Scribd
Upload
181 views

Microeconomics II: Game Theory and Its Applications

This document provides an overview of a microeconomics course on game theory and its applications. It begins by reviewing concepts covered in previous microeconomics courses such as consumer theory, producer theory, and competitive market equilibrium. It then introduces the topic of strategic interactions and how game theory can be used to formally study situations where individual decisions impact others. Examples are provided of how game theory is applied in fields like industrial organization, political science, and contract theory. The key aspects of modeling a game are defined, including players, rules, information, outcomes, and preferences. Real-world situations are suggested as examples that could be modeled as games.

Uploaded by

Saniya Siddhika Ahmed Syed
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
181 views

Microeconomics II: Game Theory and Its Applications

This document provides an overview of a microeconomics course on game theory and its applications. It begins by reviewing concepts covered in previous microeconomics courses such as consumer theory, producer theory, and competitive market equilibrium. It then introduces the topic of strategic interactions and how game theory can be used to formally study situations where individual decisions impact others. Examples are provided of how game theory is applied in fields like industrial organization, political science, and contract theory. The key aspects of modeling a game are defined, including players, rules, information, outcomes, and preferences. Real-world situations are suggested as examples that could be modeled as games.

Uploaded by

Saniya Siddhika Ahmed Syed
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
You are on page 1/ 21

Microeconomics II

Game Theory and Its Applications


PROF. SWAGATA BHATTACHARJEE
Microeconomics So Far..
 Single Person Decision Making: Consumer Theory
 Aggregating individual demands into Market Demand
 Producer Theory
 Aggregating individual firm’s supply schedules into Market Supply
 Competitive Market Equilibrium
 Assumptions:
Microeconomics So Far..
 Single Person Decision Making: Consumer Theory
 Aggregating individual demands into Market Demand
 Producer Theory
 Aggregating individual firm’s supply schedules into Market Supply
 Competitive Market Equilibrium
 Assumptions:
 Large number of buyers and sellers
 Complete Information
 Individual decision has no impact on the market outcome
 No strategic interaction
Microeconomics So Far..
 Single Person Decision Making: Consumer Theory
 Aggregating individual demands into Market Demand
 Producer Theory
 Aggregating individual firm’s supply schedules into Market Supply
 Competitive Market Equilibrium
 First and Second Fundamental Theorems of Welfare Economics
Microeconomics So Far..
 Single Person Decision Making: Consumer Theory
 Aggregating individual demands into Market Demand
 Producer Theory
 Aggregating individual firm’s supply schedules into Market Supply
 Competitive Market Equilibrium
 First Fundamental Theorems of Welfare Economics:
Every CE is Pareto Optimal
 Second Fundamental Theorems of Welfare Economics:
Every Pareto Optimal allocation can be induced as a CE
What’s Next….
 Strategic Interactions!

 Most often, in our daily lives, our own individual decisions alone do not yield to a specific
outcome.

 In any context with multiple people involved, one person’s decision affects another person’s
well-being, either positively or negatively.

 These situations of interdependence are called Strategic settings.

 Here, in order for a person to decide how best to behave, s/he must consider how others around
him/her choose their actions.
What’s Next….
 Strategic Interactions!

 In Strategic settings, in order for a person to decide how best to behave, s/he must consider
how others around him/her choose their actions.

 Eg: a game of chess. Each player has to anticipate the reaction of the opponent and choose
the best move considering this.

 Eg: a group project. A successful project depends on how well the members coordinate their
efforts

 Eg: a political contest. If a politician wants to win an election, she should pick a campaign
strategy that competes favorably with her opponent’s strategy.
Game Theory
 Game theory is a methodology of formally studying situations of strategic interdependence/
interactions.

 Game Theory gives a mathematically precise and logically consistent structure.

 With the right theoretical tools in place, we can study behavior in a variety of contexts and come
to better understand and predict the outcomes of economic and, more generally, social
interaction.
Uses of Game Theory
 Developed during the Cold War period (1950-80s) primarily in order to model the strategic
competition between the dominant countries

 Political Science/ Political Economics


 Predict wartime strategies
 Political campaign strategies in the democratic elections
 International relations
Uses of Game Theory
 Industrial Organization:

 Should a firm acquire a new firm? Should two competitors merge?


 How should the market operate if there is a dominant firm and many smaller firms?
 How to determine the optimal advertising strategies?
 Is it possible for multiple dominant firms to collude? How to detect illegal collusion?
Uses of Game Theory
 Industrial Organization:

 Should a firm acquire a new firm? Should two competitors merge?


