministers expressed their concerns about the
size of the country's debt. Over the years, Greeces credit rating declined and debt mounted. This
disrupted the political situation of the country as harsh measures leads to violent clashes in
Athens.

The Present Scenario:

The year started with the Greek National Elections. Syriza headed by Alexis Tsipras won by a
clear majority as a result of the years of harsh austerity measures demanded by the EU and the
IMF after the country's economy were given a 240 billion-euro bailout ($269 billion) in the
fallout of the global financial crisis. According to its campaigning promises, Syriza promises to
put an end to all austerity measures and the new prime minister had even threatened to leave the
Eurozone altogether, which could pose as a catastrophic problem for the EU.

On 18th February 2015, Greek officials declared that they would be applying for an extension of
four months to the bailout program. On 20th February 2015, Greece finally came to a conclusion
and decided to step back from its disorderly Eurozone exit and has listed a number of economic
reforms that it plans to implement in the upcoming months. If the three institutions overseeing
the bailout the European Commission, the European Central Bank and the International
Monetary Fund are satisfied after an initial view, Eurozone member states will ratify the
extension.

Germany on the other hand is not convinced with Greeces strategies and believes that this crisis
is all about profligacy and Greece set the tone when it lied about its circumstances and lived
beyond its means. Even though, other euro zone members decided to write down half of the
Greek debt owned by private sector, recapitalize Europe's banks and boost the fund created as a
firewall to protect solvent euro-zone governments, Germany was less accommodating and
Greece is headed towards a potentially destructive standoff with Europe after Germany rejected a
last-minute request on Thursday to extend its loan program. Germany has rejected Greeces
bailout request on the basis of the semantic difference between a program extension and a loan
extension.

Impact of such strategies and the debt crisis on the Global economy:

The credibility of Greece is constantly being questioned and it is still facing a dilemma on how
to overcome a staggering debt of several billion Euros.

One formidable scenario is of Greece exiting the Eurozone, popularly known as the Grexit. If its
bailout program is not extended, Greece will not be left with enough options and the chances of
the exit will increase. Now why is that such a huge problem? First of all, and most crucially the
value of the Euro which has already declined immensely is doomed to fall, especially in the first
year. Greece is also likely to fall into a recession if it pulls out. The Eurozone is a political as
well as an economic phenomenon and a possible Greek exit will have immensely negative
consequences for its image and will definitely hamper its trade and credibility relations with
other countries.

The Greek Finance Ministers stance, apart from being controversial is proving to be problematic
as well and calling his German counterpart a Nazi only worsens the situation. Wolfgang
Schaeuble, the German Finance Minister on the other hand is against any kind of sympathy
towards Greece as he was heard telling broadcaster ZDF: Its not about extending a credit
program but about whether this bailout program will be fulfilled, yes or no.
SECTION C: BUILDING THE GAME: A BRIEF INTRODUCTION

Based on our understanding of the above situation, we develop a two player sequential game, in
order to analyze the various potential strategies that can be followed by Greece and Germany,
keeping in mind the present course of negotiation. Greece and Germany will be our two players
under this model. Our analysis reveals that The Game of Chicken, also known as the Hawk-
dove game can be best applied in this situation.

The game of chicken basically explains and models two drivers, headed for a single lane bridge
from opposite directions. In such a scenario, one player must yield and change his direction to
dodge collision. However if none of the drivers swerve, then the worst case scenario occurs, in
which case a crash occurs. On the other hand the best thing for each driver is to stay straight
while the other driver swerves (since the other driver then becomes a chicken and a potential
crash is also avoided).

While the Tsipras led Greek government under Finance Minister Yanis Varoufakis is stubbornly
perpetrating its demand for no austerity coupled with bailout relief, the finance minister of
Germany Wolfgang Schauble is not ready to negotiate even a dollar relief in the looming large
bailout due on February 28th 2015. Clearly in a game of chicken, stubbornness leads to a
catastrophe. Therefore, looking at the current round of negotiations as of 20th February, 2015, the
two countries have not arrived at a reasonable agreement. While Germany is adamant to recover
every penny of its bailout package, Greece is looking for support from Russia and China. Our
analysis reveals that the phenomenon of Madmans Diplomacy is at play here.

