Game Theory

• Developed to explain the optimal strategy in

two-person interactions.
• Initially, von Neumann and Morganstern
– Zero-sum games
• John Nash
– Nonzero-sum games
• Harsanyi, Selten
– Incomplete information
 An example:
Big Monkey and Little Monkey
• Monkeys usually eat ground-level fruit
• Occasionally climb a tree to get a coconut
(1 per tree)
• A Coconut yields 10 Calories
• Big Monkey expends 2 Calories climbing
the tree.
• Little Monkey expends 0 Calories climbing
the tree.
 An example:
Big Monkey and Little Monkey
• If BM climbs the tree
– BM gets 6 C, LM gets 4 C
– LM eats some before BM gets down
• If LM climbs the tree
– BM gets 9 C, LM gets 1 C
– BM eats almost all before LM gets down
• If both climb the tree
– BM gets 7 C, LM gets 3 C
– BM hogs coconut
• How should the monkeys each act so as to
maximize their own calorie gain?
 An example:
Big Monkey and Little Monkey
• Assume BM decides first
– Two choices: wait or climb
• LM has four choices:
– Always wait, always climb, same as BM,
opposite of BM.
• These choices are called actions
– A sequence of actions is called a strategy
 An example:
Big Monkey and Little Monkey

Big monkey w c

w c
Little monkey w c

0,0 9,1 6-2,4 7-2,3

What should Big Monkey do?
• If BM waits, LM will climb – BM gets 9
• If BM climbs, LM will wait – BM gets 4
• BM should wait.
• What about LM?
• Opposite of BM (even though we’ll never get to the right side
of the tree)
 An example:
Big Monkey and Little Monkey
• These strategies (w and cw) are called best
responses.
– Given what the other guy is doing, this is the best thing
to do.
• A solution where everyone is playing a best
response is called a Nash equilibrium.
– No one can unilaterally change and improve things.
• This representation of a game is called extensive
form.
 An example:
Big Monkey and Little Monkey
• What if the monkeys have to decide
simultaneously?
Big monkey w c

w c
Little monkey w c

0,0 9,1 6-2,4 7-2,3

Now Little Monkey has to choose before he sees Big Monkey move
Two Nash equilibria (c,w), (w,c)
Also a third Nash equilibrium: Big Monkey chooses between c & w
with probability 0.5 (mixed strategy)
 An example:
Big Monkey and Little Monkey
• It can often be easier to analyze a game
through a different representation, called
normal form
Little Monkey

c v

Big Monkey 5,3 4,4

c

v 9,1 0,0
 Choosing Strategies
• In the simultaneous game, it’s harder to see
what each monkey should do
– Mixed strategy is optimal.
• Trick: How can a monkey maximize its
payoff, given that it knows the other
monkeys will play a Nash strategy?
• Oftentimes, other techniques can be used to
prune the number of possible actions.
 Eliminating Dominated Strategies
• The first step is to eliminate actions that are
worse than another action, no matter what.

w c
Big monkey w c

c w c 9,1 4,4
w
Little monkey
We can see that Big
0,0 9,1 6-2,4 7-2,3 Monkey will always choose
w.
Little Monkey will Or this one So the tree reduces to:
Never choose this path. 9,1
Eliminating Dominated Strategies
• We can also use this technique in normal-
form games:
Column
a b

a 9,1 4,4
Row
b 5,3 0,0
Eliminating Dominated Strategies
• We can also use this technique in normal-
form games:

a b

a 9,1 4,4

b 5,3 0,0

For any column action, row will prefer a.

Eliminating Dominated Strategies
• We can also use this technique in normal-
form games:

a b

a 9,1 4,4

b 5,3 0,0

Given that row will pick a, column will pick b.

(a,b) is the unique Nash equilibrium.
 Prisoner’s Dilemma
• Each player can cooperate or defect
Column
cooperate defect

cooperate -1,-1 -10,0

Row
defect 0,-10 -8,-8
 Prisoner’s Dilemma
• Each player can cooperate or defect
Column
cooperate defect

cooperate -1,-1 -10,0

Row
defect 0,-10 -8,-8

Defecting is a dominant strategy for row

 Prisoner’s Dilemma
• Each player can cooperate or defect
Column
cooperate defect

cooperate -1,-1 -10,0

Row
defect 0,-10 -8,-8

Defecting is also a dominant strategy for column

 Prisoner’s Dilemma
• Even though both players would be better
off cooperating, mutual defection is the
dominant strategy.
• What drives this?
– One-shot game
– Inability to trust your opponent
– Perfect rationality
 Prisoner’s Dilemma
• Relevant to:
– Arms negotiations
– Online Payment
– Product descriptions
– Workplace relations
• How do players escape this dilemma?
– Play repeatedly
– Find a way to ‘guarantee’ cooperation
– Change payment structure
 Tragedy of the Commons
• Game theory can be used to explain overuse of
shared resources.
• Extend the Prisoner’s Dilemma to more than two
players.
• A cow costs a dollars and can be grazed on
common land.
• The value of milk produced (f(c) ) depends on the
number of cows on the common land.
– Per cow: f(c) / c
 Tragedy of the Commons
• To maximize total wealth of the entire
village: max f(c) – ac.
– Maximized when marginal product = a
– Adding another cow is exactly equal to the cost
of the cow.
• What if each villager gets to decide whether
to add a cow?
• Each villager will add a cow as long as the
cost of adding that cow to that villager is
outweighed by the gain in milk.
 Tragedy of the Commons
• When a villager adds a cow:
– Output goes from f(c) /c to f(c+1) / (c+1)
– Cost is a
– Notice: change in output to each farmer is less than
global change in output.
• Each villager will add cows until output- cost = 0.
• Problem: each villager is making a local decision
(will I gain by adding cows), but creating a net
global effect (everyone suffers)
 Tragedy of the Commons
• Problem: cost of maintenance is externalized
– Farmers don’t adequately pay for their impact.
– Resources are overused due to inaccurate estimates of
cost.
• Relevant to:
– IT budgeting
– Bandwidth and resource usage, spam
– Shared communication channels
– Environmental laws, overfishing, whaling, pollution,
etc.
Avoiding Tragedy of the Commons
• Private ownership
– Prevents TOC, but may have other negative effects.
• Social rules/norms, external control
– Nice if they can be enforced.
• Taxation
– Try to internalize costs; accounting system needed.
• Solutions require changing the rules of the game
– Change individual payoffs
– Mechanism design
 Coming next time
• How to select an optimal strategy
• How to deal with incomplete information
• How to handle multi-stage games