What will you learn in this chapter?
• What strategic behavior is and what the components of a strategic game are.
• Why noncooperation is a dominant strategy in the prisoners’ dilemma.
• How repeated play can enable cooperation.
• How backward induction can be used to make decisions.
• How first‐movers have an advantage.
• How patient players have more bargaining power.
• How a commitment strategy can allow players to achieve their goals by limiting their options.
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1© 2014 by McGraw‐Hill Education 1
Chapter 9
Game Theory and Strategic Thinking
© 2014 by McGraw‐Hill Education 2
What will you learn in this chapter?
• What strategic behavior is and what the
components of a strategic game are.
• Why noncooperation is a dominant strategy in the
prisoners’ dilemma.
• How repeated play can enable cooperation.
• How backward induction can be used to make
decisions.
• How first‐movers have an advantage.
• How patient players have more bargaining power.
• How a commitment strategy can allow players to
achieve their goals by limiting their options.
© 2014 by McGraw‐Hill Education 3
Games and strategic behavior
• People behave rationally when they look at the
trade‐offs they face and pursue their goals in the
most effective way possible.
• Game theory studies how people behave
strategically under different circumstances.
– A game refers to any situation involving at least two
people that requires those involved to think
strategically.
– Behaving strategically involves acting to achieve a goal
by anticipating the interplay between your own and
others’ decisions.
2© 2014 by McGraw‐Hill Education 4
Rules, strategies, and payoffs
• All games share three features: rules,
strategies, and payoffs.
– Rules define the actions that are allowed in a
game.
– Strategies are the plans of action that players
follow to achieve their goals.
– Payoffs are the rewards that come from particular
actions.
© 2014 by McGraw‐Hill Education 5
The prisoners’ dilemma
You
Confess Don’t confess
Yo
ur
a
cc
om
pl
ic
e
C
on
fe
ss 10 years
3rd choice
10 years
3rd choice
20 years
4th choice
1 year
1st choice
D
on
’t
c
on
fe
ss 1 year
1st choice
20 years
4th choice
2 years
2nd choice
2 years
2nd choice
• Payoff depends on actions of
both players:
– Both confess.
– One player confesses.
– Neither player confesses.
• Solve game by finding what the
other player would do if you
choose a specific action and
vice‐versa.
• Because of strategic behavior,
the realized outcome is not the
best possible outcome available.
The prisoners’ dilemma is a one‐time game of strategy in
which two people in isolation make the choice to
‘confess’ or ‘don’t confess’ that together they committed
a crime.
© 2014 by McGraw‐Hill Education 6
The prisoners’ dilemma
Kerry
Go negative Stay positive
B
us
h
G
o
ne
ga
tiv
e
Tight race
Bad reputation
3rd choiceTight race
Bad reputation
3rd choice
Lose
4th choice
Win
1st choice
St
ay
p
os
iti
ve Win
1st choice
Lose
4th choice
Tight race
Good reputation
2nd choice
Tight race
Good reputation
2nd choice
• Does either player have a dominant strategy – an action
that they always choose?
– Kerry: Go negative.
– Bush: Go negative.
• The dominant strategies solve
the game.
• The realized outcome is not
the best possible outcome
available.
– This is due to an inability to
cooperate.
The prisoners’ dilemma can be extended to other
applications, such as the Bush‐Kerry presidential election
and the choice to use negative or positive advertising.
3© 2014 by McGraw‐Hill Education 7
The prisoners’ dilemma
You
Don’t litter
Yo
ur
ne
ig
hb
or
Li
tte
r
-10
3rd choice
-10
3rd choice
-15
4th choice
0
1st choice
0
1st choice
-15
4th choice
-5
2nd choice
-5
2nd choice
Litter
D
on
’t
lit
te
r
• Sometimes all players lose,
but want to contain their
losses.
• The dominant strategies solve
the game.
• The solution to the game is
called a Nash equilibrium –
when all players choose the
best strategy they can given
the choices of all other
players.
The prisoners’ dilemma can also be extended to whether
you should or should not litter.
© 2014 by McGraw‐Hill Education 8
Dominant strategies
Player B
Rock Paper Scissors
Pl
ay
er
A
R
oc
k
P
ap
er
S
ci
ss
or
s
Tie
A wins
B wins
B wins
B wins
A wins
A wins
Tie
Tie
• The game of rock,
paper, scissors has no
Nash equilibrium.