Madmans Diplomacy: Madmans Diplomacy is a course of strategy in game theory model

where the two players play completely irrationally, thereby not only minimizing the other players
payoffs, but also diminishing their own payoffs. Economist Paul Krugman defines Madmans
Diplomacy as a situation where a man is putting a trigger on his head, threatening to shoot if his
demands are not met. Game theorists commonly use this to analyse North Korean Leader Kim
Jong-Uns strategies.

We feel that the strategy of Madmans Diplomacy fully explains the current situation due to
three primary reasons:-

1) It can be reasonably concluded that the possibility of a Grexit would devastate not only
Germany and entire Eurozone, but also Greece itself. For Greece, this decision would
cause collapse of its own banking system, exponential increase in import prices and
complete disappearance of any prospects of growth. For Eurozone, this would be the
collapse of their entire irrevocable currency system. Germany will be a primary loser as
 it will lose billions of dollars from a Greek devaluation and risk its recent prosperity.
Hence this strategy is clearly harmful for all parties.
2) However one cannot ignore that the Greek demands for easing of structural reforms and
debt reduction is a reasonable negotiation. The country cannot progress without shifting
to a neutral fiscal stance as the current debt will burden Greek markets for a long time to
come. At the same time the bailout money has not really impacted the Greek population.
3) At the same time Germanys demands are not entirely unreasonable as Greece needs to
continue with some of its reform efforts, both in the sphere of tax as well as its current
reforms in labor market to prevent excessive wage inflation and thereby harm the
exchange rate.

In our game we will analyze this situation by taking Greece as Player 1 in a sequential game and
Germany as Player 2. We analyze how Germany will potentially respond conditional on
Greeces decision. We thereby propose to solve this game through Backward Induction. We
however begin the analysis by explaining our methodology of analysis.

SECTION D: INTRODUCTION TO METHDOLOGY

In are analyses we first begin by developing a Cobb Douglas function to analyse the payoffs
associated with both Greece and Germany in all the strategies under our sequential game. We
chose a Cobb Douglas Function after we identified the four primary factors that determine the
payoffs of the two players, i.e. Greece and Germany, under various strategies. The Cobb Douglas
function helped us weigh and rank the four primary determinants on the basis of their influence
on the decision of each of the two countries. Therefore, the higher the weightage of a particular
factor, the higher is its influence over the political decision of the country. The weights that have
been assigned are 0.1, 0.2, 0.3 and 0.4.

The variables are as follows:

a: Financial markets and exchange rate
b: Political stability
c: Credit rating
d: Lower dependence upon foreign credit

Following are the payoff equations of the two countries along with a brief summary justifying
our choice:

Greece

d = Financial Markets and Exchange Rate

 Justification
If Greece chooses to deny austerity, thereby moving towards a Grexit, the international value of
the new Greek currency would inevitably be much lower than the euro. This will have both
positive as well as negative impacts.

Negative effects:
1) Instant drop in living standards for Greeks
2) Import prices would spike
3) Cost of foreign debts would rise which would make Greece worse off as they would have to pay
back in Euros. Thereby also affecting businesses negatively.
4) Regular citizens would empty their bank accounts before they converted into a new currency
worth less than the previous one. The government may impose a freeze on withdrawal out of fear
of a collapse of the banking system.
5) The Greek financial markets would crash as there would be a capital flight out of Greece initially
as people would seek to offload the new Greek currency, expecting that it would promptly be
devalued.