 How should the market operate if there is a dominant firm and many smaller firms?
 How to determine the optimal advertising strategies?
 Is it possible for multiple dominant firms to collude? How to detect illegal collusion?

 Contract Theory/ Managerial Economics

 Within a firm, how best to motivate the employees so that they do not shirk even when it is not possible to track
their exact effort?
 Designing optimal incentive schemes for long and short term employment
 Collaboration between firms: how best to design the contract
 Where we can not write any legally enforceable contract, how do organizations operate?
Uses of Game Theory
 Network Theory
 How people form connections? In a society/ social media platform, what is the network structure that is
expected to emerge?
 Given any existing network structure, how to transmit information? Suppose, in a village government
wants to raise awareness about the hazards of using bio fuel. How can they design the optimal way to
transmit this information?
Uses of Game Theory
 Network Theory
 How people form connections? In a society/ social media platform, what is the network structure that is
expected to emerge?
 Given any existing network structure, how to transmit information? Suppose, in a village government
wants to raise awareness about the hazards of using bio fuel. How can they design the optimal way to
transmit this information?

 Information Economics
 A company is hiring for a position. How should they choose candidates matching the exact requirement
when the candidates have no relevant experience? How should the candidates signal their ability?
 If you are buying a used car, you have less information about the car than the owner. What happens in
such cases?
 How to disseminate information?
A Game
 A game is a multi-person strategic interaction context defined by its structure, which includes:

 The players: independent decision makers (Players)


 e.g. a game of chess has 2 players

 The rules: specifies the order of players’ decisions, their feasible decisions at each decision point (action) at each
decision point.
 e.g. different pieces in chess has different moves and at any given point, a subset of the moves are available to
choose from. The players alternate in moving pieces on the game board.

 The information: what each player knows at each decision point.


 E.g. players observe each other’s moves, so each knows the entire history of play as the game progresses

 How players’ decisions jointly determine the outcome.


 E.g. a player who captures the other player’s king wins the game, and otherwise, a draw is declared

 Players’ preferences over outcomes (or probability distributions of outcomes)


 E.g. each player prefers a win over a draw over a loss (generally)
Example 1
 Two companies share a market, in which they currently make $5,000,000 each.
 Both need to determine whether they should advertise.
 For each company advertising costs $2,000,000 and captures $3,000,000 from the competitor
provided the competitor doesn’t advertise.
 What should the companies do?
Example 2
 Three legislators vote whether they allow themselves a raise in salary of $2000 per year.
 Since voters are observing the vote, there is some loss of face for a legislator to vote for a raise.
 Let’s assume that the legislators estimate that loss of face is worth $1000 per year.
 What happens if all three vote at the same time?
Example 3
 Adam and Bob have robbed a bank and been arrested. They are interrogated separately.
 Adam and Bob have the option to confess or to remain silent.
 The police have little evidence, and if both remain silent they will be sentenced to one year on a
minor charge.
 Therefore the police interrogators propose a deal: if one confesses while the other remains silent,
the one confessing goes free while the other is sentenced to three years.
 However, if both talk, both will still be sentenced to two years.
 Each questioned in a separate cell without knowing what the other is doing.
 What will Adam and Bob do?
Example 3: Adam and Bob
Adam\Bob Deny Confess
Deny -1,-1 -3,0
Confess 0,-3 -2,-2

 This is a “normal form” representation of this game.


 Players: Adam and Bob
 Actions: Confess and Deny
 Row player (Adam)’s payoff is the first entry, column player’s (Bob’s) is the second one
 Rule of the game: simultaneous move
How to Use Game Theory
To “Model” Your Everyday World
 A model is an abstract, often mathematical, version of reality.
 You can formulate many real life instances around you as a model, that is, a game.
 This is abstract, but is supposed to yield some insight into the particular real-world situation.
 It is important not to confuse the model with reality—in reality there are many other factors that
affect the situation.
 But if we can use game theory to predict the outcome of a “model”, then we can extrapolate it to
predict the real life situation.
A Thought Exercise
 Think of any real life context, try to formulate it (model it) as a game.
 In particular, specify the players, the rules, the order of the plays, the information, how the
outcome is determined, and the players’ preferences.
Next Class
 A primer on decision making under uncertainty
 Representation of Games

You might also like