BE 510 Business Economics 1

2. Game theory – Nash equilibrium and other

solution concepts
Prof. Dr. Henrik Orzen

Office hour: Tuesdays, 16:00-17:00 (by appointment)

Room 4.01 (Department of Economics, L7, 3-5)
E-Mail: henrik.orzen@uni-mannheim.de
 BE 510 Business Economics 1 • Expected utility theory

A question
} I give you €10,000. Think about what you want to do with that money.
} You now have two options. 78% choose “safe”
} 50-50 chance of another €10,000 on top or €0 on top.
} Or: An extra €5,000 for sure.

} I give you €20,000. Think about what you want to do with that money.
} You now have two options.
66% choose “safe”
} 50-50 chance of losing €10,000 or losing nothing.
} Or: You give up €5,000 for sure.

Statistical significance of this effect (p-value): 0.029

 BE 510 Business Economics 1 • Expected utility theory

The common consequence effect

Experimental evidence
} For example, Starmer and Sugden (1991), AER.
} Alternative A: 1.00[£7] D
} Alternative B: 0.75[£7] ⊕ 0.05[£0] ⊕ 0.20[£10]
} Alternative C: 0.75[£0] ⊕ 0.25[£7] D

} Alternative D: 0.80[£0] ⊕ 0.20[£10] C

C
} What did you do?
A Choices B Choices
} Alternative A: 1.00[€1m] 100%
} Alternative B: 0.85[€1m] ⊕ 0.05[€0] ⊕ 0.10[€5m]
80%
B, 59
} Alternative C: 0.85[€0] ⊕ 0.15[€1m] D, 105
60%
} Alternative D: 0.90[€0] ⊕ 0.10[€5m]
40%
20% A, 57
C, 24
0%
Statistical significance of this effect (p-value): < 0.001
A vs B C vs D
 BE 510 Business Economics 1 • Game theory – Nash equilibrium and other solution concepts

Quiz questions
(1) “If there is common knowledge of rationality, all players know that the other
players are rational.” This statement…

} ...is incorrect. 1

} ...is incomplete. 64

} ... both correct and complete. 42

0
 BE 510 Business Economics 1 • Game theory – Nash equilibrium and other solution concepts

Quiz questions
(2) A strictly dominant strategy…

} …is the explicit attempt to defeat ALL rival players.

0

} …is the ONLY obvious strategy but not necessarily

11
the best one.
} …yields a strictly greater expected payoff than all
21
other strategies.
} …yields a strictly greater payoff than all other
76
strategies regardless of the other players’ strategies.
 BE 510 Business Economics 1 • Game theory – Nash equilibrium and other solution concepts

Quiz questions
(3) Having reached a Nash equilibrium means that…

} ……no individual player has any reason to switch his or 43

her strategy unilaterally.
} …no player has any reason to switch his or her strategy, 10
and if (s)he DID switch, (s)he would be worse off.

} …all players use (weakly or strictly) dominant strategies. 14

} …there is no other outcome that would make any one

41
player better off without making at least one other player
worse off.
 BE 510 Business Economics 1 • Game theory – Nash equilibrium and other solution concepts

Quiz questions
(4) The battle of the sexes…

} …is a particular kind of coordination problem. 83

} …shows that pairs (or groups) may suffer when the 17

individual players all pursue their self-interest.
} …demonstrates that sometimes there is no Nash 3
equilibrium.
} …illustrates how iterated elimination of weakly
5
dominated strategies can lead to multiple solutions.
 BE 510 Business Economics 1 • Game theory – Nash equilibrium and other solution concepts

TRAQ: Top Rated Questions

 BE 510 Business Economics 1 • Game theory – Nash equilibrium and other solution concepts

Equilibrium in dominant strategies vs. NE

Example 1: Equilibrium in dominant strategies

Column player

X Y Z

A 5, 5 2, 3 7, 1

Row player B 4, 4 1, 3 7, 4

C 5, 8 0, 6 5, 5
 BE 510 Business Economics 1 • Game theory – Nash equilibrium and other solution concepts

Equilibrium in dominant strategies vs. NE

Example 1: Nash equilibria

Column player

X Y Z

A 5, 5 2, 3 7, 1

Row player B 4, 4 1, 3 7, 4

C 5, 8 0, 6 5, 5
 BE 510 Business Economics 1 • Game theory – Nash equilibrium and other solution concepts

Equilibrium in dominant strategies vs. NE

Example 2: Coordinating on industry standards – No dominant strategies!
Firm 2
Standard 1 Standard 2
Standard 1 2, 1 0, 0
Firm 1
Standard 2 0, 0 1, 2

The battle of the firms

} Coordinating better than not, but players differ in their views about how to best coordinate.
} Two outcomes where we have mutual best responses.
} Given that Firm 1 adopts standard 1, firm 2’s best response is to also us that standard – and vice versa.
} Given that Firm 1 adopts standard 2, firm 2’s best response is to also us that standard – and vice versa.
} Mutual best responses = Nash equilibrium.
 BE 510 Business Economics 1 • Game theory – Nash equilibrium and other solution concepts