Positive effects:
1) Greek exports would become more competitive in international markets.
2) Greek tourist industry would be likely to get an immediate boost.
3) A devalued currency many forecast an initial drop by at least 50% and much reduced public
and private sector debt after a general default could put Greece in a good starting position for a
dynamic recovery.
4) As imports would become much more expensive, they might soon be substituted with
domestically produced alternatives, broadening the manufacturing base and boosting
employment.
5) As Greece could save the 4% of GDP it is currently spending on interest on its public debt, it
could redirect the money into public investment and education, building the foundations for
stronger productivity growth.

In the very current line of events, even the news of economic reforms to be proposed by Greece
of being slightly optimistic, i.e. a general pledge to stick with state asset sales, along with a
clampdown on tax evasion lead to the FTSE 100 index of leading blue-chip shares to hit its
highest level in 15 years, sending the FTSE up by 0.4% at the start of trading, to 6943 points.
Thus this is the very extent to which financial markets can be affected by the slightest news by
the Greek Government and hence has enormous powers to further affect the Governments
decision. Thus, since this factor has a colossal impact on decision making taking the economy as
a whole into consideration we have assigned the highest weight to the same.

c = Political Stability
The new Greek government has primarily come into power promising to ensure relief from the
punitive and counter-productive austerity imposed on it. Thus, this factor will also affect
decision making to a great extent and thereby sway Greeces decision towards denying austerity.

Greece faced a tax evasion percentage of 69.7% in 2010 at a personal tax rate of 49% and
corporate tax rate of 24%. This clearly shows the dissent amongst people and why they would
oppose further austerity measures. A further rise in tax rates would lead to a further increase in
tax evasion. Thus, this would form the basis of our second-most dominant factor, after financial
markets. We have assigned a lower weight to this factor than financial markets since the Greek
Government has undertaken a decision in favour of the stock market rather than the tax payers as
in case of the scenario mentioned above.

b = Credit Rating
Denying austerity and a further default would result in very poor credit ratings for Greece. This
would result in the price of bonds to fall while their interest rates, which respond inversely to
bond prices, would rise. Higher interest rates translate to higher borrowing costs and less capital
investment. This would also cause a further decline in stock markets.

a = Lower dependence upon foreign credit

Since, Greece also depends a lot upon foreign aid we conclude by lower dependence or lack of
dependence to be the fourth and final factor in affecting Greeces decision.

Both factors b and a represent Greeces relation with other countries and investors in other
countries, hence we have assigned them a rank lower than the other two factors. This is because
Greece is going through a huge internal turmoil and surely the government would first focus on
its internal situation (especially since this was why they were voted in) rather than the external
situation before arriving at any decision. Also, the factors d and c would have tremendous
external impacts too and will form a base in affecting the credit rating and investor sentiment.
Thus, primarily for these two reasons a and b have been assigned lower weights. Also, since
credit ratings also affect the stock market of the country, we have assigned a higher weight to the
same as compared to less dependence on foreign aid.

Hence, the function for Greece will be as follows: a0.1b0.2c0.3d0.4

Germany

d = Financial Markets
An impending market crash, withdrawal of money by investors from the Eurozone, etc could
highly affect Germanys decision as to comply or deny austerity.
 Clearly the effects of the financial markets pose the highest threat to Germany as compared to
the three other factors, thus, we have assigned the highest weight to the same.

c = Political stability
There could be wide dissent amongst the Germans, if the German government were to deny
austerity measures in Greece and accept a Greek loan reduction, as this would mean the cost of
the debt would fall upon the tax payers.

The political situation of the country would then come in 2nd for Germany after financial markets
as was the case with Greece.

b = Credit Rating
Credit ratings of Germany would remain strong as ever thereby not having a considerable effect
upon their decision making, and hence have been assigned the lowest weight.

a = Lower dependence upon foreign credit

Since Germany does not depend much on foreign aid, this would be a factor which does not
affect its decision much and hence is ranked 3rd.

The reason for a and b being assigned lower ranks than factors c and d remains the same
for Germany as was for Greece. However lower dependence on aid has been assigned a higher
weight than credit rating as it will have some effect on Germanys decision as compared to the
credit rating which will not be affected by the decisions at all.

