Chapter 2 People, Preferences and Society

Human Behaviour Human Behavior in economics is modeled as being purposive: Individuals make choices to take various actions (within their constraints); they seek to bring about the outcomes they desire (according to their preferences); and they base their choices on their understandings (beliefs) about how certain actions may bring about the desired outcomes.

Homo Economicus Recall Definition of ‘Homo Economicus’; most economists short hand description of human behavior Self-interested, rational, maximizer of utility.

Trying to Assess Human interaction when Self Interest Prevails Entire Sub Branch of Economics: Game Theory A Beautiful Mind? Strategic Interactions giving rise to social outcomes Use Self-interest to model institutional regularities

Inspiration: John von Neumann Founded Game Theory with Oskar Morgenstern ( ) John von Neumann ( ) created two intellectual currents in the 1930s and 40s

Robert Aumann Nobel 2005 Thomas Schelling Nobel 2005 John Nash Jr Nobel 1994 John Harsanyi Nobel 1994 Richard Selten Nobel 1994 Lloyd Shapley Nobel ???? GAME THEORY PIONEERS

What is a Game? There are many types of games, board games, card games, video games, field games (e.g. football), etc. We focus on games where: –There are 2 or more players. –There is some choice of action where strategy matters. –The game has one or more outcomes, e.g. someone wins, someone loses. –The outcome depends on the strategies chosen by all players; there is strategic interaction. What does this rule out? –Games of pure chance, e.g. lotteries, slot machines. (Strategies don't matter). –Games without strategic interaction between players, e.g. Solitaire

Why Do Economists Study Games? Games are a convenient way in which to model the strategic interactions among economic agents. Many economic issues involve strategic interaction. –Behavior in imperfectly competitive markets, e.g. Coca-Cola versus Pepsi. –Behavior in auctions, e.g. Investment banks bidding on U.S. Treasury bills. –Behavior in economic negotiations, e.g. trade. Game theory is not limited to Economics.

Five Elements of a Game: 1.The players –how many players are there? –does nature/chance play a role? 2.A complete description of the strategies of each player 3.A description of the consequences (payoffs) for each player for every possible profile of strategy choices of all players. 4.Sequence in which game is played 5. Can represent in a ‘payoff matrix’

The Prisoners' Dilemma Game Two players, prisoners 1, 2. Each has two strategies. –Prisoner 1: Don't Confess, Confess –Prisoner 2: Don't Confess, Confess –Payoff consequences quantified in prison years. fewer years=greater satisfaction. –If P1 confesses and the other does not, P1 gets 10 years, P2 gets 1 year,and vice versa. If P1 does no confess and P2 does not confess, they both get 2 years each. If they both confess, they get 5 years each.

E-Commerce Lab, CSA, IISc 11 Dominant Strategy Equilibrium No Confess NC Confess C No Confess NC - 2, , - 1 Confess C-1, , - 5 (C,C) is a dominant strategy equilibrium A dominant strategy is a best response whatever the strategies of the other players

12 Nash Equilibrium No Confess NC Confess C No Confess NC - 2, , - 1 Confess C-1, , - 5 (C,C) is a Nash equilibrium A Nash equilibrium occurs when every player is undertaking the best strategy given the strategies of the other players

Dilbert!

Applications: Many! Two countries share a water body. Two strategies: pollute or don’t pollute. Not polluting is costlier than polluting. What will happen? Two firms can collude or compete. If they collude, they set higher prices and both make a profit of 10. If one competes with a slightly lower price, it makes 15 and the other 5. If they both compete, they both make 5. What will happen?

Concept of Nash Equilibrium Nash Equilibrium: Every player is undertaking his or her best strategy given the strategies of the other players Some games have more than one Nash Equilibrium Not all games need have Nash Equilibria

The coordination game I am supposed to meet a friend for Coffee. I prefer to meet at UMB. My friend prefers to meet me at Cambridge. We both prefer to meet rather than not to meet. What is the game structure for this game?

E-Commerce Lab, CSA, IISc 17 Example : Coordination Game F A UMBCambridge UMB 50,100,0 Cambridge 0,010,50 Models the strategic conflict when two players have to choose their priorities

E-Commerce Lab, CSA, IISc 18 Equilibria in Coordination Game Frd Arjun UMBCambridge UMB 50,100,0 Cambridge 0,010,50 Two Nash Equilibria

Matching Pennies Player A and Player B. Each player has a penny and must secretly turn the penny to heads or tails. The players then reveal their choices simultaneously. If the pennies match (both heads or both tails), Player A receives one dollar from Player B (+1 for A, -1 for B). If the pennies do not match (one heads and one tails), Player B receives one dollar from Player A (-1 for A, +1 for B).

20 Example : Matching Pennies 1, -1-1,1 1,-1

E-Commerce Lab, CSA, IISc 21 Equilibria in Matching Pennies No pure strategy NE here (1,-1)(-1,1) (1,-1)

Try this one out yourself uYudVAhttp:// uYudVA If you jump out first- you lose face, the other guy wins. If you both jump out, no one loses. If you both don’t jump out-you die.

23 Example : Chicken Game Is there a Nash Equilibrium? SwerveStraight Swerve 0, 0-1,1 Straight 1, ,-1000

What can self interest not explain? Interesting set of experiments in the 1980s and 1990s using game theory and other sorts of tools. Ernst Fehr and Simon Gachter

“Ultimatum Game” Version of Take it or Leave it Bargaining Player 1 moves first and proposes a division of $1.00. Suppose there are just 3 possible divisions, limited to $0.25 increments. Player 1 can propose x=$0.25, x=$0.50, or x=$0.75 for himself, with the remainder, 1-x going to Player 2. Player 2 can then accept or reject Player 1’s proposal. If Player 2 accepts, the proposal is implemented. If Player 2 rejects, both players get $0 each. The $1.00 gains from trade vanish.

What happened? Check out chapter 2 Paves the way for reconsideration of homo economicus

Findings from the Ultimatum game Most common offer: 50,50 Offers lower than that were often rejected Different findings from arbitrary differences such as in the dictator game.

Some findings proposers can be said to have altruistic preferences—preferences that lead them to act to benefit others at some cost to themselves (even with no expectation that reciprocal benefits will be received later). Notion that is increasingly approved of: homo reciprocans (reciprocal behavior) Otherwise- ‘rational fools’

Other findings Anthropologists have studied this game with many different regions. Offer goes up with: 1. Cooperation 2. Market Integration

Human Behavior and Economics Self interest assumption gives us a lot of predictable outcomes which gives insight into social regularities 1) Difficulty of maintaining cooperation and the persistence of socially suboptimal outcomes. 2) Free Riding and the difficulty of maintaining public goods 3) The need for regulation to help with certain coordination activities But Self-Interest is a limited notion to understand the range of human behavior: now, more and more, people are trying to understand the behavior of homo reciprocans