WIRTSCHAFTSUNIVERSITÄT WIEN

DEPARTMENT OF STRATEGY AND INNOVATION

INSTITUTE FOR MARKETS AND STRATEGY

SBWL Strategy and Data

Strategic Thinking and Analysis I

Lecture I-5

© WU IMS
 Organization
 A game is defined by: Players, Strategies, Payoffs, Info
 Game payoffs are utility payoffs. They depend on the
preferences of players, and are not necessarily equal to
$$$ payoffs.
  We have to know the preferences of players!
Otherwise we solve the wrong game.
• Experiments:
– Experiment 8: Dictator game
– Experiment 9: Ultimatum game
– Experiment 10: Repeated Ultimatum game
– Experiment 11: Market game
  And we assume rationality of all players. But what if
they aren’t?
• Experiment 12: Centipede Game
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 Experiment 12
 Centipede game
a) Derive the subgame perfect Nash equilibrium for the
one-shot game (game played only for one round).
Prove that the equilibrium you found is indeed one.
Are there more Nash equilibria, which are not
subgame perfect?

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 Experiment 12
 Centipede game
1 2 3 4 5 6 7 8 9 10
A: 96
A B A B A B A B A B B: 32

A: 3 A: 1.5 A: 6 A: 3 A: 12 A: 5.5 A: 24 A: 11.5 A: 48 A: 22.5

B: 1 B: 4 B: 2 B: 8.5 B: 4 B: 17 B: 8 B: 34 B: 16 B: 68

 The only subgame perfect Nash equilibrium:

(“down at every node”, “down at every node”)
  When observing players playing this game, given these
strategies, the only outcome we will observe will be A
choosing down at the very first node.
 There are more than one Nash equilibria (but all of them
involve going “down” at the first and second node).
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 Experiment 12
 Data
b) Analyze the data set of experiment 12. How do
participants behave? Do you observe different
behavior over time, over the 3 rounds of the game?
c) How would you explain the behavior of participants?

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 Experiment 12
 When do participants choose down?
1 2 3 4 5 6 7 8 9 10
A: 96
A B A B A B A B A B B: 32

A: 3 A: 1.5 A: 6 A: 3 A: 12 A: 5.5 A: 24 A: 11.5 A: 48 A: 22.5

B: 1 B: 4 B: 2 B: 8.5 B: 4 B: 17 B: 8 B: 34 B: 16 B: 68

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 Experiment 12
 When do participants choose down?
1 2 3 4 5 6 7 8 9 10
A: 96
A B A B A B A B A B B: 32

A: 3 A: 1.5 A: 6 A: 3 A: 12 A: 5.5 A: 24 A: 11.5 A: 48 A: 22.5

B: 1 B: 4 B: 2 B: 8.5 B: 4 B: 17 B: 8 B: 34 B: 16 B: 68

 Given observed behavior,

Player B in Step 10 is the first who would make
more money from going down than from going
right (and planning to go down at the next
possibility).
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 Limited depth of reasoning
 How far can you think?
 Cognitive psychology:
• short term memory capacity limit of 7±2 “chunks”
• Embedding creates cognitive problems
Four levels: “The movie that the script that the novel
that the producer whom she thanked discovered
became was made into was applauded by the critics.”
 k-level thinking models
• Players have different levels of rationality, which can be
expressed by a level k.
• Level-0 players play some simple strategy which is not
dependent on other players’ behavior. Examples:
random, just cooperate, ...
• Level-k>0-players play a best response to the
distribution of players of levels 0 to k-1.
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 Limited depth of reasoning
 Example
1 2 3 4 5 6 7 8 9 10
A: 96
A B A B A B A B A B B: 32