Thus, the German function will differ slightly and will be as follows: a0.2b0.1c 0.3d0.4

Therefore, to summarize the game theory model:

Players: Germany and Greece
Actions: Comply and Deny

The game seeks to study the actions of the players with reference to compliance with or defiance of
the austerity measures that Greece is currently subject to. The methodology is highlighted below.
SECTION D: METHDOLOGY OF CALCULATING THE VARIABLES

Variable 1: Financial Markets

Financial market variable is crucial in our analysis since financial markets broadly comprise of
financial and lending institutions as well as the stock market. We have incorporated in this
analysis the potential impact on exchange rates on each of the alternate strategies. Hence for our
purposes we have analyzed the trends and fluctuations in Germanys Deutche Borse Dox Index
and British FTSE 100 over a period of the past 5 years to understand its trends and fluctuations.
At the same time we have also based our subjective analyses based on the predictions of Heritage
indicators. Heritage indicator portal is an online platform for prediction of stock market indices
under alternative political stands and repercussions. The methodology of their calculations is an
elegant equation that takes into consideration all the other factors leading to stock market
fluctuations along with alternative political strategies.

To summarize:
Strategy Germany Greece
Comply|Defy 91.11 33.37
Defy|Defy 160.67 48.70
Defy|Comply 111.11 28.87
Comply|Comply 144 52.4

Variable 2: Political Stability

In order to measure political stability, we have devised our own index based on our analysis and
data derived from Viewshare. Our political stability index is a qualitative index comprising of
five sub-components. Each of these sub-categories are allotted weights ranging from 0-2, 0 being
highly unstable, 1 being moderate and 2 indicating reasonable stability. These ranks are allotted
based on our own subjective analysis and judgment of the potential impact a particular strategy
will have on the stated sub-category. We have then scaled down these ranks to make calculations
easier. Following are the five aforementioned sub-categories:

1) Government Profile: This variable is primarily indicative of the public sentiment that will
be witnessed after a particular strategy is chosen. Many economists have pointed out that the
election manifesto of Tsipras government had played with Greek sentiments by promising
them a better financial future. Hence with the Greek hopes high, Tsipras must live upto their
expectations and fulfill the promises he made. At the same time German governments public
 image is also at stake here, wherein German public sentiment is not in favor of negotiation in
the current scenario.
2) Investor Sentiment: The decision will definitely impact the investor sentiment where a
Grexit could trigger a complete collapse of Greek import and banking system. At the same
time a weakening and collapse of Euro could completely shatter Germanys dream of being a
superpower.
3) Foreign Relation: It is crucial for both the economies to maintain congenial international
relations. In such a scenario madmans diplomacy will surely not work in their favor.
4) Political Motivated Aggression: We are predicting that mass unrest would be triggered in
both the economics due to potential strategies and their impact on tax as well as labor market
policies. Hence this is a crucial component determining political stability.
5) Quality of Life: The chance of Greece getting freedom from structural reforms will have
substantial impact on labor market and may generate employment and improve the standard
of living. Secondly the possibility of a Grexit will lead to losses of billions worth debt to
Germany, thereby triggering another Eurozone Crisis.

Comply|Comply Defy|Defy Defy|Comply Comply|Defy

Government 0,2 2,1 0,1 0,0
Profile
Investor 1,1 2,1 1,0 0,0
Sentiment
Foreign 2,2 1,1 0,1 0,0
Relations
Politically 0,2 1,1 0,0 0,0
Motivated
Aggression
Quality of Life 0,2 0,1 1,1 0,0
Total 3,9 6,5 2,3 0,0

To summarize:

Strategy Germany Greece

Comply|Defy 0 0
Defy|Defy 6 5
Defy|Comply 2 3
Comply|Comply 3 9

Variable 3: Credit Rating of the country

We have used Standard & Poor's credit ratings of the two countries in order to account for the
two cases of comply and deny. The present ratings are as follows:
Germany: AAA
Greece: B-

Now, in all, there are 21 categories of ratings. Thus on the basis of this, we can plot an Ogive
curve with 'D' status being allotted a 0. This breaks up our data sets into 20 parts with the highest
ranking being 'AAA' which will be allotted a 100 percentile. For the list of all ratings, please
refer to Table 1 in the Appendix.

