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C H A P T E R

2
Tools I: An Introduction
to Game Theory
In football, everything is complicated by the presence of the opposite team. (French original: Au football,
tout est complique par la presence de lequipe adverse.)1

O U T L I N E

2.1 Introduction 25 2.5.3 Nash Equilibria 31


2.2 Understanding a Strategic Game 26 2.6 How Many Games Can
We Play? 31
2.3 The Invisible Hand and the Fallacy
of Aggregation Again 27 2.7 Summary 31
2.4 How Not to Play a Game 29 Chapter References 32
2.4.1 Pareto Dominance 29
Further Reading 32
Pareto Optimality and Suboptimality 29
Further ReadingOnline 32
2.5 How to Play a Game 29
2.5.1 Dominance 29 Exercises 32
2.5.2 Best Answers 30

2.1 INTRODUCTION order to let person B passhowever, so will


person B, in her case to let person A pass.
We all know the following situation: Person It only takes a moment for the both of them
A is about to enter a building through a nar- to realize that the other person is trying to let
row doorway when person B attempts to leave them pass, A realizes that B stepped aside;
through the same exit. Trying to show good B realizes that A is waiting for her to pass.
manners, person A will politely step aside in So they will again enter the doorway at the
same time only to find that this attempt to
1
Attributed to Jean-Paul Sartre. coordinate has also failed.

The Microeconomics of Complex Economies.


DOI: http://dx.doi.org/10.1016/B978-0-12-411585-9.00002-6 25 2015 Elsevier Inc. All rights reserved.
26 2. TOOLS I: AN INTRODUCTION TO GAME THEORY

We are faced with a situation that seems to reveals a whole new layer in the social system
be both simple, almost trivial, and difficult to that is investigatedthe layer of strategies and
resolve, thus complex. There are only two indi- their consequences. This chapter will give
viduals involved (A and B), they can choose a basic introduction to the modeling with stra-
between only two options (to wait or to enter tegic games, an introduction to game theory.
the doorway), their objective is the same: to More formal concepts and advanced methods
resolve the situation and pass the doorway will be discussed in Chapter 8.
either A first or B firstit does not even mat-
ter who passes first.
When faced with the situation it may seem
like a game: choose a strategy and hope for 2.2 UNDERSTANDING
some luck. Depending on what the other per- A STRATEGIC GAME
son does you win (i.e., you are able to pass) or
you lose. And this idea is not at all wrong. To distinguish our model games from the
Many interactive situations, in fact, most of the common sense term for recreational games,
social sphere may be conceptualized as one in we may specify our models as strategic games.
a family of strategic games, each with its own A strategic game is characterized by a set of
rules. There are games in which the players participants, a set of behavior options for each of
share a common objective like in the present the participants, and a set of rules as well as the
example and games where they try to exploit information available to each of the participants.
each other. There are games that offer an obvi- The participants in a strategic game are com-
ous best choice option to all those involved monly called agents; the options among which
and games where the resolution is tricky and an agent chooses are referred to as her strategies.
full of uncertainty (like in the present case). There are many possible forms of games;
There are games with only two agents and some of the more prominent ones, including
only two options per agent and those with mil- repeated games and sequential games, will be
lions and millions of participants and an infi- explained in Chapter 8. One form, however,
nite continuum of possible strategies. There is as universally applicable and powerful as
are games which may be played repeatedly a model as it is simple and easy to use as
and games that only offer one single try. a theoretical concept: simultaneous 2-person
It is obvious that in an interactive world, it 2-strategy normal-form games. Common to this
is always a simplification to reduce a social sit- group of strategic games is that the game
uation to one game. The game can merely be a involves two agents each of which chooses
model; it is a way to analyze the structure that between only two strategies and the choices are
lies beneath the social interaction, its possibili- to be made simultaneously without any possi-
ties and opportunities, the development paths bility for collusion between the two agents.
of the interaction, less likely and more likely
outcomes. A word of warning should not be Player B
foregone: Oversimplification results in inaccu- Pass Wait
rate models; assuming a strategic game as a 0 1
Pass
model (or as part of a model) implies a num- 0 1
Player A
ber of other assumptions (such as rational Wait
1 0
decision making) that are not always justified. 1 0
The skilled and careful use of strategic games FIGURE 2.1 Anti-coordination game; payoffs of the
in models of social interactions, however, row player (A) highlighted in bold face.