A: 3 A: 1.5 A: 6 A: 3 A: 12 A: 5.5 A: 24 A: 11.5 A: 48 A: 22.5

B: 1 B: 4 B: 2 B: 8.5 B: 4 B: 17 B: 8 B: 34 B: 16 B: 68

 Level 0: go down at last move, i.e. 9/10

 Level 1: best response (BR) against level 0: go down at 7/8
 Level 2: BR against 0 and 1: mix of down at 7/8 or 5/6
 Level 3: BR against 0, 1, 2: mix of down at 7/8, 5/6, 3/4
 Level 4: BR to 0, 1, 2, 3: mix of down at 7/8, 5/6, 3/4, 1/2
 … more levels …
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 Limited depth of reasoning
 What are the issues with this level-k reasoning approach?
• All depends on choice of level-0 behavior. (Is it
random? Is it an „intuitive“ choice? What does
„intuition“ mean?)
• Frequency of levels can be econometrically estimated
(maximum likelihood estimation), but should be
constant across games.
• It‘s not an equilibrium concept. (It‘s always better to
have a higher level.)
• The applicability of the model is limited to simple
games. (In particular, we cannot use any other tools of
game theory to analyze (more complex) games under
the assumption of level-k behavior.)

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 Take-aways
 A game is defined by: Players, Strategies, Payoffs, Info
  We have to know the preferences of players! Otherwise
we may solve the wrong game.
 Utilities over game outcomes might depend on other’s
payoffs or intentions.

  We assume rationality of all players. But people may not

be rational.
 We can model bounded rationality. But then we cannot
use our traditional game-theoretical tools and concepts
anymore.

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 Experiment 13
 Repeated price competition with 2 firms
a) Derive all Nash equilibria for the one-shot game
(game played only for one round). Prove for each
equilibrium you found that it is indeed one. Show that
there are no other equilibria.
b) Derive the subgame perfect equilibrium for the 10-
rounds repeated game.

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 Experiment 13
Player 2
0.08 0.12
 The Nash equilibrium of
the one-shot game is:
12* 0 • Player 1: Choose
0.08 price of 0.08.
Player 1

12 * 24 *
• Player 2: Choose
24* 17.5
price of 0.08.
0.12
0 17.5

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 Experiment 13
 The equilibrium of the repeated game (repeated with the
same players) corresponds to playing the one-shot
equilibrium in each repetition.
 Why? Backward induction!
• In the very last repetition, what is the equilibrium of
the game?
• The unique one-shot equilibrium! That means, behavior
in the very last round is completely independent of any
behavior before.
• Thus, in the second last round, as behavior has no
impact on how players will behave in the last round,
the game is played as if it is the last game.
• The same is true for the second-to-last round, etc.etc.,
until we arrive at the first round.
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 Recap: Finitely repeated games theorem
 Theorem:
• If a game G has a unique subgame perfect Nash
equilibrium, then there exists a unique subgame
perfect Nash equilibrium in the finitely repeated game
G(T) in which the subgame perfect Nash equilibrium of
the game G is played in each repetition.

• Proof: We find the SPNE of the T times repeated game

by rollback. The SPNE solution for the last repetition T
will be the SPNE of the one-shot game. So play in the
second-to-last repetition T-1 cannot change what
comes after in T. As a result, the SPNE solution for the
second-to-last repetition T-1 will also be the SPNE of
the one-shot game. Etc. etc. until the first repetition.
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 Experiment 13
 The subgame perfect Nash equilibrium of the repeated game is:
• Player 1: Choose price of 0.08 in each round.
• Player 2: Choose price of 0.08 in each round.

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 Experiment 13
 What about punishing strategies. E.g. both play: “I start
with a high price, but I will select a low price whenever I
see the other selecting a low price?” Is this an equilibrium?
 No:
• A best response to someone playing this strategy would
be: I do the same, only that in the very last period I
choose a low price.
• A best response against that would be to defect in the
second-to-last period …. etc. etc.
 Even if the other guy believes my punishing strategy, and
plays cooperatively, I myself would have an incentive to
choose another strategy.
 Even in the repeated game, there is only one unique Nash
equilibrium. There are no other Nash equilibria
(for example involving not credible threats or similar).
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 Experiment 13
 Data
c) Analyze the data set of experiment 13. What do
people do? Can you observe specific patterns of
behavior over time?