Therefore, given the present ratings:

Germany: 100 percentile
Greece: 30 percentile (Since C,CC,CCC-,CCC,CCC+ lie below it)

A Reuters article titled 'Germany holds up Greek bid for euro zone loan extension' stated that
''Credit ratings agency Standard & Poor's said a Greek exit would be less financially risky for the
remaining euro zone members than it would have been during the last scare in 2012''.

This implies that irrespective of whatever Greece chooses, Germany's credit rating shall
remain unaffected at AAA due to its stable economic conditions, thrifty approach towards
credit accumulation and its ability to withstand shocks.

On the other hand, Greece's rating shall vary on the basis of the situation. S&P in a statement
mentioned that they would reduce Greece to a junk status ('D') if the Greek economy was to
leave the Eurozone due to limited cash buffers, failure of banking system and failure to arrive
upon an agreement with the Eurozone countries. The effects can be summarized in the following
cases:

1) Greece chooses to 'Defy' when Germany chooses to 'Comply'

The Greek economy is then bound to face another degradation, as S&P in a Reuters article titled
'S&P downgrades Greece, warns time limited for a deal with creditors' mentioned that a
consequence of the same in the long term would be removal from the Eurozone. So, assuming a
degradation to CCC (this is the minimal possible degradation), the rating falls to a 20 percentile.

2) Greece chooses to 'Defy' when Germany also chooses to 'Defy'

The world at large shall see a unified Euro front, meaning that Germany will assist Greece in
reducing its debt burden. However, even though this may increase the cash buffers, it won't
resolve the debt crisis, thereby implying that S&P will leave the credit rating unchanged and
shall wait to see whether or not the Greek economy is able to benefit from the truce.

3) Greece chooses to 'Comply' when Germany chooses to 'Defy'

The world economy and rating agencies will be surprised if such a situation arose. In such a
situation, it will be implied that Germany will refuse to assist Greece in following its austerity
measures. Though this may help the economy in the long run, the lack of cash buffers will persist
and thereby the Greek economy shall face a slight degradation to CCC, making the rating fall to
25 percentile.
4) Greece chooses to 'Comply' when Germany chooses to 'Comply'
This shall improve the Greek credit rating as it is reinforce Greece's participation in the Eurozone
and shall also incentivize donors to help the Greek economy in its recovery. However, the
increase in credibility will not be very large and Greece will only be upgraded to 'B' which is 35
percentile.

Thus, the results can be summarized as shown in the following table:

Strategy Germany Greece

Comply|Defy 1 0.2
Defy|Defy 1 0.3
Defy|Comply 1 0.25
Comply|Comply 1 0.35

Variable 4: Lower dependence upon foreign credit

In order to study the effect of each action on both countries, we have looked at the public debt to
GDP ratio and thereby forecasted any future changes in the same on the basis of the actions of
the two players.

As of now, the public debt to GDP ratio as per the CIA world factbook estimates for 2014 are as
follows:
Germany: 79.97%
Greece: 174.9%

Now to assign a higher absolute number to a country with a lower debt, we have taken 100%
public debt to GDP ratio as the basis from which we shall calculate the deviation of that
particular country's actual debt. The deviation shall be added to hundred in case the ratio is lower
than 100% and shall be subtracted from hundred if the ratio is higher than 100% so as to reinstate
that a lower dependence on foreign credit will be better for the country. The base of 100% has
been taken on the basis of the paper titled 'The impact of high government debt on its economic
growth and its channels: An empirical investigation for the euro area' which concludes that at
around a 90-100% public debt to GDP ratio the negative impacts of the high debt can start to be
experienced by the economy. Thus at 100% public debt to GDP ratio the inverted-U curve
experiences its turning point since a ratio of 100% implies that the country's debt is equal to its
GDP.

