In our previous Learning Path, we learned the basics about Information economics. We saw what adverse selection and moral hazard are, using as en example the healthcare insurance market. Of course, insurance companies have ways of getting around adverse selection and moral hazard to a certain extent. But an insurance company is never going to be able to segment their policies fully: when was the last time you were asked about your driving style when subscribing to a dental plan? And most sane people won’t risk their life just because their healthcare is covered (in fact, most countries with a free, national health service have longer life expectancies and shorter hospital stays than countries that don’t), but how many of us park our friend’s car more carefully because we are not insured in it?

In this LP we’ll cover the implications of asymmetrical information, looking at the most important examples. We’ll start by looking at adverse selection, then we’ll learn more about moral hazard.

Adverse selection:

Adverse selection, ex-ante asymmetric information;

The Market for Lemons, a paper describing adverse selection and moral hazard;

Screening, which employers use to beat adverse selection;

Signalling, which good employees-to-be use to avoid adverse selection.

Moral hazard:

Moral hazard, ex-post asymmetric information;

Credit Rationing in Markets with Imperfect Information, a paper explaining how moral hazard affect credit markets;

Incentives, used by employers to avoid moral hazard.

Information economics, also known as economics of information, is the study of how different degrees of information affect economic analysis. Since it’s usually studied as a part of microeconomic theory, information economics mainly deal with micro problems, although it is easy to see examples in our own life: why should I study a college degree? Should I look for a job with a fixed salary or should I go for incentives-based salaries? If I quit smoking, drinking or driving, should I stop paying healthcare insurance?

In this Learning Path we’ll learn the basics about information economics, especially about adverse selection and moral hazard, in order to make a thorough analysis in the next LP. We’ll start with:

Information economics, a basic definition.

Information:

Complete and incomplete information, their differences and how to deal with them;

Perfect and imperfect information, taking special interest into

Asymmetric information, the main reason why information economics exist.

Problems and how to deal with them:

Adverse selection, an ex-ante problem;

Moral hazard, an ex-post problem;

Agency theory, the frame we’ll use to analyse these issues.

In game theory, games are usually classified under two categories: simultaneous games and sequential games. Although simultaneous games make up for a lot of the research made during the early years of game theory, sequential games represent a closer step when modeling economic reality. Consider for instance a firm thinking about entering a new market, dominated by a monopoly. The new firm must take into account that its move (entering or not) will affect the monopolist decisions. Since both actions, the entrance and the monopolist’s reaction, don’t take place at the same moment, they are better represented by a sequential game.

Duopolies are commonly used when explaining sequential games, because they model the interdependence between two firms. We’ll learn in this Learning Path how duopolists react to each other’s actions, how collusions work and how repeated sequential games may change the essence of a game. We’ll learn about:

Sequential games, how they work and how they differ from simultaneous games.

Some basic definitions:
Subgames, which must be understood when dealing with sequential games;

Folk theorem, a necessary tool for the analysis of duopolies and collusion.

Duopolies and collusion:

Cournot duopolies, which we review to see the main differences with

Stackelberg duopolies, a true sequential game;

Collusion agreements would reduce consumer’s surplus while increasing the firm’s.

Repeated games, and how everything changes when considering repetitions.

In this LP, the second of our series on Game theory, we’ll learn everything there is about simultaneous games. These games, used when considering a game where players move or play their strategies simultaneously, are commonly used in many fields. From military strategies to collusion agreements, the analysis of these situations as simultaneous games can help us discover the best way to act. Finding Nash equilibria or knowing how to proceed to eliminate dominated strategies will get us the best outcome (and therefore help us win the game!).

We’ll consider that the rules of the game and each player’s payoffs are common knowledge, and that information is complete. Since moves are simultaneous, information will be imperfect. We’ll see the following definitions:

Simultaneous games, where we’ll learn the basics about these games.

Nash equilibria and dominant strategies:

Prisoner’s dilemma, the well-known game;

Nash equilibria, which are the best possible strategies given the other player’s;

Dominant strategies and elimination of dominated strategies, another way to proceed.

Mixed strategies:

The Battle of the Sexes, where a couple has to decide what to do over the weekend;

Mixed strategies, and how to analyse them where no clear equilibrium can be reached.

Continuous strategies:

Cournot duopolies, the best example of a simultaneous game where continuous strategies  are used.

Game theory is a fascinating part of micro, and macro, economics. It’s based on the psychological current that underpins all Economics, and simplifies the main economic problem: optimising the use of limited resources; into a series of sets of events that illustrate how this problem drives human interaction. The aim of game theory is to take simple situations as allegories of the much more complex social and economic interaction that takes place every day to explain anything from price wars to altruism.

Understanding game theory may or may not make us more effective in business, economics or our personal lives, but it undoubtedly helps us to highlight and recognise the economic (in the non financial sense of the word) patterns that underpin the better part of the way we base our societies and the way we lead our lives. The fact that many of these same social patterns occur all throughout nature also helps remind us that the most complex societies are based on behaviours and choices not all that far removed from the natural world.

In this first Learning Path on Game theory, we will learn about the main tools and conditions required in order to make a thorough analysis of games. We’ll see how the quality of information shape the way we solve games, and learn about how to describe them. We will start with a simple definition:

Game theory: what it is and how did it evolve for during the last century.

The importance of information:

Complete and incomplete information will determine the scenario we’ll work in;

Common knowledge is a notion that adds importance to complete information;

Perfect and imperfect information, which determines whether players can see each other moves.

Description of games:

Strategic form (or normal form), used mainly for describing simultaneous games using a game matrix;

Extensive form, used when dealing with sequential games, by using a game tree.