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 Experiment 13

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 Little
No
cooperation Experiment 13 cooperation
in last round

Some
successful
cooperation Tit for tat
attempts (punishment)
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 Experiment 13
 Data
d) Compare the results of theoretical and data analysis
to experiment 2 (simultaneous price competition,
conducted in tutorial 1 and analyzed in lecture 2).
What are the most important differences between
experiment 13 and experiment 2?

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 Experiment 13
 For the competition game of experiment 2, we had a
similar prediction of behavior as for the game of this
experiment: all firms set the lowest price.
 In experiment 2 we observed that this was indeed the
case: already in the 1st round, the equilibrium price was
reached, and most individual price offers were at the
equilibrium in the 2nd round, with very few deviations.
 In experiment 13, we observe more cooperation but still
not much.
 Generally speaking:
• Groups of 2: better coordination on collusion.
• Same partner in all rounds: potential of punishment!

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 Dilemma games
 A dilemma game is a game where
• individual rationality and
• group rationality
suggest different ways of behavior
 In other words: given behavior of other group members,
what’s best for the individual is not best for the group.
 General problem:
• negative external effects of my behavior on others
are not “internalized“
• Others’ profit reduction when I undercut
• Team’s loss in marks when I do not contribute = don’t
• Friends’ loss when I take too much for myself affect or
bother me
• Partner’s loss if I do not cooperate
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 Dilemma games: Examples
 Collusion of firms (also experiments 2, 3, 7)
• “Group” rationality: all choose monopoly price and
share the resulting monopoly profits
• Individual rationality: undercutting others’ prices yields
high profits
• Outcome: competitive prices, all firms make less profits
than when cooperating
 Note: this outcome is good for a larger group: the society

 Means to solve the dilemma:

• Communication
• Commitment to price matching policies
• Reputation / repeated interaction
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 Dilemma games: Examples
 Provision of public goods
• non-excludable: nobody can be excluded
• non-rival: one’s consumption does not hurt others
• Public transport, streets and sidewalks, …
• Group rationality: everybody benefits if provided
• Individual rationality: free-ride on others’ contributions
• Outcome: public goods are not (or under-) provided
 Means to solve the dilemma
• Observation and punishment
• Threshold public goods – everybody says how much he
would provide in case sum of contribution reaches
certain threshold, does not have to provide otherwise
 everybody is “marginal”
 put problem on head and compare to price matching
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 Dilemma games: Examples
 Common pool resources (very similar to public goods)
• Imagine a pond with a number of fishermen. Each
fisherman can fish how many he likes, but if too many
fish are caught, the fish will die out
• Group rationality: fish as much as optimal long term
• Individual rationality: given other fisherman reduce, just
fish a little more which does not hurt myself
• Outcome: everybody fishes more

 Other examples: fertilizers and water salinisation, air

pollution, carbon emissions

 Means to overcome the dilemma:

• Tax or tradable quotas – costs to society are internalized
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 Dilemma games
 The prototype: The Prisoner‘s dilemma
WIFE

Confess Deny

10 years 25 years
Confess
10 years 1 year
HUSBAND
1 years 3 years
Deny
25 years 3 years

 Unique Nash equilibrium in dominant strategies

 If the other confesses, I should confess
 If the other denies, I should confess

 I am not sure what the other does: Murder by numbers

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 Dilemmas
 Behavioral/strategic aspects of social dilemmas:
• Repetition with the same persons
• Positive reciprocity, conditional cooperation
• Negative reciprocity, punishment
• Counter-punishment

 Things known to influence cooperation in social dilemmas

• Group size • Communication
• Benefits from cooperation • Gender
• Leadership • Culture

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 Infinity
 We started with most restrictive assumptions: complete
information, full rationality, selfish players
Application Game theory with above assumptions We get better predictions
helps us to understand … when relaxing the
assumption of …
Markets the incentives of buyers and sellers, the -
value of timing and commitment
Bargaining bargaining power based on the rules of selfish players
the interaction  social preferences
Centipede the fragility of cooperation, and the need full rationality
to think about others’ depth of reasoning  bounded rationality
Infinite social the power of the “shadow of the future” -
dilemma
… … …

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 Experiment 14
 Dilemma of unknown (probabilistic) length
a) Write down this game as exact and concise as you
can. Derive at least one subgame perfect Nash
equilibrium of this game. Show that the equilibrium
you found is indeed subgame perfect.
b) Can cooperation be achieved in this game by rational,
egoistic players? How could they reach it?

