Jan 22

D.6 Battle of the sexes

Description

This video explains how the battle of the sexes work. We explain how, by searching for a Nash equilibrium, we won’t be able to solve the game.

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In the battle of the sexes, a couple argues over what to do over the weekend. Both know that they want to spend the weekend together, but they cannot agree over what to do. The man prefers to go watch a boxing match, whereas the woman wants to go shopping. This is a classical example of a coordination game, analysed in game theory for its applications in many fields, such as business management or military operations.

In this case, knowing your opponent’s strategy will not help you decide on your own course of action, and there is a chance an equilibrium may not be reached. This can be easily seen by looking for a dominant strategy, eliminating all dominated strategies. However, there will be two dominant strategies, two Nash equilibria. The way to solve this dilemma is through the use of mixed strategies, in which we look at the probability of our opponent choosing one or the other strategy and balance our pay off against it.

Learn more by reading the dictionary entry.

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Jan 22

Lope Gallego

D.5 Dominant strategies and Nash equilibrium

Description

This video explains how dominant strategies work, and how to reach a Nash equilibrium. We start by analysing dominant strategies, then explain what the Nash equilibrium is. Finally, we show an example of elimination of dominated strategies.

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Nash equilibria are defined as the combination of strategies in a game in such a way, that there is no incentive for players to deviate from their choice. This is the best option a player can make, taking into account the other players’ decision and where a change in a player’s decision will only lead to a worse result if the other players stick to their strategy. One of the best known Nash equilibria can be found in the prisoner’s dilemma. This concept belongs to game theory, specifically to non-cooperative games, and was named after John Nash who developed it.

There are a few consistency requirements that must be taken into account when dealing with Nash equilibria. One of them is known as common knowledge, which extends the necessity of complete information. Therefore, expectations about other player’s strategies must be rational.

A Nash equilibrium is therefore a combination of beliefs about probabilities over strategies and the choices of the other player.

Nash equilibria can be used to predict the outcome of finite games, whenever such equilibrium exists. Furthermore, the best equilibrium outcome can be found by using the method of elimination of dominated strategies, which will help us find the best Nash equilibrium by excluding ‘unreasonable’ Nash equilibria.

Learn more by reading the dictionary entry.

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Jan 22

Lope Gallego

D.4 Battle of the Bismarck Sea

Description

This video shows how the Battle of the Bismarck Sea works. We start by explaining the military operation, and then see all possible outcomes. Finally, we analyse the game using a game matrix.

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The Battle of the Bismarck Sea was a battle fought in February 1943 in Southeast Asia during World War II, between the Japanese Navy and the US Air Force. In game theory, its modeling was done by O. G. Haywood, Jr. in his article “Military Decision and Game Theory”, 1954. It’s a game used in game theory to analyze zero-sum games with two players.

The game, based on the actual military operation, is based on the decision General Kenney had to make. General Kenney, as Commander of the Allied Forces in the South-west Pacific Area, received intelligence reports indicating part of the Japanese Navy was about to sail from Rabaul, in the island of New Britain, to Lae, in New Guinea. Knowing this, General Kenney decided to make his five-step “Estimate of the Situation”, a technique used in US military operations.

In this game, Kenney has no dominant strategy (the sum of the payoffs of the first strategy equals the sum of the second strategy), but the Japanese do have a weakly dominating strategy, which is to go North (the payoffs are equal for one strategy but strictly better for the other). Since only one of them has a dominant strategy, there is no dominant strategy equilibrium. We must then proceed by eliminating dominated strategies. As we’ve already mentioned, for the Japanese the strategy ‘go North’ weakly dominates strategy ‘go South’. Therefore, we eliminate the strategy ‘go South’ for the Japanese, who will go North. Now that we only consider the Japanese going North, Kenney’s strategy ‘go North’ is strictly dominant over strategy ‘go South’, which will be eliminated. Therefore, North-North is the weak-dominance equilibrium.

Learn more by reading the dictionary entry.

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Jan 22

Lope Gallego

D.3 Prisoner’s dilemma

Description

This video explains how the prisoner’s dilemma game works. We start by explaining the prisoners’ situation, then we see how to solve the game, and analyse its consequences.

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The prisoner’s dilemma is probably the most widely used game in game theory. Its use has transcended Economics, being used in fields such as business management, psychology or biology, to name a few. Nicknamed in 1950 by Albert W. Tucker, who developed it from earlier works, it describes a situation where two prisoners, suspected of burglary, are taken into custody. However, policemen do not have enough evidence to convict them of that crime, only to convict them on the charge of possession of stolen goods.

If none of them confesses (they cooperate with each other), they will both be charged the lesser sentence, a year of prison each. The police will question them on separate interrogation rooms, which means that the two prisoners cannot communicate (hence imperfect information). The police will try to convince each prisoner to confess the crime by offering them a “get out of jail free card”, while the other prisoner will be sentenced to a ten years term. If both prisoners confess (and therefore they defect), each prisoner will be sentenced to eight years. Both prisoners are offered the same deal and know the consequences of each action (complete information) and are completely aware that the other prisoner has been offered the exact same deal (therefore, it’s common knowledge).

Since prisoners cannot communicate and will (supposedly) make their decision at the same time, this is considered to be a simultaneous game, and can be analysed using the strategic form.

Learn more by reading the dictionary entry.

