In-Depth Notes on Game Theory and Strategic Decision Making

Strategic Game Playing

• Outcomes in games often involve cooperation.
• Cooperative solutions can benefit all players, but achieving them is not always guaranteed.
• Distinction between cooperation games (where players can jointly benefit) and coordination games (where specific coordination leads to better outcomes).

Definition of Game Theory

• Game Theory: A subfield of economics analyzing decision-making where the choices of one player affect the outcomes of others.
• Outcomes depend on strategies chosen by all players involved.

Firm Strategies in Competitive Markets

• Firms possess market power and can charge prices above marginal cost based on product differentiation.
• Competitive behavior includes pricing, customer service, and product features influencing another firm's decisions and profitability.
• Firms respond to each other's strategies in the same market structure to maximize market share.

Interdependence Principle

• Understanding payoffs requires acknowledging the strategies of other players.
• Payoffs are outcomes derived from the interaction of strategies among economic agents (e.g., firms, consumers).

Common Examples of Game Theory

• Familiar contexts include board games and competitive interactions in everyday life (negotiating with family, market competitor behaviors).
• Applications also appear in politics, international relations, and strategic interactions in real-world scenarios.

Steps to Analyze Decision-Making in Game Theory

1. Identify Outcomes: Determine the possible outcomes of the game.
2. Consider Opponent's Strategies: Analyze what strategies opponents may employ.
3. Best Response: Decide on the best response to opponent strategies.
4. Analysis: Assess overall decisions considering the strategies of multiple players.

Key Definitions in Game Theory

• Players: Economic agents making decisions (e.g., firms, consumers).
• Strategies: Choices made by players (e.g., pricing, advertising).
• Payoffs: The consequences of chosen strategies (e.g., profits, market share).

Game Representations

• Normal Form Game: Displayed in a payoff table for simultaneous moves where players make decisions at the same time.
  • Requires knowledge of payoffs based on concurrent strategies of players.
• Extensive Form Game: Represents sequential moves where one player decides first, and the others respond.
  • Useful in cases like first-mover advantages in various industries.

Example of Game Theory in Practice: Golden Balls Game

• Basic gameplay involves choices to "split" funds or "steal" them.
• Outcomes depend on the decisions of both players regarding these two strategies.
  • Split: Each player receives half.
  • Steal: One player takes all funds if the other chooses split; both leave empty-handed if both choose steal.
  • The game illustrates trust and strategic choice in decision-making.

Using Payoff Tables

• Payoff tables outline potential outcomes based on player decisions.
• Each cell in the table represents a combination of strategies and their respective payoffs.
• Players evaluate payoffs to determine best strategies based on what the other may choose.

Nash Equilibrium

• Occurs when no player can benefit by changing their strategy while the other player's strategy remains unchanged.
• The outcome persists because it's the best response for each player given the other's choice.

Prisoner's Dilemma

• Demonstrates a situation where individual rationality leads to collective non-cooperation.
• Both players have incentives to defect for a better individual payoff, leading to worse outcomes overall.
  • Example: Two prisoners deciding to confess or remain silent with varying incentives.

Application of the Prisoner's Dilemma

• Commonly studied in economics, politics, and social sciences to understand cooperation failures.
• Often, players act in self-interest leading to suboptimal collective outcomes despite potential benefits from cooperation.

Economic Examples: Coca-Cola and Pepsi

• The scenario posits advertising budgets driving competitive behavior.
  • If both cooperate by not advertising, profits are maximized.
  • If one defects while the other cooperates, the defector gains all market share at the expense of the cooperator.