• There is no stable
outcome where you
or your opponent
would wish to change
your strategy once
you find out what the
other player is doing.
While dominant strategies can sometimes solve for the
Nash equilibrium, sometimes games do not have an
equilibrium.
© 2014 by McGraw‐Hill Education 9
Reaching equilibrium
• The Nash equilibrium is sometimes referred to
as the non‐cooperative equilibrium.
– This is because players act independently, only
pursuing their individual interests.
• Sometimes players may collude (or cooperate)
to obtain a better outcome for both.
– In the case of the prisoners’ dilemma, the
cooperative equilibrium would make both players
better off.
4© 2014 by McGraw‐Hill Education 10
Active Learning: Finding equilibrium
Suppose Greg and Renee must choose whether or not to
offer a lunch special at their respective restaurants.
• Find the Nash equilibrium.
Greg’s Pizzeria
Don’t offer lunch special
R
en
ee
’s
G
re
ek
S
al
ad
B
ar
O
ffe
r l
un
ch
sp
ec
ia
l
-10
-5
-15
20
30
-10
35
25
Offer lunch special
D
on
’t
of
fe
r
lu
nc
h
sp
ec
ia
l
© 2014 by McGraw‐Hill Education 11
Avoiding competition through commitment
• Sustaining collusion to obtain the cooperative
equilibrium is extremely difficult, as one player
can typically be made better off by defecting.
• It may require a punishment for defecting that
is larger than the payoff for defecting.
– An agreement to submit to a penalty for defecting
to obtain a certain outcome is an example of a
commitment strategy.
• Often the commitment is non‐binding and
individuals break their agreement.
© 2014 by McGraw‐Hill Education 12
Promoting competition in the public interest
Collusion
Exxon
Low prices High prices
Co
no
co
Lo
w
p
ric
es Low profits
3rd choice
Low profits
3rd choice
No profit
4th choice
High profits
1st choice
H
ig
h
pr
ic
es High profits
1st choice
No profit
4th choice
Moderate profits
2nd choice
Moderate profits
2nd choice
Competition • Suppose a small town has
two gas stations, each
setting their price.
– If they collude, they will
earn moderate profits.
– If they compete, they will
earn low profits.
• The non‐cooperative
Nash equilibrium is the
competitive equilibrium.
While cooperation may serve the best interests of the
players directly involved, it may have societal
consequences.
5© 2014 by McGraw‐Hill Education 13
Repeat play in the prisoners’ dilemma
• Repeated games are not one‐time, but are
played more than once.
• The cooperative equilibrium is more likely to
occur because simple commitment
mechanisms exist.
– Tit‐for‐tat: One player does the same action as the
other did in the previous game.
© 2014 by McGraw‐Hill Education 14
Sequential games
• In all of the previously discussed games, both
players moved simultaneously.
• In many instances, an individual or company must
move prior to other participants choosing an
action.
– Typically the player who chooses first gets a higher
payoff, a first‐mover advantage.
• The optimal strategies are determined by using
backward induction, in which the optimal strategy
of the last player to choose is determined,
followed by the second‐to‐last player, and so on.
© 2014 by McGraw‐Hill Education 15
Sequential games
Q. What do you have to do to win the Pulitzer prize?
A. You have to work for a top newspaper.
Q. What do you have to do to get a job at a top newspaper?
A. You have to have a graduate degree in journalism.
Q. What do you have to do to get a graduate degree in journalism?
A. You have to have an undergraduate degree in English.
Q. What do you have to do to get that degree?
A. You have to take the prerequisite courses in nonfiction writing.
Therefore, you should take introductory nonfiction writing next semester.
• Suppose you aspire to win the Pulitzer Prize.
• Start with the outcome and work backwards to
determine your sequence of choices.
6© 2014 by McGraw‐Hill Education 16
Deterring market entry: a sequential game
Burger King:
Should we enter?
If so, where?
Bu ger King:
Shoul we e ter?
If so whe e?
Center of town
Outskirts of town
No
Outskirts
Outskirts
Center
Center
No
Profits
BK: 2%
McD: 12%
BK: 4%
McD: 4%
BK: 10%
McD: 12%
BK: 8%
McD: 8%
BK: 12%
McD: 2%
BK: 10%
McD: 20%
McDonalds:
Where should we
build?