The Deutsche Bank report titled 'Public Debt in 2020' forecasted that German public debt to
GDP ratio will be approximately 100%. This can be forecasted to be the same for all the
strategies (unless specified otherwise) since Greece's compliance or denial will not affect the
debt of Germany, since the German debt ratio is relatively stable and generally the German
government is the donor rather than the lender and Germany will avoid future lending to Greece
irrespective of the final stance taken by Greece. Let us forecast the numbers in the following
cases:

1) Greece chooses to 'Defy' when Germany chooses to 'Comply'

To describe such a case, we have referred to the paper titled 'The Long Haul: Debt Sustainabilit y
Analysis'. It has been mentioned in the article that if Greece chooses to defy then it can probably
take an ESM loan in order to pay back its IMF loan, without being subject to the austerity
measures that are being proposed. In such a scenario, by 2020 the Greek debt will reduce by
121% of GDP. Thus, the value for Greece will be 0.79.

2) Greece chooses to 'Defy' when Germany also chooses to 'Defy'

This is the scenario where Germany agrees with the measures proposed by the Greek
government as against the austerity measures that were supposed to be implemented. In such a
scenario the paper titled 'The Greek Sisyphus and its public debt: towards an end to the ordeal' by
Sciences Po estimates that the Greek public debt will fall to 128% of the GDP. Thus the value
for Greece will be 0.72.

3) Greece chooses to 'Comply' when Germany chooses to 'Defy'

In the Brookings article titled 'Breaking the Greek Debt Impasse' it is discussed that if such a
situation was to arise, the Greek debt is expected to fall to 90% of the GDP by the end of the year
2020 as fiscal consolidation plan will only benefit the Greek economy irrespective of the German
stance, making the number that is to be entered in the formula to be equal to 1.1.

4) Greece chooses to 'Comply' when Germany chooses to 'Comply'

This is a situation that most world markets were predicting preceding the January 30th 2015
elections in Greece. Hence, a Deutsche Bank report titled 'Public Debt in 2020' helps to calculate
the public debt values of the same. The report predicts that by 2020, Greece will face a public
debt to GDP of 175%, which is equal to 0.25 when adjusted to our computational techniques. In
such a situation, the Brookings article titled 'Breaking the Greek Debt Impasse' predicts that the
German public debt to GDP ratio will fall to around 60% by 2020, making it 1.4 as per our
calculations.

To summarize:

Strategy Germany Greece

Comply|Defy 1 0.79
Defy|Defy 1 0.72
Defy|Comply 1 1.1
Comply|Comply 1.4 0.25
 SECTION E: SOLVING THE GAME

The following assumptions have been made while making the game theory model:

Other players likes EU countries, Russia, China, US are being ignored.

We're ignoring Troika's stand on the same.
Political pressure put by other countries is being ignored.

The expected payoffs of each strategy for each player are as follows:

Case 1: Comply|Defy
Germany: 10.110.200.391.110.4 = 0
Greece: 0.790.10.20.200.333.370.4 = 0

Case 2: Defy|Defy
Germany: 0.720.10.30.260.3160.670.4 = 9.9306
Greece: 10.110.250.348.700.4 = 7.6683

Case 3: Defy|Comply
Germany: 10.110.220.3111.110.4 = 8.1023
Greece: 1.10.10.250.230.328.870.4 = 4.0835

Case 4: Comply|Comply
Germany: 10.11.40.230.31440.4 = 10.8569
Greece: 0.250.10.350.290.352.40.4 = 6.6468

Normal Form of the sequential game:

The normal form of the game can be summarized through the following table:

Germany
Comply | Comply Comply | Comply Defy | Comply Defy | Comply
Comply | Defy Defy | Defy Comply | Defy Defy | Defy
Greece Comply 6.6,10.9 6.6,10.9 4.1, 8.1 4.1, 8.1
Defy 0,0 7.7, 9.9 0,0 7.7, 9.9

The cases described above are as follows:

Germany will choose to comply irrespective of the choice that Greece makes.
Germany will follow Greece and adhere to whatever stance that Greece takes.
Germany will take a stance that is opposite of Greece.
 Germany will choose to Defy irrespective of the choice that Greece makes.

