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 Contents
Cover
Title Page
Copyright

Why is it called “game theory”?

Working with models
“It’s a draw.”
Dealing with complexity: art and science
Rationality
Keynes’ Beauty Contest
Thaler’s Guessing Game
Problems with rationality and common knowledge of rationality
Booms and crashes: applying rationality to financial markets
Simultaneous-move games
Strategic form of the game
Payoffs
Nash equilibrium
Prisoners’ Dilemma
Pareto efficiency
Network engineering
The tragedy of the commons
Nuclear build-up
Cooperation
Education
Environmental policy and cooperation
Multiplicity of equilibria
Multiplicity of equilibria: Battle of the Sexes
Social norms
Coordination devices
Banking and expectations: bank runs
Mixed-strategy Nash equilibrium
The Currency Speculation Game
The Chicken Game
The Exit Game
Criticism and defence of mixed strategies
Tax evasion
Repeated interaction
At the end of the game
What if there is no definite last stage?
Prisoners’ Dilemma experiment
Evolutionary game theory
Hawk-Dove Game
The Hawk-Dove Game with small cost of conflict
The Hawk-Dove Game with large cost of conflict
Evolutionary stability as an equilibrium refinement
Sequential-move games
A dynamic Battle of Sexes Game
The extensive form of the game
Subgame perfection
Non-credible threats
Credit markets
Microcredit
Nuclear deterrence
Information problems
Asymmetric information
Asymmetric information and unemployment
More on asymmetric information
Signalling product quality
Warranties as a signalling device
Advertising as a signalling device
Religious ritual as a signalling device
Decision making in groups
Where we’ve come from …
… and where to go from here

About the Authors

Index

Published by Icon Books Ltd, Omnibus Business Centre, 39–41 North Road,
London N7 9DP
Email: [email protected]
www.introducingbooks.com

ISBN: 978-178578-083-7

Text copyright © 2017 Icon Books Ltd

Illustrations copyright © 2017 Icon Books Ltd

The author and illustrator have asserted their moral rights

Editor: Kiera Jamison

No part of this book may be reproduced in any form, or by any means,
without prior permission in writing from the publisher.
 What is game theory?
Game theory is a set of tools used to help analyze situations where an
individual’s best course of action depends on what others do or are expected
to do. Game theory allows us to understand how people act in situations
where they are interconnected.

Connections between people arise in all sorts of situations. Sometimes

through cooperation with others we can achieve more than we can on our
own. Other times conflict arises where an individual benefits at the expense
of others. And in many situations, there are benefits to cooperation but
elements of conflict also exist.
 We only win when we work together, but right now everybody is trying to
be the star.

Because game theory can help analyze any environment where a person’s
best action depends on others’ behaviour, it has proven useful in a wide
variety of fields.

In economics, the decisions of firms are affected by their expectations of a

competitor’s choice of product, price and advertising.

In political science, a candidate’s policy platform is influenced by the policy

announcements of their rival.
In biology, animals must compete for scarce resources, but can be hurt if they
are too aggressive with the wrong rival.

In computer science, networked computers compete for bandwidth.

In sociology, public displays of non-conformist attitudes are influenced by

others’ behaviour, which is shaped by social culture.

Darn! I was going to offer healthcare reform as the Key part of my policy
platform. Guess I’ll have to come up with something else.

Game theory is useful whenever there is strategic interaction, whenever

how well you do depends on the actions of others as well as your own
choices. In these cases, people’s actions are influenced by their expectations
of others’ actions.
 Santa brought you a game. This isn’t a game! It has no strategic
interaction. The other players moves don’t affect my best action. Global
thermonuclear war is a game. In war. other players’ choices affect my best
response, and my actions affect their behaviour. we should never have sotten
him that Game Theory book!
 Why is it called “game theory”?
Game theory is the study of strategic interaction. Strategic interaction is also
the key element of most board games, which is where it gets its name. Your
decision affects the other player’s actions and vice versa. Much of the jargon
of game theory is borrowed directly from games. The decision makers are
called players. Players make a move when they make a decision.
 Sometimes I forget that I’m not playing chess.

Working with models

Real-world strategic interaction can be very complicated. In human
interaction, for instance, it’s not just our decisions, but also our expressions,
our tone of voice and our body language that influence others. People bring
different histories and points of view to their dealings with others. This
infinite variety can create very complex situations that are difficult to
analyze.

We can circumvent this complexity by creating simplistic structures, called

models. Models are simple enough to analyze but still capture some
important feature of the real-world problem. A cleverly chosen simple model
can help us learn something useful about the complex real-world problem.

what are you doing? Learning engineering.

The game of chess is useful for understanding the complexity that variation
brings to playing (and to predicting) games and outcomes. There are well-
defined rules in chess. There are a limited number of options in each move.
Yet the complexity of the game is daunting even though it is much simpler
than even the most basic human interaction.

There are 1040 sensible sequence of moves in a chess game – far more than
there are grains of sand on Earth. So how on Earth can I predict what you’re
soins to do next and plan my moves?
 “It’s a draw.”
One feature of complex board games like chess is that the more skilled the
players are, the more frequently the game ends with a draw. How can we
explain this observation?

