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EC403:	
  Microeconomics	
  4	
  
Assessed	
  Essay	
  
	
  
	
  
	
  
	
  
	
  
	
  
	
  
	
  
	
  
	
  
	
  
	
  
	
  
	
  
	
  
Katherine	
  Anne	
  Gilbert	
  (201135988)	
  	
  
Word	
  Count:	
  1992	
  |	
  17th	
  November	
  2014	
  
  2	
  
This	
  essay	
  focuses	
  on	
  the	
  theme	
  of	
  social	
  dilemmas	
  where	
  the	
  rational	
  behavior	
  of	
  
an	
  individual	
  leads	
  to	
  a	
  suboptimal	
  outcome	
  from	
  the	
  collective	
  standpoint	
  
(Kollock,	
  1988).	
  Robyn	
  Dawes	
  (1980)	
  describes	
  the	
  theory	
  as	
  having	
  two	
  unique	
  
properties:	
  1)	
  an	
  individual	
  will	
  receive	
  a	
  higher	
  payoff	
  if	
  they	
  defect	
  against	
  the	
  
cooperative	
  choice	
  and	
  2)	
  all	
  individuals	
  will	
  receive	
  a	
  higher	
  payoff	
  if	
  they	
  all	
  
choose	
  to	
  cooperate	
  than	
  if	
  they	
  all	
  choose	
  to	
  defect.	
  This	
  theme	
  will	
  be	
  discussed	
  
through	
  the	
  example	
  of	
  Robert	
  and	
  Stuart	
  where	
  a	
  model	
  will	
  be	
  adopted	
  to	
  
analyze	
  their	
  strategic	
  situation	
  through	
  a	
  simple	
  yet	
  insight-­‐rich	
  process.	
  The	
  
game	
  is	
  played	
  regarding	
  the	
  level	
  of	
  effort	
  Robert	
  and	
  Stuart	
  both	
  choose	
  to	
  exert	
  
into	
  a	
  joint	
  project.	
  	
  
	
  
Game	
  theory	
  is	
  defined	
  as	
  the	
  interaction	
  between	
  people	
  in	
  society	
  where	
  
interdependent	
  behaviors	
  cause	
  the	
  action	
  of	
  one	
  person	
  to	
  affect	
  another	
  
person’s	
  well	
  being,	
  either	
  positively	
  or	
  negatively	
  (Watson,	
  2013).	
  In	
  this	
  
example,	
  the	
  effort	
  level	
  that	
  Robert	
  chooses	
  to	
  exert	
  will	
  have	
  an	
  impact	
  on	
  the	
  
value	
  of	
  the	
  project	
  which	
  in	
  turn	
  affects	
  the	
  payoff	
  to	
  Stuart	
  and	
  vice	
  versa.	
  This	
  
interdependence	
  shows	
  a	
  game	
  is	
  being	
  played.	
  	
  When	
  acting	
  independently,	
  
individuals	
  are	
  assumed	
  to	
  act	
  rationally	
  with	
  the	
  incentive	
  to	
  maximize	
  their	
  own	
  
payout.	
  	
  Rational	
  behavior	
  has	
  two	
  unique	
  properties:	
  1)	
  from	
  experience	
  or	
  
knowledge,	
  a	
  belief	
  is	
  formed	
  regarding	
  the	
  expected	
  strategies	
  of	
  opponents	
  2)	
  
given	
  this	
  belief;	
  a	
  strategy	
  is	
  selected	
  to	
  maximize	
  the	
  expected	
  payoff	
  (Watson,	
  
2013).	
  	
  
	
  
When	
  analyzing	
  mixed	
  strategies,	
  the	
  beliefs	
  that	
  are	
  formed	
  are	
  a	
  probability	
  
distribution	
  over	
  opponent’s	
  possible	
  effort	
  level.	
  As	
  this	
  example	
  is	
  a	
  non-­‐
cooperative	
  simultaneous-­‐move	
  game,	
  players	
  do	
  not	
  fully	
  internalize	
  their	
  
chosen	
  value	
  of	
  effort	
  and	
  individuals	
  are	
  unsure	
  what	
  their	
  opponents	
  will	
  
choose	
  therefore	
  beliefs	
  are	
  central	
  to	
  individuals	
  decision	
  making	
  process.	
  The	
  
characteristics	
  of	
  this	
  game	
  show	
  there	
  is	
  information	
  asymmetry	
  in	
  the	
  game,	
  as	
  
players	
  cannot	
  observe	
  opponents	
  decision	
  before	
  taking	
  theirs.	
  