I. BASICS OF THE INTERDEPENDENT ECONOMY AND ITS PROCESSES


2.3 THE INVISIBLE HAND AND THE FALLACY OF AGGREGATION AGAIN 27

BOX 2.1

ORDINAL AND CARDINAL UTILITY


In game theory, utility is commonly given as choices of the other players) preferred to another
a cardinal measure, i.e., specific (quantified) pay- option B, if instead B is preferred to A or if the
offs are stated and payoff and utility variables agent is indifferent between the two as long as
are treated as standing for exact quantities. this preference order is consistent. This is known
This, however, is not required for normal-form as ordinal utility measure. For details on theoret-
games in pure strategies. It would be sufficient ical requirements for game-theoretic preference
to be decidable if one option A is (given the functions see Chapter 8.

The game introduced in Figure 2.1 is a 2.3 THE INVISIBLE HAND AND
member of this group. We can write it as THE FALLACY OF AGGREGATION
shown in Figure 2.1. The strategies of player A AGAIN
are given in the rows, those of player B in the
columns; for 2 3 2 strategies there are four pos- In Chapter 1, we introduced two general
sible outcomes for which the payoffs of both concepts of economic modeling, the invisible
players are given (see Box 2.1 for details on the hand and the fallacy of aggregation. Both tell
concepts utility and payoff in game theory). illustrative stories of the direct interaction of
Payoffs of the row player (A) are given in the rational agents. The invisible hand describes a
lower left (bold), those of the column player situation where every agent chooses the
(B) are given in the upper right of the respec- socially optimal option out of her incentive to
tive field. This matrix notation is commonly maximize individually. Say, every agent has
used to write strategic games. an option to contribute (costs: 1) or not to con-
The view obtained from writing the game in tribute (zero cost) to a public good and
matrix notation (Figure 2.1) is the following: receives three times her own contribution (ben-
As said, both agents try to pass through the door, efit: 2 or 0 respectively) and twice the contribu-
one first, then the other. There are two solutions tion of the other player(s) (2 or 0 respectively);
that allow to accomplish this end: A waits and B see Figure 2.2.
passes or B waits and A passes. There are also The concept of optimality in interactive
two less fortunate outcomes namely one where situations, specifically the Pareto optimum, has
both agents attempt to pass and another one been introduced in Chapter 1. It is easy to see
with both agents waiting for the other one to that the game will arrive at the socially opti-
pass and neither of them actually attempting to mal (and single Pareto-optimal) point (4,4).
move through the doorway. Consequently, this model justifies ignoring the
Game theory offers a number of approaches micro-level of direct interactions (since every-
to solve strategic games and make predictions one chooses equivalently and optimally). A
regarding outcomes. Before these methods are different story is told by the fallacy of
discussed, however, the following section will aggregation.
illustrate that strategic games may be used to Say, as before, the agents choose whether to
model a broad range of concepts and phenom- contribute or not; but this time, they only
ena in interactive economics. receive twice the payoff of their opponents.