In the normal form, we have highlighted the first players higher payoff in red and the second
players higher payoff in blue.

Solving for Nash equilibrium, we get three Nash equilibria, which are as follows:
1. Greece plays Comply, Germany plays (Comply|Comply, Comply|Defy);
2. Greece plays Defy, Germany plays (Comply|Comply, Defy|Defy);
3. Greece plays Defy, Germany plays (Defy|Comply, Defy|Defy).

Considering the first strategy where Germany chooses to comply regardless of Greeces stand
with regards to austerity measures cannot be a credible Nash Equilibrium because Germany will
take the stand of not cooperating with Greece under any situation. Basically this situation can be
summarized with the following dialogue:

Germany to Greece: No matter what you do we will continue to have the Nazi mentality
your Varoufakis accuses us of!

This clearly is an empty threat because if Germany takes this stand it will clearly receive
international criticism. If Germany is rational in its approach to the game, it must choose a
strategy where it is in agreement with Greece, otherwise no country will benefit without mutual
agreement.

Now considering the third strategy where Germany chooses to defy regardless of Greecess stand
with regards to austerity measures cannot be a credible Nash Equilibrium either because
Germany will not only take the stand of not cooperating with Greece, but it will also choose a
strategy which the country is strictly not in favor of currently. Clearly this will trigger mass
unrest in the German economy as the countrys choice is not in lines with the idea of peoples
welfare. This can be summarized in the following dialogue:

Germany to Greece: Hey Tsipras! Since you cant do it, let me implement your manifesto
and save you from your own people.

Clearly Germany is behaving in a rather suspiciously cooperative manner which will worsen
their own best interests. Hence this is not a credible choice as it is an empty threat.

Thus through this analogy one can reasonably conclude that the only rational move for Germany
will be to follow the stand taken by Greece as it would leave both the parties better off and shall
obtain the highest payoff. Hence the Nash Equlibrium is (Defy, (Comply|Comply,
Defy|Defy)).
Extensive form of the game:

This data can be represented in the form of the following tree diagram:

6.6,10.9

Key:
4.1, 8.1
Subgame 1

Subgame 2

0,0

7.7,9.9

The entire extensive form of the game accounts for subgame 3.

Solving the game through backward induction:

Let us refer to the extensive form above in order to solve the game through backward induction
which is a technique to solve for subgame perfect Nash equilibrium by working from the end of
the game to the beginning.

Analyzing subgame 1:

Conditional on Greeces decision to Comply, the payoff for Germany of 10.9 is greater than the
choice of 8.1. Therefore, Germany will choose to Comply.

Analyzing subgame 2:

Conditional on Greeces decision to Defy the payoff for Germany of 9.9 is greater than the
choice of 0. Therefore, Germany will choose to Defy.

Analyzing subgame 3:
On the basis of the analysis of the above two games, we come up with the following diagram:

2 plays
Comply|Comply
6.6,10.9

2 plays
Defy|Defy
7.7,9.9

Now, the decision will be made by player 1, i.e. Greece. Greece obtains a higher payoff of 7.7 as
compared to 6.6, if it chooses to Defy.

Hence, the subgame perfect Nash equilibrium comes out to be (Defy, Defy|Defy) which yields
the payoff of (7.7,9.9).
SECTION F: REFERENCES

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APPENDIX:

Table 1: Standard and Poors rating Indices

Source: Standard and Poors