	
  
This	
  game	
  will	
  begin	
  through	
  a	
  discrete	
  example	
  of	
  Robert	
  and	
  Stuart	
  selecting	
  
from	
  a	
  finite	
  choice	
  of	
  either	
  1	
  or	
  2	
  units	
  of	
  effort	
  to	
  exert	
  into	
  the	
  joint	
  project.	
  
The	
  project	
  value	
  is	
  calculated	
  by	
  subtracting	
  the	
  individual	
  cost	
  function	
  of	
  
Robert	
  and	
  Stuart	
  from	
  the	
  value	
  function,	
  which	
  measures	
  the	
  cost	
  minus	
  the	
  
benefit	
  from	
  exerting	
  a	
  particular	
  unit	
  of	
  effort.	
  The	
  x	
  value	
  measures	
  the	
  effort	
  
expended	
  by	
  Robert	
  and	
  the	
  y	
  value	
  measures	
  the	
  effort	
  expended	
  by	
  Stuart.	
  
	
   	
  
Project	
  value:	
  V	
  (x,	
  y)	
  =	
  5(x	
  +	
  y)	
  +	
  xy	
  
	
  
Project	
  value	
  depends	
  on	
  the	
  level	
  of	
  effort	
  exerted	
  by	
  Robert	
  (x)	
  and	
  Stuart	
  (y).	
  
	
  
As	
  Robert’s	
  cost	
  function	
  is	
  3x2	
  à	
  Payoff	
  function	
  =	
  5(x	
  +	
  y)	
  +	
  xy	
  –	
  3x2	
  
As	
  Stuart’s	
  cost	
  function	
  is	
  4y2	
  à	
  Payoff	
  function	
  =	
  5(x	
  +	
  y)	
  +	
  xy	
  –	
  4y2	
  
  3	
  
When	
  calculating	
  the	
  payoffs	
  to	
  each	
  player	
  from	
  each	
  chosen	
  effort	
  combination,	
  
the	
  effort	
  values	
  are	
  substituted	
  into	
  the	
  individual’s	
  cost	
  function:	
  
	
  
For	
  V	
  (1,	
  1)	
  !	
  5(1	
  +	
  1)	
  +	
  (1	
  x	
  1)	
  =	
  11	
   	
  	
  	
  For	
  V	
  (2,	
  1)	
  !	
  5(2	
  +	
  1)	
  +	
  (2	
  x	
  1)	
  =	
  17	
  
	
  
For	
  V	
  (1,	
  2)	
  !	
  5(1	
  +	
  2)	
  +	
  (1	
  x	
  2)	
  =	
  17	
   	
  	
  	
  For	
  V	
  (2,	
  2)	
  !	
  5(2	
  +	
  2)	
  +	
  (2	
  x	
  2)	
  =	
  24	
  
	
  
Constructing	
  the	
  normal	
  form	
  for	
  this	
  game	
  summarizes	
  the	
  players	
  in	
  the	
  game,	
  
strategies	
  available	
  and	
  payoff	
  received	
  to	
  each	
  individual	
  based	
  on	
  the	
  strategy	
  
combination	
  the	
  player’s	
  choose	
  (Gibbons,	
  1992).	
  The	
  columns	
  correspond	
  to	
  the	
  
strategies	
  of	
  Stuart	
  and	
  the	
  rows	
  correspond	
  to	
  the	
  strategies	
  of	
  Robert.	
  	