I. BASICS OF THE INTERDEPENDENT ECONOMY AND ITS PROCESSES


28 2. TOOLS I: AN INTRODUCTION TO GAME THEORY

Player B this result and justifies it being called an


Strategy 1 Strategy 2 equilibriumspecifically a Nash equilibrium.
Strategy 1
4 2 This property (no incentive for unilateral devia-
4 2 tion) does not hold for any of the alternative
Player A
2 0 three possible outcomes; the Nash equilibrium
Strategy 2
2 0
is thus unique and it is furthermore the only
FIGURE 2.2 Social optimum game. Pareto-optimal outcome. The game discussed
for the fallacy of aggregation is a prisoners
Player B
dilemma; it is a symmetric game as well, it too
Strategy 1 Strategy 2 contains a strictly dominant strategy for both
1 2
players, leading to the single Nash equilibrium.
Strategy 1 However, this time the Nash equilibrium is the
1 1
Player A
1 0 only outcome that is not Pareto optimal.
Strategy 2
2 0 Thus far, both games are 2-person, 2-strategy
FIGURE 2.3 Prisoners dilemma game.
normal-form games; however, the same two
games may be defined as n-person games with
the same results. All n agents choose one of the
We can see that the second strategy seems to two strategies. In order to make this choice,
be strictly better (strictly dominant) against the every agent will take into consideration the pos-
first one, the most likely outcome would there- sible choices of all the other agents. Say among
fore be (0,0) which of course is Pareto inferior the other agents, there are n1 who choose the
compared to (1,1); see Figure 2.3. The message first and n2 that opt for the second strategy
conveyed by this metaphor is that it is possible such that n1 1 n2 5 n 2 1. In the social optimum
that agents choose a socially suboptimal situa- game, the payoffs resulting from the two strate-
tion and do so rationally. Social interactions gies, 1 and 2 , are as follows:
may take any form out of an extensive contin-
1 5 21 1 3 1 2n1 5 2 1 2n1
uum of game structures with different proper-
ties. Though it should be carefully chosen 2 5 0 1 0 1 2n1 5 2n1
which game structure applies, game theory as
That is, by choosing n1 the agent awards
a method is extremely powerful when consid-
herself and every other agent an additional
ering socioeconomic systems. To quote from
payoff of 2. She willas long as she is
one of the most important recent game theory
rationalfind that this option is always prefer-
textbooks, Hargreaves Heap and Varoufakis:
able no matter how many other agents made
One is hard put to find a social phenomenon
the same choice (i.e., no matter which value n1
that cannot be so described [as a strategic
assumes). For the prisoners dilemma on the
game.] (2004, p. 3).
other hand, the payoffs resulting from the two
The game given as an example for the meta-
strategies are as follows:
phor of the invisible hand is called a social
optimum game; it is symmetric and for both 1 5 21 1 0 1 2n1 5 21 1 2n1
players the first strategy is preferable to the sec-
2 5 0 1 0 1 2n1 5 2n1
ond no matter what the opponent does (a strictly
dominant strategy). Both players choosing this It is easily seen that the second term, the
strategy leads to a situation where neither of the one resulting from the contributions of other
players has an incentive to unilaterally deviate agents, is equal in both games. However, the
from this outcome which brings stability to first, individual, term becomes negative in the

I. BASICS OF THE INTERDEPENDENT ECONOMY AND ITS PROCESSES


2.5 HOW TO PLAY A GAME 29
prisoners dilemma. This does again not wants to avoid the lower left field; player A
depend on what the other agents do. No ratio- does not agreeshe is very much in favor of
nal agent would therefore be willing to con- getting to exactly this field. Hence, it is imper-
tribute by playing strategy 1 in this game. ative to obtain a neutral, general, and robust
Hence, provided that all agents are suffi- notion which outcomes are bad for all of the
ciently informed and act rationally, we can involved and definitely to be avoided.
predict that a social optimum game will result The concept is called Pareto dominance,
in all agents contributing as much as possible, named in honor of the Italian economist
while a game of the prisoners dilemma type Vilfredo Pareto. The concept recognizes that
will prevent rational agents from contributing payoffs of different agents are fundamentally
at all. As mentioned, the two games reflect uncomparable. Utility of agent A cannot be
two different if not oppositional economic transformed into utility of agent B and vice
principles, the invisible hand, which for more versa. Still an outcome is still doubtlessly pref-
than two centuries has guided classical and erable if both agents improve or if one agent
neoclassical thought, and the fallacy of aggre- improves while the other retains the same pay-
gation, which describes a more complex, con- off. Such an outcome is called Pareto superior;
flictive, and interdependent setting. the other one is called Pareto dominated or
Having discussed the game theory models Pareto inferior.
of two radically different stories, of two oppo-
site ways of conceptualizing economic reality, Pareto Optimality and Suboptimality
it has become clear that game theory is a A desirable outcome is one that is not
method. It is a powerful tool, perhaps the most Pareto dominated by any other possible out-
appropriate one to investigate socioeconomic come. This may be illustrated as in Figure 2.4:
systems, but it is nothing more than that. One in a figure with the payoffs of both agents on
concept may be modeled using game theory the two axes, an outcome is Pareto dominated
just as well as an entirely different one. if there is another outcome to the upper right
of this outcome. Outcome X is Pareto domi-
nated by outcome Y. Outcomes Y, V, and W,
2.4 HOW NOT TO PLAY A GAME however, are not Pareto dominated. Such an
outcome is called Pareto optimal or a Pareto
2.4.1 Pareto Dominance optimum of the game.
A simple way of finding Pareto optima in a
After detailing a number of illustrative strategic game is to go through the possible
examples in the previous sections, it is now outcomes one by one and cross every outcome
time to proceed to the core concepts of game out that is Pareto dominated by another (any
theory. The above examples have shown that other) one; see Figure 2.5.
there are more preferable outcomes and less
preferable outcomes. Some outcomes should
definitely be avoided.
For instance, considering the anti-
2.5 HOW TO PLAY A GAME
coordination game again, the agents will
want to avoid to be coordinated (i.e., being
2.5.1 Dominance
stuck in the doorway or waiting for nothing). It has been discussed which outcomes are
However, things are not always as easy: In the desirable. The question now is: How do we
prisoners dilemma game (Figure 2.2), player B manage to achieve one of them?