Burger King:
Should we enter?
If so, where?
Burger King:
Should we nter?
If so, where?
• If McD enters in the center of
town:
– BK will not enter and earns a
10% return.
– McD earns 12% return.
• If McD enters in outskirts of
town:
– BK will enter at center and
earns a 12% return.
– McD earns 2% return.
• McD chooses between 12%
return or 2% return.
• McD chooses to locate at the
center of town and BK does not
enter.
• A decision tree visualizes sequential games. For example,
McDonald’s is considering a new store in a small town.
• Profits (the payoffs) are affected by what location is built in
and by how many burger joints enter.
© 2014 by McGraw‐Hill Education 17
Sequential games
Company:What
shouldwepay
employees?
Company: 0%
Union: 0%
1%
surplus Yes
Share of surplus
No
Labor Union:
Should we accept
the new offer?
Company: 99%
Union: 1%
Company: t
should we pay
employees?
• If this was a one‐round game and the company moved first, it could offer just 1 percent of the
surplus and the union would have to make a choice:
– Accept the offer.
– Reject it by going on strike and shutting down production.
• The union chooses between a 1% pay raise and 0%.
– The union will accept the offer.
• This is an example of an ultimatum game: One player makes an offer and the other player has
the simple choice of whether to accept or reject.
• First‐mover advantage can be extremely important in one‐round sequential
games.
• Consider a bargaining game, in which a company is negotiating with its
employees’ labor union over wages.
© 2014 by McGraw‐Hill Education 18
Commitment in sequential games
Aztecs:
Advance or
retreat?
Cortés:
Advance or
retreat?
Cortés: fight to death
Aztecs: fight to death
Cortés: lives
Aztecs: keep land
Cortés: wins land
Aztecs: live
Cortés: lives
Aztecs: keep land
Advance
Retreat
Advance
Retreat
Retreat
Advance
Result
Cortés:
Advance or
retreat?
• Both prefer land, lives,
and then a fight to the
death.
• If all strategies are
available:
– If Aztecs advance, Cortes
will retreat.
– If Aztecs retreat, Cortes will
advance.
• Given these strategies,
Aztecs will advance and
Cortes will retreat.
• Commitment in sequential games can affect the realized
outcome.
• Suppose that the Aztecs and Cortes’ men have the choice to
either advance or retreat.
7© 2014 by McGraw‐Hill Education 19
Commitment in sequential games
Cortés: fight to death
Aztecs: fight to death
Cortés: wins land
Aztecs: live
Advance
Retreat
Advance
Retreat
Retreat
Advance
Result
Eliminated
Aztecs:
Advance or
retreat?
Cortés:
Advance or
retreat?
Cortés:
Advance or
retreat?
Eliminated
• Consider the same game, but now assume that Cortes commits
to advancing by burning his ships.
• Burning his ships
eliminates the choice to
retreat.
• Given this limited choice
set, Aztecs choose
between:
– Advancing, and fighting to
the death.
– Retreating, and living.
• Given these strategies,
Aztecs will retreat and
Cortes will advance.
© 2014 by McGraw‐Hill Education 20
Active Learning: Commitment in sequential
games
Burger King:
Should we enter?
If so, where?
Bu ger King:
Shoul we e ter?
If so whe e?
Center of town
Outskirts of town
No
Outskirts
Outskirts
Center
Center
No
Profits
BK: 2%
McD: 12%
BK: 4%
McD: 4%
BK: 10%
McD: 12%
BK: 8%
McD: 8%
BK: 12%
McD: 2%
BK: 10%
McD: 20%
McDonalds:
Where should we
build?
Burger King:
Should we enter?
If so, where?
Burger King:
Should we nter?
If so, where?
In an effort to not lose market share, suppose Burger King commits
to build in every new town that McDonalds does.
• How does this affect the outcome?
© 2014 by McGraw‐Hill Education 21
Summary
• The concept of strategic games was
introduced.
• Many real‐life decisions can be analyzed as if a
strategic game is being played.
• Game theory can explain choices that may
seem unintuitive, such as why people in
custody confess to their crimes.
• Simultaneous move games were examined as
well as sequential move games.
– Commitment can affect the outcome of both.