  
	
  
Normal	
  Form:	
  
	
  
	
  
	
  
	
  
	
  
	
  
	
  
	
  
The	
  underlining	
  method	
  identifies	
  the	
  rational	
  best	
  response	
  made	
  by	
  individuals	
  
if	
  their	
  opponent	
  chooses	
  a	
  particular	
  effort	
  level.	
  By	
  constructing	
  the	
  normal	
  
form,	
  the	
  Nash	
  equilibrium	
  can	
  be	
  identified:	
  Robert	
  chooses	
  1	
  unit	
  of	
  effort	
  and	
  
Stuart	
  chooses	
  1	
  unit	
  of	
  effort	
  at	
  V(1,	
  1).	
  The	
  Nash	
  equilibrium	
  represents	
  a	
  point	
  
in	
  the	
  game	
  where	
  players	
  have	
  no	
  incentive	
  to	
  change	
  their	
  strategy	
  and	
  have	
  
mutually	
  consistent	
  best	
  responses.	
  For	
  both	
  players,	
  strategy	
  1	
  is	
  the	
  dominant	
  
strategy	
  therefore	
  we	
  can	
  predict,	
  due	
  to	
  rational	
  behavior,	
  that	
  neither	
  player	
  
will	
  select	
  strategy	
  2	
  (Gibbons,	
  1992).	
  The	
  identification	
  of	
  the	
  best	
  response	
  in	
  
this	
  game	
  shows	
  that	
  both	
  players	
  have	
  the	
  incentive	
  to	
  underperform	
  and	
  reduce	
  
their	
  individual	
  effort	
  to	
  gain	
  a	
  higher	
  payout.	
  	
  
	
  
When	
  analyzing	
  the	
  Nash	
  equilibrium	
  and	
  normal	
  form	
  of	
  this	
  game,	
  it	
  is	
  apparent	
  
that	
  the	
  rational	
  behavior	
  of	
  Robert	
  and	
  Stuart	
  does	
  not	
  necessarily	
  imply	
  
coordinated	
  behavior,	
  as	
  the	
  Nash	
  equilibrium	
  is	
  inefficient	
  with	
  both	
  players	
  able	
  
to	
  gain	
  a	
  higher	
  payoff	
  by	
  playing	
  differently.	
  The	
  players	
  realize	
  they	
  are	
  jointly	
  
better	
  off	
  if	
  they	
  select	
  1	
  unit	
  of	
  effort,	
  however	
  individual	
  incentives	
  result	
  in	
  
individuals	
  defecting	
  against	
  this	
  choice:	
  Robert	
  can	
  gain	
  a	
  payoff	
  of	
  13	
  instead	
  of	
  
7	
  and	
  Stuart	
  can	
  gain	
  a	
  payoff	
  of	
  14	
  instead	
  of	
  8.	
  In	
  this	
  game,	
  individuals	
  gain	
  
from	
  being	
  non-­‐cooperative	
  and	
  have	
  the	
  incentive	
  to	
  free	
  ride	
  on	
  the	
  
contributions	
  of	
  others.	
  	
  	
  
	
  
R/S	
   1	
   2	
  
	
  
1	
  
	
  
8,	
  7	
  
	
  
14,	
  1	
  
	
  
2	
  
	
  
5,	
  13	
  
	
  
12,	
  8	
  
V	
  (1,	
  1)	
  à	
  	
   Robert	
  =	
  11	
  –	
  3	
  (1)2	
  =	
  8	
  
	
   	
   Stuart	
  =	
  11	
  –	
  4	
  (1)2	
  =	
  7	
  
V	
  (1,	
  2)	
  à	
  	
   Robert	
  =	
  17	
  –	
  3	
  (1)2	
  =	
  14	
  
	
   	
   Stuart	
  =	
  17	
  –	
  4	
  (2)2	
  =	
  1	
  
V	
  (2,	
  1)	
  à	
  	
   Robert	
  =	
  17	
  –	
  3	
  (2)2	
  =	
  5	
  
	
   	
   Stuart	
  =	
  17	
  –	
  4	
  (1)2	
  =	
  13	
  
V	
  (2,	
  2)	
  à	
  	
   Robert	
  =	
  24	
  –	
  3	
  (2)2	
  =	
  12	
  
	
   	
   Stuart	
  =	
  24	
  –	
  4	
  (2)2	
  =	
  8	
  
  4	
  
This	
  result	
  is	
  similar	
  to	
  the	
  Prisoner’s	
  dilemma	
  where	
  individual	
  incentives	
  
interfere	
  with	
  the	
  interests	
  of	
  the	
  group	
  (Rapoport,	
  1965)	
  resulting	
  in	
  group	
  loss	
  
–	
  this	
  concept	
  will	
  be	
  analysed	
  later	
  in	
  the	
  game.	
  	
