2.

5 Behavioral Economics
2.5.1 Introduction: the Shubik auction

The 10-francs-first-two-pay-auction.

▪ Everybody can make as many bids as he/she wants.

▪ Bids must be multiples of 1 franc.
▪ No communication is allowed between bidders.
▪ At the end
− 10-franc bill goes to the highest bidder.
− Both the highest and second highest bidder have to pay me their bids.

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 Case in point: the Campeau-Federated merger* Example of bidding war

▪ Jan 1988: Canadian businessman Robert Campeau initiates hostile

takeover of “Federated Department Stores” (parent company of
“Bloomingdale’s”)
▪ Feb & March: Extreme bidding war between Campeau and Macy’s—
value of Federated decreases due to confusion of management. Price
exorbitant
▪ March 31: Campeau offers to cede, if Macy’s sells him Burdines and
Bloomingdale’s—Macy’s declines!
▪ Campeau makes even higher offer and “wins”:
− Payment: $8.17 billion
− Pre-acquisition market value: $2.93 billion Federated
▪ Jan 1990: Campeau declares bankruptcy.

“The biggest, looniest deal ever.”

Fortune Magazine (1990)

*Bazerman, M., & Neale, M. (1992). Nonrational escalation of commitment in negotiation. European Management Journal, 10(2), 163-168.
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Further examples of non-rational escalations

▪ Arms races
− WW I
− US/USSR during Cold War
− India/Pakistan
− Greece/Turkey
− Armenia/Azerbaijan
− …
▪ Escalation of sanctions
− Iran/USA

«I can calculate the motions of heavenly bodies, but not the

madness of people»

Isaac Newton

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2.5.2 Integrating game theory and psychology
▪ Studying deviations of human behavior from strict rationality is the objective of behavioral economics.

Economics/Game
Psychology
Theory

Behavioral Economics

Recommended reading

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2.5.3 Conflict-relevant heuristics and biases
Oftentimes, time pressure prevents us from acting super rational and we use heuristics (cognitive shortcuts) and
biases. We will merely discuss the most conflict-relevant biases and heuristics.

Anchoring
▪ Anchoring occurs when a salient reference point (the “anchor”) influences/restricts decision-making
▪ Example: Questions to visitors in San Francisco Observatory*
Q1: Is the height of the tallest redwood more or less than x feet?
Q2: What is your best guess about the height of the tallest redwood?
→ Mean answer to Q2 was 844 for x=1200 in Q1; The first question influenced the people for the
→ Mean answer to Q2 was 282 for x=180 in Q1; question 2

▪ Relevance for initial offers in negotiations!

*Jacowitz, K. E., & Kahneman, D. (1995). Measures of anchoring in estimation tasks. Personality and Social Psychology Bulletin, 21(11), 1161-1166.
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Framing
▪ Framing refers to whether the same decision situation is construed as a loss
or a gain.
▪ Example:
Q1: You obtain CHF 10. You can share an arbitrary fraction of this with another player.
How much to you give?
Q2: Another player obtains CHF 10. You can take an arbitrary fraction of this from the
other player. How much to you take?
→ Experimental finding: Player keep sufficiently more under Q1 than under Q2!*
▪ Relevance:
− Positively framed concessions are easier to make
− Loss-frame negotiators are more reluctant to reveal information because of fear of
exploitation

*Engel, C. (2011). Dictator games: A meta study. Experimental Economics, 14(4), 583-610.

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Decision fatigue
▪ Decision making can be tiring and this can lead to deviations
from strict rationality.

Reading suggestions (German):

https://www.republik.ch/2018/01/13/wie-angela-merkel-verhandelt

Confirmation bias
▪ Tendency to give exaggerated weight to observations and arguments that are in favor of one’s hypotheses and
preconceptions.
▪ Example: This might have happened to Robert Campeau in the Campeau-Federated Merger when assessing the
value of Federated to his own business strategy.