I. BASICS OF THE INTERDEPENDENT ECONOMY AND ITS PROCESSES


30 2. TOOLS I: AN INTRODUCTION TO GAME THEORY

3 FIGURE 2.4 Outcomes in prisoners


dilemma game (Figures 2.2 and 2.5) and
Pareto dominance: X is Pareto dominated
by Y; Y, V, and W are Pareto optimal.
2 X
V
Payoff player B

1 X
Y

0 X
X

1 X
W

2
2 1 0 1 2 3
Payoff player A

Player B Player B
Strategy 1 Strategy 2 Strategy 1 Strategy 2
1 2 0 1
Strategy 1 Strategy 1
1 1 0 1
Player A Player A
1 0 1 0
Strategy 2 Strategy 2
2 0 1 0

FIGURE 2.5 Pareto optima in a prisoners dilemma FIGURE 2.6 Best answer strategies (payoffs underlined)
game. (Crossed payoffs indicate Pareto dominated outcomes; in an anti-coordination game.
all other outcomes are Pareto optima.)
Hence, the concept of dominance is not helpful
Obviously in the prisoners dilemma game in predicting outcomes.
above, neither player would be inclined to play Still, it is clear which outcomes are prefera-
their second strategy. Any possible payoff they ble and thus to decide which strategy the
could obtain with this strategy is less than the agents choose given the choice of the other
alternative given the other players choice. Such player. This concept is termed the best answer
a strategy is called a strictly dominated strategy. strategies. If a strategy 1 of player A leads
No rational agent will ever make this choice. player B to choose her strategy 2 then strategy
A strategy for which every payoff (given the 2 of B is called the best answer (or a best
choice of the opponent) is better than all alter- answer since there may be several strategies
natives is called a strictly dominant strategy. with equal payoffs) to strategy 1 of A. Every
player has at least one best answer strategy
corresponding to every choice of the other
player(s). It is helpful to identify all best
2.5.2 Best Answers answer strategies to all the strategies of all the
Returning to the anti-coordination game players in a game: Underline the payoff the
(Figure 2.1), we find that there are no domi- player hopes to achieve as a best response to
nant or dominated strategies in this game. the choice(s) of the opponent(s) (Figure 2.6).