  
	
  
When	
  opponents	
  have	
  complete	
  freedom	
  over	
  their	
  effort	
  choices,	
  the	
  players	
  no	
  
longer	
  choose	
  from	
  a	
  finite	
  set	
  of	
  strategies	
  and	
  can	
  undertake	
  a	
  continuous	
  
strategy.	
  As	
  the	
  strategy	
  spaces	
  are	
  continuous	
  in	
  this	
  game,	
  the	
  game	
  can	
  be	
  
analysed	
  by	
  calculating	
  best	
  responses	
  as	
  opposed	
  to	
  through	
  a	
  payoff	
  matrix.	
  	
  
This	
  is	
  calculated	
  by	
  differentiating	
  the	
  individual’s	
  payoff	
  functions	
  and	
  re-­‐
arranging	
  for	
  x	
  and	
  y	
  respectively.	
  The	
  derivative	
  is	
  set	
  to	
  0	
  to	
  find	
  where	
  the	
  
slope	
  of	
  this	
  function	
  is	
  maximized	
  at	
  zero,	
  which	
  is	
  the	
  best	
  response	
  for	
  each	
  
individual.	
  	
  
	
  
Substituting	
  the	
  best	
  response	
  function	
  for	
  y	
  into	
  the	
  x	
  function	
  will	
  find	
  the	
  
payoff	
  for	
  Robert	
  and	
  substituting	
  the	
  best	
  response	
  function	
  for	
  x	
  into	
  the	
  y	
  
function	
  will	
  find	
  the	
  payoff	
  for	
  Stuart.	
  	
  
	
  
The	
  Nash	
  equilibrium	
  is	
  at	
  point	
  (
𝟒𝟓
𝟒𝟕
,	
  
𝟑𝟓
𝟒𝟕
),	
  which	
  represents	
  the	
  set	
  of	
  effort	
  choices	
  
for	
  Robert	
  and	
  Stuart	
  where	
  both	
  players	
  are	
  maximizing	
  their	
  payoff	
  given	
  the	
  
actions	
  of	
  the	
  other	
  player	
  (Varian,	
  1987).	
  Under	
  this	
  equilibrium,	
  Robert	
  will	
  
exert	
  
!"
!"
  units	
  of	
  effort	
  and	
  Stuart	
  will	
  exert	
  
!"
!"
units	
  of	
  effort.	
  
Robert:	
   f(x)	
  =	
  5(x	
  +	
  y)	
  +	
  xy	
  –	
  3x2	
  
	
   	
   f(x)	
  =	
  5x	
  +	
  5y	
  +	
  xy	
  –	
  3x2	
  
	
  
Differentiate	
  with	
  respect	
  to	
  x:	
   	
  
f’(x)	
  =	
  5	
  +	
  y	
  –	
  6x	
  
	
  
Set	
  f’(x)	
  =	
  0	
  to	
  find	
  optimal	
  point:	
  
0	
  =	
  	
  5	
  +	
  y	
  –	
  6x	
  
	
   	
   6x	
  =	
  5	
  +	
  y	
  
	
   	
   x	
  =	
  
𝟓!𝒚
𝟔
	
  
BRr(x)	
  =	
  
𝟓!𝒚
𝟔
	
  
Stuart:	
   f(y)	
  =	
  5(x	
  +	
  y)	
  +	
  xy	
  –	
  4y2	
  
	
   	
   f(y)	
  =	
  5x	
  +	
  5y	
  +	
  xy	
  –	
  4y2	
  
	
  
Differentiate	
  with	
  respect	
  to	
  y:	
   	
  
f’(y)	
  =	
  5	
  +	
  x	
  –	
  8y	
  
	
  
Set	
  f’(y)	
  =	
  0	
  to	
  find	
  optimal	
  point:	
  
0	
  =	
  	
  5	
  +	
  x	
  –	
  8y	
  
	
   	
   8y	
  =	
  5	
  +	
  x	
  
	
   	
   y	
  =	
  
𝟓!𝒙
𝟖
	
  
BRs(y)	
  =	
  
𝟓!𝒙
𝟖
	
  
Substitute	
  y	
  into	
  equation	
  x:	
  
X	
  =	
  (5	
  +	
  
!!!
!
!
)	
  
6x	
  =	
  5	
  +	
  
!!!
!
	