Pareto efficiency
The idea in more detail
} An outcome is Pareto-efficient if there is no other (available) outcome that would make at least
one player better off without making at least one other player worse off.
} In other words:
} If we find ourselves in a situation…
n in which all of us could be made better off if we did something differently, perhaps collectively and in a coordinated way, or…

n in which at least one of us could be made better off (without harming anyone else) if we did something differently, perhaps
collectively and in a coordinated way,
then we should not stay where we are! We should try to achieve this improvement!
The current situation is NOT Pareto-efficient.
} But if we find ourselves in a situation in which there is no possible collective move that would make at least
one of us better off without harming anyone else, then the current situation IS Pareto-efficient.
} Side remark: Even if a situation is Pareto-efficient, there may still be reasons for changing it.
For example: Redistribution (because of fairness concerns or because of alternative ideas about efficiency).
 BE 510 Business Economics 1 • Game theory – Nash equilibrium and other solution concepts

Another example
Nash equilibria?

Column player

X Y Z

A 5, 5 2, 7 4, 6

Row player B 4, 2 3, 3 2, 1

C 3, 8 0, 6 7, 5
 BE 510 Business Economics 1 • Game theory – Nash equilibrium and other solution concepts

Another example
IEWDS?

Column player

X Y Z

A 5, 5 2, 7 4, 6

Row player B 4, 2 3, 3 2, 1

C 3, 8 0, 6 7, 5
 BE 510 Business Economics 1 • Game theory – Nash equilibrium and other solution concepts

Another example
IEWDS?

Column player

X Y Z

A 5, 5 2, 7 4, 6

Row player B 4, 2 3, 3 2, 1

C 3, 8 0, 6 7, 5
 BE 510 Business Economics 1 • Game theory – Nash equilibrium and other solution concepts

Another example
IEWDS?

Column player

X Y Z

A 5, 5 2, 7 4, 6

Row player B 4, 2 3, 3 2, 1

C 3, 8 0, 6 7, 5
 BE 510 Business Economics 1 • Game theory – Nash equilibrium and other solution concepts

Another example
IEWDS?

Column player

X Y Z

A 5, 5 2, 7 4, 6

Row player B 4, 2 3, 3 2, 1

C 3, 8 0, 6 7, 5
 BE 510 Business Economics 1 • Game theory – Nash equilibrium and other solution concepts

Another example
Pareto efficiency?

Column player

X Y Z

A 5, 5 2, 7 4, 6

Row player B 4, 2 3, 3 2, 1

C 3, 8 0, 6 7, 5
 BE 510 Business Economics 1 • Game theory – Nash equilibrium and other solution concepts

A game

Choose a number between 0 and 100.

The winner is the person whose number

is closest to 2/3 times the average of all
chosen numbers.
 BE 510 Business Economics 1 • Game theory – Nash equilibrium and other solution concepts

The guessing game

Why does Nash equilibrium not predict well in this game?
} Bounded rationality prevents players from fully reasoning their way to the equilibrium.
} Rational players reckon that other players are boundedly rational and best-respond to the
behavior they expect from the other players.
} A possibility: Nobody is actually boundedly rational!
} Everybody is fully rational but believes that other players aren’t.
} Everybody is fully rational and knows that the others are fully rational too but believes that other players
believe that there are boundedly rational players.
} Everybody is fully rational, knows that the others are too and knows that the others know this as well, but
believes that other players believe that other players believe that there are boundedly rational players.
} …
 BE 510 Business Economics 1 • Game theory – Nash equilibrium and other solution concepts

The guessing game

Some evidence: The typical pattern
} 3 newspaper experiments:
} Financial Times (UK)
} Expansión (Spain)
} Spektrum der Wissenschaft (Germany)

} 7,900 submissions.
 BE 510 Business Economics 1 • Game theory – Nash equilibrium and other solution concepts

The guessing game

Some evidence: The typical pattern
Histogram of numbers chosen
} Classroom experiments in BE1:
0.10

0.09

0.08

0.07

0.06

0.05

0.04

0.03

0.02

0.01

0.00
0 5 10 15 20 25 30 35 40 45 50 55 60 65 70 75 80 85 90 95 100
Number
The level-k model
Levels of outsmarting others:
} Level-0: “It all looks quite random, so I’ll just guess.”
} Level-1: “I think that most people won’t have a clue what to choose and so the average number
will be around 50. Two-third of that would be 33.”
} Level-2: “Assuming that everyone thinks the average will be 50 based on random probability, I
expect most choices to be located around 33. I am going to choose two-third of that, 22.”

Thus:
} Level-0: Uninformed random play.
} Level-𝑘: Best responding to level-(𝑘 − 1).
} Nash equilibrium at level-∞.

Question: Do people buy stocks just based on their fundamental values?