I. BASICS OF THE INTERDEPENDENT ECONOMY AND ITS PROCESSES


2.7 SUMMARY 31

2.5.3 Nash Equilibria more complex strategies since they may con-
tain instructions for more than one period
An outcome that is achieved as a result of and since they may also take the opponents
every player playing her best answer strategy is actions and reactions into consideration.
called a Nash equilibrium named in honor of Repeated games may be repeated for a certain
game theorist and Nobel memorial laureate John time or indefinitely; they are also called super-
Nash. Every involved strategy is the best answer games, particularly in case of indefinite repe-
to the strategies of the other player(s), thus no tition. These different types of games also
player has an incentive to unilaterally deviate require refinements of some of the game-
from the Nash equilibrium. It follows that theoretic concepts; these will be detailed in
a Nash equilibrium isfor rational players Chapter 8.
an absorbing state, an outcome that is dynami-
cally stable (if there were the option that one or
more players revise their choices), an outcome 2.7 SUMMARY
that is more probable than others.
To obtain the set of Nash equilibria in a This chapter offered a basic understanding
strategic game, underline the best answer of what a strategic game is, how it is used in
payoffs and identify the outcomes for which modeling interactive situations, and how the
all payoffs for all players are underlined. central concepts of basic game theorybest
Figure 2.6 does this for the anti-coordination answers, dominance, Nash equilibria, and
game discussed earlier in this chapter: the Pareto optimalityare applied. Game theory
Nash equilibria are the lower left and upper is only one in a number of methods that may be
right fields, the outcomes in which the players used to analyze and understand economic
choose different strategies. interactions and their consequences. Until very
recently, a large part of the profession of
economics chose to forego using game theory
2.6 HOW MANY though this is now slowly but steadily chang-
GAMES CAN WE PLAY? ing. This was because direct interactions are
very difficult to fit into general equilibrium
So far we restricted the considerations in models which in turn made it possible for the
this chapter to a specific type of games: Games first time to analyze the economy as a whole
that are limited to exactly one time period and the nontrivial interdependence between
in which all agents act simultaneously. These different sectors, still one of the most impor-
games are referred to as normal-form games tant accomplishments in the history of eco-
(because they are conveniently represented in nomics. However, this came at the cost of
the matrix form, also called normal-form, as sacrificing heterogeneity and direct interaction
shown above). However, many different types and reducing the social sphere to an agglomer-
of games are conceivable. The agents may ation of homogeneous agents. The elaborate
choose strategies sequentiallyin this case, the models of perfect markets in effect shifted the
second player knows the decision of the first attention away from strategic interactions to
one when she chooses her strategy (sequential another part of economic reality. The market
games). Normal-form games may be played perspective will be explained in Chapters 5
repeatedly, which means that the agents through 7 while Chapter 8 and the following
remember choices and outcomes from previ- chapters explain more advanced methods for
ous periods (repeated games). This allows the analysis of interactive economies.

I. BASICS OF THE INTERDEPENDENT ECONOMY AND ITS PROCESSES


32 2. TOOLS I: AN INTRODUCTION TO GAME THEORY

A broad perspective on interactive econom- (Figure 2.3) and the social optimum
ics using and applying the methods explained game (Figure 2.2)
in this chapter will be detailed in Chapters 3 c. whether there are strictly dominant
and 4. strategies in the social optimum game
(Figure 2.2)?
Chapter References 2. Consider the following game and identify
Pareto optima, best answer strategies, and
Hargreaves Heap, S.P., Varoufakis, Y., 2004. Game Theory:
Nash equilibria. Are there strictly dominant
A Critical Introduction. Routledge, London, New York.
strategies?

Further Reading Player B


Strategy 1 Strategy 2
Binmore, K., 2007. Game Theory: A Very Short
4 3
Introduction. Oxford University Press, Oxford. Strategy 1
2 3
Bowles, S., 2006. Social interactions and institutional Player A
design. In: Bowles, S. (Ed.), Microeconomics: Behavior, 1 2
Strategy 2
Institutions, and Evolution. Princeton University Press, 1 4
Princeton, NJ, pp. 23 55. , Chapter I.

3. How many Nash equilibria, how many best


Further ReadingOnline answer strategies, and how many Pareto
optima does a 2-person 2-strategy normal-
For further reading, see the textbook website at http://
booksite.elsevier.com/9780124115859 form game have at least? How many
(of any of those concepts) does it have at
most? Consider as an example the
EXERCISES following game.

1. Identify: Player B
a. the Pareto optima in the anti- Strategy 1 Strategy 2
coordination game (Figure 2.1) and in 0 0
Strategy 1
the social optimum game (Figure 2.2) 0 0
Player A
b. the best answer strategies and Nash Strategy 2
0 0
equilibria in the prisoners dilemma 0 0

I. BASICS OF THE INTERDEPENDENT ECONOMY AND ITS PROCESSES

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