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 Optimistic overconfidence
▪ Overconfidence is a mis-calibration of subjective probabilities
▪ Example: Brenner-Koehler-Tversky experiment on court cases*
− Three parts of information: 1) background 2) plaintiff’s argument 3) defendant’s argument
− Four groups
− Group 1 receives only background information
− Group 2 receives background information and plaintiff’s argument Groups 2 and 3 were less accurate
− Group 3 receives background information and defendant’s argument and more confident than Group 4
− Group 4 receives all information
▪ In conflicts, optimistic overconfidence carries the risk that conflicting parties both overestimate their own chance
of success.

*Brenner, L. A., Koehler, D. J., & Tversky, A. (1996). On the evaluation of one‐sided evidence. Journal of Behavioral Decision Making, 9(1), 59-70.

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Certainty effect
▪ Probabilities are often systematically overestimated or underestimated (depending on context)
E(x)=825
▪ Allais’ example: E(x)=2490 E(x)=2400 E(x)=816

Probability Lottery 1a Lottery 1b Lottery 2a Lottery 2b

0.66 2400 2400 0 0
0.33 2500 2400 2500 2400
0.01 0 2400 0 2400
Maurice Allais
Expected utility hypothesis (normalize ): (Nobel Laureate, 1988)

Experimental finding
▪ In conflicts, there is a risk that uncertain outcomes will be incorrectly assessed.

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 Loss aversion
▪ Losses are generally viewed as more negative than equal gains would be regarded positive:*
Curve is flatter.

Value function (~utility) flat

Value function (~utility) steep

Reference point depends on framing
The gain of happiness when I gain 100 CHF
will be smaller athan the sadness that I feel
when I lose 100 CHF

▪ Applies if a good is viewed as a good for use – but less so if a good is viewed as a means of exchange (e.g. a
bargaining chip
▪ Loss aversion may lead to concession aversion:
− In a disarmament process, own disarmament is a loss and weighs higher than opponents disarmament (=gain)

*Kahneman, D., & Tversky, A. (2013). Prospect theory: An analysis of decision under risk. In Handbook of the fundamentals of financial decision making: Part I (pp. 99-127).

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Many more cognitive biases are known are more are being explored!

Further reading
▪ Kahneman, D. (2011). Thinking, fast and slow. Macmillan. (see above)
▪ Elster, J., Arrow, K., Mnookin, R. H., Ross, L., Tversky, A., & Wilson, R. (1995). Barriers to Conflict Resolution.
▪ Deutsch, M., Coleman, P. T., & Marcus, E. C. (Eds.). (2011). The handbook of conflict resolution: Theory and
practice. John Wiley & Sons, Chapter 11.

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2.6 Summary
4 Approaches
▪ International relations: how to deal with the anarchy of the international system?
− Realism (→ power, security, machtstaat); source in human nature (classical) vs. source in structure (neo)
− Liberalism (→collaboration, institutions, democratic peace, morality, rechtsstaat)
▪ (Social) psychology
− Deutsch’s cooperation-competition theory (interdependence of goals and action types influence substitutatiblity, cathexis and
inducibility) and crude law of social relations
− Emotions: fear, hatred, humiliation
▪ Game theory
− Richardson’s arms race model as a non-game theoretic example of an arms race
− Utility and rationality
− Pareto efficiency
− Static games: dominant strategies, Nash equilibrium (in pure and mixed strategies)
− Dynamic games (sequential move games only): subgames, backward induction, subgame perfection
▪ Behavioral economics: merging psychology and economics/game theory. Heuristics and biases: anchoring,
framing, decision fatigue, confirmation bias, optimistic overconfidence, certainty effect, loss aversion

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3 Strategic Elements of Conflicts and Their Resolution
3.1 Overview
3.2 The Security Dilemma Revisited
3.3 Trust
3.4 Strategic Moves
3.5 Summary

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3.1 Overview
▪ If the eruption of (violent/inefficient) conflict is so costly, why would rational actors engage in it?
▪ If we want to resolve or even prevent the violent/inefficient eruption of conflict, we must have a better
understanding of what causes war.
▪ In this chapter we focus on bilateral conflicts and ignore external (f)actors (e.g. the legal system, the state
community, security alliances, external mediators, etc.).