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 Experiment 14
 Dilemma of unknown (probabilistic) length
 Backward induction?
Player 2
 No defined end, so no
0.08 0.12 rollback possible!
 Any round is equal, as
12* 0 the expected number of
0.08
rounds to play stays the
Player 1

12* 24*
same in each round.
0.12
24* 17.5  What now?
0 17.5  Is 0.08/0.08, played
in all rounds, still an
δ=0.9 equilibrium?
 Yes.
But there are more!
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 Experiment 14
Player 2
0.08 0.12
12* 0
Player 1

0.08
12* 24*
24* 17.5
0.12
0 17.5

 Assume players choose the following strategies:

• Player 1: I choose a low price all the time.
• Player 2: I choose a low price all the time.

 This is a Nash equilibrium. Given the strategy of the

other guy, I have no incentive to ever deviate from this.

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 Experiment 14
 What is a subgame in this game?
• Remember: a subgame is a game which starts at
some decision node after the root node of the original
game.
• In an infinite game with a fixed discount
factor/continuation probability per repetition, the
same game is repeated again and again.
• Thus, a subgame of the infinitely repeated game is
the same infinitely repeated game as the original
game.
• Ergo, an equilibrium found for the original game, the
infinitely repeated game starting today, must be also
an equilibrium in each subgame starting later, and
can therefore be called subgame perfect.
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 Experiment 14
Player 2  Assume the following grim trigger
0.08 0.12
strategies: “I start with cooperating. If
12* 0
Player 1

0.08 you cooperate, then I will continue

12* 24*
cooperating. If you defect once, from the
24* 17.5
0.12
0 next round on I will defect forever.”
17.5 

 Is playing these strategies an equilibrium? 
t 1
 
t

1 
 Say I comply with the strategy, then my expected profit is:

0.9
17.5  0.9 17.5  0.9 17.5  ...  17.5   0.9 17.5  17.5  17.5  175
2 t

t 1 1  0.9
 If I deviate once, and then always have no cooperation:

0.9
24  0.9 12  0.9 12  ...  24   0.9 12  24 
2 t
12  132
t 1 1  0.9
 Is the punishment credible? Yes: It’s the one-shot Nash!!!
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 Experiment 14
 Data
c) Analyze the data set of experiment 14. Do you see
any pattern in the interactions of the two players?

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 Experiment 14

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 Experiment 14

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 Infinitely repeated games
 Some players might have limited foresight such that
they see a game as infinite
 A game might actually be infinite, or has a certain
continuation probability after each round
 Does this change rational behavior in such games?
 Yes:
• Backward induction is not feasible anymore, thus
arguments relying on rollback cannot be applied
• Rather, each repetition of the game can be seen
as having the same future prospects  solving for
one round (under the shadow of the future!)
should yield a solution for all rounds
 Note: Playing the one-shot equilibrium in each round
is still an equilibrium in the infinitely repeated game.
But there are others now …
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 Infinitely Repeated games theorem
 If a game G has a unique Nash equilibrium, then there
exists a unique subgame perfect Nash equilibrium in the
infinitely repeated game G(T∞) in which the Nash
equilibrium of the game G is played in reach round t.

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 Infinitely repeated games
Player 2  How to interpret δ ?
Round 1
D C a) Game continuation probability:
2 1
Player 1

D
2 6
with a probability of δ the game is
6 5 continued. Thus, in expected terms,
C
1 5 seen from today, the next game is
Player 2 δ played for amounts of δ · X, etc.
Round 2 D
δ
C b) Discount factor: right now, money
δ2 δ1 earned next year is less valuable to
Player 1

D
δ2 δ6
δ6 δ5
us than money earned today. So
C
δ1 δ5 when a game is played infinitely,
Player 2 δ
income from later rounds is less
Round 3 D C valuable than today’s income. 1 – δ
δ22 δ21 is this loss of value for each round in
Player 1

D the future, seen from today.