Since chess itself is too complex to fully analyze, let’s use a simple model
that captures some of the important features of the chess game: noughts &
crosses (tic-tac-toe). Both chess and noughts & crosses have well-defined
boards and victory conditions. Players take turns making choices from a
limited selection of possible moves.

There is quite a lot going on in chess that is not captured by noughts &
crosses. But because the two games share some important features, noughts
& crosses can help improve our understanding of why skilled players tend to
end the game with a draw.
 By playing tic-tac-toe I an learning about chess. Quit Stalling and move
already!

Noughts & crosses is fun for small children. While the game between
unskilled players tends to have a victor, after a bit of practice you quickly
learn to reason via backward induction: you can figure out your opponent’s
response to your possible actions and take that into consideration before
making your own move.

Once players learn to reason via backward induction, all noughts & crosses
games are likely to end in a draw. In this way, noughts & crosses works as a
simple model of chess, in which there are far more possible moves, but
which, when played between skilled players is also likely to end in a draw.
 Time to move on to something a bit more complicated.

Dealing with complexity: art and science

The primary concern of game theory is not board games like chess. Rather,
its aim is to improve our understanding of interactions between people,
companies, countries, animals, etc., when the actual problems are too
complex to fully understand.
To do this in game theory we create very simplified models, which are called
games. The creation of a useful model is both a science and an art. A good
model is simple enough to allow us to fully understand the incentives
motivating players. At the same time, it must capture important elements of
reality, which involves creative insight and judgement to determine which
elements are most relevant.

There is not one true model of any situation. There can be many models,
each of which highlights a different aspect of the actual strategic interaction.

Rationality
Game theory usually assumes rationality and common knowledge of
rationality. Rationality refers to players understanding the setup of the game
and exercising the ability to reason.
Common knowledge of rationality is a more subtle requirement. Not only
do we both have to be rational, but I have to know that you are rational. I also
need a second level of knowledge: I have to know that you know that I am
rational. I need a third level of knowledge as well: I have to know that you
know that I know that you know I am rational. And so on to deeper and
deeper levels. Common knowledge of rationality requires that we are able to
continue this chain of knowledge indefinitely.

I Know that you Know that I Know you are rational. I Know that.

Keynes’ Beauty Contest

The requirements for common knowledge of rationality are confusing to read.
But worse, they might well break down in reality, especially in games with
many players. A classic example is Keynes’ Beauty Contest, in which
English economist John Maynard Keynes (1883–1946) likens investment in
financial markets to a newspaper competition in which readers have to
choose the “prettiest face”; the readers who choose the most frequently
chosen face win.

‘It is not a case of choosing those which, to the best of one’s judgement,
are really the prettiest, nor even those which average opinion genuinely
thinks the prettiest… we devote our intelligences to anticipating what average
opinion expects the average opinion to be.’
At first glance, Keynes’ Beauty Contest has very little to do with financial
markets: there are no prices, and there are no buyers or sellers. But they have
one crucial feature in common. Success in financial markets depends on
being one step ahead of the crowd. If you can predict the behaviour of the
average investor, you can make a killing. Likewise in Keynes’ Beauty
Contest, if you can predict the average choice of newspaper readers, you can
win the contest.
 I think brunettes are prettier, but most people prefer blondes, so I think the
blonde will be the most popular. I choose the blonde. This stock is too
expensive. But I’ll buy it anyway because I think others will be buying it, so
the price will go up even further.

Thaler’s Guessing Game

In 1997 the American behavioural economist Richard Thaler (b. 1945) ran
an experiment in the Financial Times a Guessing Game which was a version
of Keynes’ Beauty Contest.

GUESS THE NUMBER! Readers pick a number between zero and 100.
The winner is the contestant with the number closest to 2/3 of the average of
all numbers entered in the contest.
Which number would you pick?
 If everyone picks a random number between zero and 100. the average
would be 50. 2/3 X 50 = 33 But, others will think the way I do – everybody
else is rational, In that case. I expect the average to be 33, so I should pick
2/3 Of 33 which is 22. But I Know that everybody else Knows that
everybody is rational, so other people will probably choose 22 as well. So I
should pick 2/3 Of 22. Which is approximately 15. But…

In Thaler’s Financial Times experiment, the newspaper received more than a

thousand entries. The entry 33 was the most frequently picked number,
followed by the number 22. This suggests that many people reasoned one
step and so chose 33. But many others thought that other readers would stop
there and tried to be one step ahead of them by choosing 22 (which is 2/3 of
33).
 If you believe that others will stop at the first step of reasoning, it is
rational -for you to stop at the second step.

However, if there is common knowledge of rationality, you know that others

will not stop at the first step, so you can continue this iterative reasoning
forever – a process of reasoning that involves repetition of the same process,
taking the result from one round as a starting point for the next.

Game theorists solve the Guessing Game in a similar fashion using iterative
elimination of dominated strategies.
Remember that you’re looking for 2/3 of the average number entered into the
contest. If all contestants were to pick the highest permissible number, 100,
the average would be 100. Hence, no matter what one expects the average to
be, it makes no sense to ever guess a number greater than 2/3 of 100, which is
67.

In other words, any strategy with a guess greater than 67 is dominated by 67.
A strategy is dominated if it (in this case, a guess higher than 67) is worse
than another strategy (guessing 67) regardless of what other players do.
Hence, even if no one else is rational, all strategies with a guess greater than
67 can be eliminated.
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