  
48x	
  =	
  40	
  +	
  5	
  +	
  x	
  
47x	
  =	
  45	
  
x	
  =	
  
𝟒𝟓
𝟒𝟕
	
  
Substitute	
  x	
  into	
  equation	
  y:	
  
Y	
  =	
  
!!  
𝟒𝟓
𝟒𝟕
!
	
  
8y	
  =	
  5	
  +	
  
𝟒𝟓
𝟒𝟕
	
  
376y	
  =	
  235	
  +	
  45	
  
376y	
  =	
  280	
  
y	
  =	
  
!"#
!"#
	
  
y	
  =	
  
𝟑𝟓
𝟒𝟕
	
  
  5	
  
Substituting	
  the	
  x	
  and	
  y	
  values	
  into	
  individual	
  payoff	
  functions	
  and	
  subtracting	
  
the	
  effort	
  costs,	
  each	
  partner	
  receives	
  the	
  following	
  payoff:	
  
	
  
	
  
	
  
	
  
	
  
	
  
	
  
From	
  the	
  reaction	
  functions	
  calculated,	
  the	
  relationship	
  can	
  be	
  diagrammatically	
  
presented	
  by	
  finding	
  points	
  on	
  Robert	
  and	
  Stuart’s	
  reaction	
  function.	
  This	
  is	
  
calculated	
  by	
  setting	
  the	
  x	
  and	
  y	
  values	
  of	
  Robert	
  and	
  Stuart’s	
  reaction	
  function	
  to	
  
0	
  as	
  follows:	
  
	
  
The	
  following	
  graph	
  depicts	
  the	
  best-­‐response	
  functions	
  of	
  the	
  two	
  players.	
  When	
  
calculating	
  the	
  equilibrium,	
  the	
  dominated	
  strategies	
  are	
  removed	
  and	
  the	
  lower	
  
and	
  upper	
  bounds	
  converge	
  to	
  the	
  point	
  where	
  the	
  players’	
  best	
  response	
  
functions	
  cross,	
  which	
  is	
  where	
  the	
  equilibrium	
  point	
  lies.	
  These	
  response	
  
functions	
  are	
  positively	
  sloped	
  as	
  they	
  are	
  a	
  complementary	
  strategy	
  set.	
  	
  
	
   	
  
Robert:	
  x	
  =	
  
𝟓!𝒚
𝟔
	
  
	
  
To	
  calculate	
  reaction	
  function:	
  
	
  
When	
  y	
  =	
  0,	
  x	
  =	
  
!!!
!
  =	
  
!
!
	
  
When	
  x	
  =	
  0,	
  0	
  =	
  
!!!
!
  =	
  -­‐5	
  
	
  
Points	
  on	
  reaction	
  function:	
  	
  
(5/6,	
  0)	
  and	
  (0,	
  -­‐5)	
  
Stuart:	
  y	
  =	
  
𝟓!𝒙
𝟖
	
  
	
  
To	
  calculate	
  reaction	
  function:	
  
	
  
When	
  y	
  =	
  0,	
  x	
  =	
  
!!!
!
  =	
  -­‐5	
  
When	
  x	
  =	
  0,	
  y=	
  
!!!
!
  =	
  
!
!
	