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Jan 22

Lope Gallego

D.2 Extensive form

Description

This video explains what the extensive form is. We start by learning how to build a game tree to analyse games, and then use a couple of examples to see how to use it.

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In game theory, the extensive form is a way of describing a game using a game tree. It’s simply a diagram that shows that choices are made at different points in time (corresponding to each node). The payoffs are represented at the end of each branch. Since the extensive form represents decisions at different moments, it’s usually used to describe sequential games, while simultaneous games are described using the strategic form. Since sequential games imply making decisions at different moments for each player, information is perfect since each player can see the decision taken by the previous player, complete and the rules of the game and each player’s payoffs are common knowledge.

A good example of a sequential game described with the extensive form is when considering collusion agreements. Two firms share the market, colluding and maintaining high prices. Each firm can decide to stop colluding and start a price war, in order to increase their market share, even force the other to quit the market. It’s easy to see that collude-collude is both the Nash equilibrium and a Pareto optimum situation. This result may change when considering repeated games.

It’s worth mentioning that the extensive form can be used also to describe simultaneous games, by using information sets. These information sets, usually represented by a dashed line uniting two nodes or by encircling them, mean that the player does not know in which node he is, which implies imperfect information, like when using the strategic form.

Learn more by reading the dictionary entry.

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Jan 22

Lope Gallego

D.1 Strategic form

Description

This video explains what the strategic form is. We start by learning how to build a matrix to analyse games, and then use a couple of examples to see how to use it.

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In game theory, the strategic form (or normal form) is a way of describing a game using a matrix. The game is defined by exhibiting on each side of the matrix the different players, each strategy or choice they can make, and sets of payoffs they will each receive for a given strategy.

The strategic form allows us to quickly analyse each possible outcome of a game. It is usually the right description for simultaneous games, where both players choose simultaneously, as opposed to sequential games for which is better to describe the game using the extensive form (or tree form). It’s worth mentioning that simultaneous games imply there is complete and imperfect information, and the rules of the game as well as each player’s payoffs are common knowledge.

Although is not very common, sequential games can also be described using the strategic form.

Learn more by reading the dictionary entry.

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Jan 6

Lope Gallego

Market structures

The analysis of market structures is of great importance when studying microeconomics. How the market will behave, depending on the number of buyers or sellers, its dimensions, the existence of entry and exit barriers, etc. will determine how an equilibrium is reached. Even though market structures were thoroughly analysed by economists from the early 20^th century on, its study can be traced back to economists such as Antoine Cournot, Alfred Marshall or even Adam Smith.

In this Learning Path we’ll learn about the main market structures, which we’ll analyse more in depth in future LPs. This is what we’ll be learning about:

Market structure, a basic definition;

Perfect competition:

Perfect competition, a perfect but theoretical market structure;

Imperfect competition:

Imperfect competition, which can take different forms, such as:

Monopolies, when there is only one seller;

Oligopolies, with a few sellers which have price-setting power;

Duopolies, with only two sellers, it makes it easy to study oligopolies;

Monopolistic competition, when many sellers have monopolistics power over small share s of the market;

Buyer’s price setting powers:

Monopsony, when there is only one buyer;

Oligopsonies, with few buyers with great negotiating powers.

Dec 13

Lope Gallego

Risk and uncertainty II

In this LP, the second of our series on Risk and Uncertainty, we’ll learn a bit more about risk, but also about uncertainty. We’ll start by seeing again how risk is analysed using Morgenstern and von Neumann’s expected utility theory. We’ll also learn about alternative approaches, such as the Friedman-Savage and Markowitz perspectives, but especially Daniel Kahneman’s prospect theory. We’ll end our study of risk and uncertainty by learning how game theory can help when analysing uncertainty.

Here’s the summary of this Learning Path:

Risk:

Risk, when outcomes are unknown but individuals can assign probabilities to each of them;

Risk aversion, or how to analyse individuals’ decisions using the expected utility theory;

Demand for insurance, the analysis of how to deal with risky situations.

EUT and alternative aproaches:

Expected utility theory, Morgenstern and von Neumann’s main contribution to economics;

Other approaches, such as the Friedman-Savage or Markowitz’s perspectives;

Prospect theory, Kahneman’s views on expected utility.

Uncertainty:

Uncertainty, when individuals cannot assign probabilities to each outcome;

Game theory, the perfect framework to analyse uncertainty.

Dec 1

Lope Gallego

Risk and uncertainty I

Everyone has to make decisions, every day. However, it is not always clear to us what outcomes can derive from these decisions. When this happens, we say we are making decisions in situations under risk or uncertainty. When risk appears, although we are not sure about the possible outcomes of a given decision, we do know the probability of each outcome, while in situations under uncertainty we are not capable of making such assumptions.

In this Learning Path we’ll learn bout risk and uncertainty. We will see how risk can be analysed by using expected utility instead of expected value, and how different kind of people will behave differently when facing risk.

Risk and uncertainty:

Risk, when different outcomes are unknown but individuals can assign them probabilities;

Uncertainty, when individuals cannot assign probabilities to each outcome.

Expected utility:

Saint Petersburg paradox, solved by Daniel Bernoulli;

Expected utility, an alternative way to make decisions;

Expected utility theory, developed by John von Neumann and Oskar Morgenstern.

Risk aversion analysis:

Risk aversion, where we analyse different degrees of risk aversion;

Arrow-Pratt measures of risk aversion.

Nov 29

Lope Gallego

Information economics II

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.