▪ Main themes
− (Mis)trust
− Deterrence
− Assurance
− Commitment
− …

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“More than an end to war, we want an end to the beginning of all wars. Yes, an end to this
brutal, inhuman and thoroughly impractical method of settling the differences between
governments.”

Winston Churchill

When will our consciences grow so tender that we will act to prevent human misery rather
than avenge it?

Eleanor Roosevelt

It is a big mistake to say that war is irrational. We take all the ills of the world – wars, strikes,
racial discrimination – and dismiss them by calling them irrational. They are not necessarily
irrational. Though it hurts, they may be rational. If war is rational, once we understand that it
is, we can at least somehow address the problem. If we simply dismiss it as irrational, we
can’t address the problem.
Robert Aumann in his (controversial) Nobel Prize acceptance speech

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 Recall
Escalation (often fast) De-escalation (often slow)

Conflict intensity
level Conflict containment
▪ Not an exact science,
Conflict management some authors use
different terminology
Conflict settlement ▪ Prevention and
resolution measures
Conflict resolution
may coincide
Direct prevention (often also denotes the
entire process)

Structural prevention Conflict transformation

time

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3.2 The Security Dilemma Revisited
3.2.1 Why rational actors engage in destructive behavior

Prisoner’s dilemma
In this game conflict can be individually rational
“Defect” was dominant → conflict
can be individually rational! Which game are we actually
playing?
Stag hunt (=Assurance game)
Which equilibrium will be played?
Can I trust that the opponent will
cooperate?

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A refined model of the security dilemma*
Consider the following game

Remark: We could draw this game in as a

complicated extensive form game. Not
necessary: consider it as a standard
normal form game – endowed with an
We assume that all parameters are > 0 and . explicit motivation of the payoffs.
*Kydd, A. H. (2007). Trust and mistrust in international relations. Princeton University Press.

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 ! We will only consider pure-strategy Nash equilibria for this model !
Observations
▪ is a Nash equilibrium: if the other defects, then better void his/her first-mover advantage.
▪ By the same token, and are not Nash equilibria.
▪ is a Nash equilibrium if and only if for both players, i.e.
(c, c) is an equilibrium if deviation is not
If the gains are not to high, the probability of conflict is
profitable
lower.

in which case the game is a (somewhat asymmetric) version of the stag hunt.

Terminology
Player is a security seeker if , and an expansionist if .

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In reality, player might not know the value of and therefore payoffs are uncertain: incomplete information.
Harsayni’s trick and Bayesian games
▪ Each player’s value can assume two values and with .
▪ Introduce a new player, “Nature”, who moves first and decides between the two values for each player.
There is a common prior probability distribution according to which Nature chooses.
▪ Information regarding this first move is imperfect:
− Each player observes his/her own value.
− Each player can only form a belief regarding the other’s value – according to the common prior
probability distribution.
John Harsanyi
Introducing “Nature” transforms a game of incomplete information into one of imperfect information. (1920-2000)
Nobel Prize 1994
Incomplete information Imperfect information

Which game?

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 We assume that Nature draws the types ( vs. ) independently*: let be the probability that player is a
probability seeker (~ level of trust that player has). We also assume that there is a common prior probability
distribution.
Four states of the world:

In a Bayesian game, a strategy for player is a specification of his chosen action(s) for each each value of his/her type,
i.e. strategies are now functions of type.

A strategy profile is a Bayesian Nash equilibrium if it maximizes the expected payoff for each player given
their beliefs and given the strategies played by the other players.

*The
independence assumption is for simplicity. For more general distributions, each player updates his/her beliefs regarding the types of the other upon
observing his/her own type according to Bayes rule --- hence the name “Bayesian game”. For more complicated examples, attend a game theory course.
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