  
	
  
Points	
  on	
  reaction	
  function:	
  	
  
(-­‐5,	
  0)	
  and	
  (0,	
  5/8)	
  
Payoff	
  Robert:	
  	
  
5x	
  +	
  5y	
  +	
  xy	
  -­‐	
  3x2	
  
5(
𝟒𝟓
𝟒𝟕
)	
  +	
  5(
𝟑𝟓
𝟒𝟕
)	
  +	
  (
𝟒𝟓
𝟒𝟕
)(  
𝟑𝟓
𝟒𝟕
)	
  –	
  3(
𝟒𝟓
𝟒𝟕
)2	
  
=	
  6.47	
  
Payoff	
  Stuart:	
  
5x	
  +	
  5y	
  +	
  xy	
  –	
  4y2	
  
5(
𝟒𝟓
𝟒𝟕
)	
  +	
  5(
𝟑𝟓
𝟒𝟕
)	
  +	
  (
𝟒𝟓
𝟒𝟕
)(  
𝟑𝟓
𝟒𝟕
)	
  –	
  4(
𝟑𝟓
𝟒𝟕
)2	
  
=	
  7.00	
  
(
𝟒𝟓
𝟒𝟕
,	
  
𝟑𝟓
𝟒𝟕
)	
  
Robert’s	
  Effort	
  Level	
  (x)	
  
Stuart’s	
  Effort	
  Level	
  (y)	
  
  6	
  
Game-­‐theoretic	
  analysis	
  generally	
  assumes	
  that	
  each	
  player	
  behaves	
  rationally	
  
according	
  to	
  his	
  preferences	
  however;	
  it	
  does	
  not	
  take	
  into	
  account	
  other	
  
motivations	
  such	
  as	
  that	
  of	
  the	
  altruistic	
  player.	
  Tony	
  will	
  be	
  introduced	
  to	
  this	
  
example	
  as	
  the	
  social	
  planner	
  who	
  has	
  the	
  main	
  objective	
  of	
  maximizing	
  the	
  total	
  
payoff	
  of	
  the	
  project,	
  which	
  is	
  then	
  split	
  between	
  Robert	
  and	
  Stuart.	
  
	
  
The	
  function	
  used	
  to	
  consider	
  this	
  game	
  of	
  social	
  welfare	
  is	
  the	
  project	
  value	
  
function	
  of	
  both	
  Robert	
  and	
  Stuart	
  (5(x	
  +	
  y)	
  +	
  xy	
  +	
  5(x	
  +	
  y)	
  +	
  xy)	
  minus	
  the	
  two	
  
cost	
  functions	
  of	
  Robert	
  (3x2)	
  and	
  Stuart	
  (4y2)	
  to	
  calculate	
  the	
  best	
  responses	
  to	
  
maximize	
  the	
  total	
  payoffs	
  from	
  the	
  game.	
  
	
  
!	
  V	
  (x,	
  y)	
  =	
  5(x	
  +	
  y)	
  +	
  xy	
  +	
  5(x	
  +	
  y)	
  +	
  xy	
  –	
  3x2	
  –	
  4y2	
  
!	
  V	
  (x,	
  y)	
  =	
  10(x	
  +	
  y)	
  +	
  2xy	
  -­‐	
  3x2	
  –	
  4y2	
  
	
  
	
  
The	
  x	
  and	
  y	
  effort	
  values	
  are	
  calculated	
  by	
  substituting	
  the	
  x	
  and	
  y	
  figures	
  into	
  one	
  
another	
  as	
  before.	
  
	
  
	
  
	
  
	
  
	
  
	
  
	
  
	
  
Robert:	
  	
   f(x)	
  =	
  10(x	
  +	
  y)	
  +	
  2xy	
  –	
  3x2	
  –	
  4y2	
  
	
   	
   f(x)	
  =	
  10x	
  +	
  10y	
  +	
  2xy	
  –	
  3x2	
  –	
  4y2	
  
	
  
Differentiate	
  with	
  respect	
  to	
  x:	
   	
  
f’(x)	
  =	
  10	
  +	
  2y	
  –	
  6x	
  	
  
	
  
Set	
  f’(x)	
  =	
  0	
  to	
  find	
  optimal	
  point:	
  
0	
  =	
  10	
  +	
  2y	
  –	
  6x	
  
	
   	
   6x	
  =	
  10	
  +	
  2y	
  
	
   	
   x	
  =	
  
𝟏𝟎!𝟐𝒚
𝟔
	
  
Stuart:	
   f(y)	
  =	
  10(x	
  +	
  y)	
  +	
  2xy	
  –	
  3x2	
  -­‐	
  4y2	
  
	
   	
   f(y)	
  =	
  10x	
  +	
  10y	
  +	
  2xy	
  –	
  3x2	
  -­‐	
  4y2	
  
	
  