δ22 δ26
δ26 δ25
C
δ12 δ5 2 … c) Product of both
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 Infinitely repeated games
 Let C, D, H, and L be the utility Player 2
payoffs from a dilemma game, D C
with H > C > D > L.
D L
 Let 0 p 1 be the probability D

Player 1
D H
that the game continues after a
round. Let 0 d 1 be the H C
C
discount factor per round. Let L C
δ = p · d.
 Define a Tit-for-tat strategy as: “I play C in the first
round, and in each other round I play whatever the other
player played before.”
 Is mutual Tit-for-tat an equilibrium in this game?
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 Infinitely repeated games
 Is one-time defection worthwhile? Player 2
 If a player complies, then¥his net D C
present value is C + dC + åd t ×C
D L
t=2 D

Player 1
D H
 If a player defects once against
T4T his net present value¥is H C
H + d L + åd ×C t C
L C
t=2
 So he should one-time defect if
¥ ¥
H -C
H + d L + åd ×C > C + dC + åd ×C Þ
t t
>d
t=2 t=2
C- L
 If loss from punishment (C-L) is large or benefit from
defecting (H-C) is small or the next round has relatively
high value, then one-time defection does not pay.
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 Infinitely repeated games
 Is all-time defection worthwhile?   t  

Player 2
1 
 If a player complies, then his net t 1 D C
present value is 

C   C  C  t D L
C D
1 

Player 1
t 1 D H
 If a player defects forever against
H C
T4T then his netpresent value is
 C
H   t  D  H  D L C
t 1
1 
 So he should defect if
H

1 
DC

1 
C  H C


C  D 1   H C

1
C  D 1 
1
 If loss from continued punishment (C-D) is high or one-
time benefit from defection (H-C) is low or the future has
a high value, then all-time defection does not pay.
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 Infinitely repeated games
 Partially numerical example: δ=0.9
   0.9  H  C  0.9  C  L 
H C
 One-time defection if
CL
Player 2
 If the gain from defecting today,
D C
compared to cooperation, H-C, is larger
D L

Player 1
than the discounted loss from the T4T D
D H
player’s punishment next round, 0.9(C-L), H C
C
then I should defect once. L C
H C
 1  9  H  C  9 C  D 
1
 All-time defection if 
C  D 1 
 If the gain from defecting today, compared to
cooperation, H-C, is larger than the loss from mutual
defection in the discounted remaining rounds (expected
value=9), 9(C-D), then I should defect forever.
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 Infinitely repeated games
 Folk Theorem (Friedman 1971):
• Let G be a static n-person game with complete
information. Let e = (e1, ..., en) be the payoff vector in a
Nash equilibrium of G and let x = (x1, ..., xn) be a feasible
payoff vector in G, and let xi > ei for all players i .
• If  close enough to 1, then there exists a subgame
perfect Nash equilibrium of the infinitely repeated
game G(,  ) which implements the payoff vector x als
average payoff.
 In other words: any feasible payoff combination (x1, ..., xn)
(with xi > ei for all players i) can be implemented by some
trigger strategies in an infinite game.
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 Infinitely repeated games Player 2
 What does that mean? D C
• Payoff vectors 2 1

Player 1
D
• Feasible payoff vectors 2 6

• with xi > ei for all players i 6 5

C
1 5
 Folk theorem: Each point in the
green area can be implemented as (1,6)
average payoff, by a) playing a 6 (5,5)
combination plan over the 4 cells
and b) threatening to always play

Player 2
(2,2) if somebody deviates from
this plan
 Note: (2,2) is a credible threat, as (2,2)
it is a stage game equilibrium, and (6,1)
worse than any payoff in the green
area. 0 Player 1 6
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 Take-aways

 Not all people are fully rational. We can model bounded

rationality. But then we cannot use the standard game-
theoretical tools and concepts anymore.

 If the shadow of the future is important enough, almost

anything can be an equilibrium.

© WU IMS 47