Differentiate	
  with	
  respect	
  to	
  y:	
   	
  
f’(y)	
  =	
  10	
  +	
  2x	
  –	
  8y	
  
	
  
Set	
  f’(y)	
  =	
  0	
  to	
  find	
  optimal	
  point:	
  
0	
  =	
  10	
  +	
  2x	
  –	
  8y	
  
	
   	
   8y	
  =	
  10	
  +	
  2x	
  
	
   	
   y	
  =	
  
𝟏𝟎!𝟐𝒙
𝟖
	
  
Substitute	
  y	
  into	
  equation	
  x:	
  
X	
  =	
  
!"  !  !
!"!!!
!
!
	
  
6x	
  =	
  10	
  +	
  2(
!"!!!
!
)	
  
48x	
  =	
  80	
  +	
  20	
  +	
  4x	
  
44x	
  =	
  100	
  
x	
  =	
  
!""
!!
	
  
x	
  =	
  
𝟐𝟓
𝟏𝟏
	
  
	
  
Substitute	
  x	
  into	
  equation	
  y:	
  
Y	
  =	
  
!"  !  !
!"!!!
!
!
	
  
8y	
  =	
  10	
  +	
  2(
!"!!!
!
)	
  
48y	
  =	
  60	
  +	
  20	
  +	
  4y	
  
48y	
  =	
  80	
  +	
  4y	
  
44y	
  =	
  80	
  
y	
  =	
  
!"
!!
	
  
y	
  =	
  
𝟐𝟎
𝟏𝟏
	
  
  7	
  
Payoff	
  Robert:	
  	
  
5x	
  +	
  5y	
  +	
  xy	
  -­‐	
  3x2	
  
5(
𝟐𝟓
𝟏𝟏
)	
  +	
  5(
𝟐𝟎
𝟏𝟏
)	
  +	
  (
𝟐𝟓
𝟏𝟏
)(  
𝟐𝟎
𝟏𝟏
)	
  –	
  3(
𝟐𝟓
𝟏𝟏
)2	
  
=	
  9.09	
  
	
  
Payoff	
  Stuart:	
  
5x	
  +	
  5y	
  +	
  xy	
  –	
  4y2	
  
5(
𝟐𝟓
𝟏𝟏
)	
  +	
  5(
𝟐𝟎
𝟏𝟏
)	
  +	
  (
𝟐𝟓
𝟏𝟏
)(  
𝟐𝟎
𝟏𝟏
)	
  –	
  4(
𝟐𝟎
𝟏𝟏
)2	
  
=	
  11.36	
  
	
  
Acting	
  independently,	
  Robert	
  can	
  gain	
  a	
  payoff	
  of	
  6.47	
  and	
  Stuart	
  can	
  gain	
  a	
  
payoff	
  of	
  7,	
  however,	
  when	
  adding	
  an	
  altruistic	
  player	
  to	
  maximize	
  social	
  welfare,	
  
Robert	
  can	
  gain	
  a	
  larger	
  payoff	
  of	
  9.09	
  and	
  Stuart	
  can	
  gain	
  a	
  larger	
  payoff	
  of	
  11.36.	
  
This	
  would	
  suggest	
  that	
  Robert	
  and	
  Stuart	
  should	
  optimally	
  act	
  together	
  to	
  ensure	
  
they	
  both	
  gain	
  larger	
  payoffs	
  than	
  if	
  they	
  were	
  acting	
  independently.	
  
	
  
When	
  comparing	
  the	
  effort	
  levels	
  of	
  each	
  player	
  to	
  the	
  Nash	
  equilibrium	
  
calculated	
  when	
  acting	
  independently,	
  the	
  social	
  planner	
  states	
  the	
  players	
  should	
  
exert	
  more	
  than	
  double	
  the	
  effort	
  that	
  the	
  players	
  would	
  exert	
  when	
  acting	
  
independently.	
  Analysing	
  in	
  terms	
  of	
  the	
  effort	
  to	
  payoff	
  ratio,	
  the	
  individuals	
  gain	
  
more	
  from	
  acting	
  independently	
  than	
  if	
  they	
  were	
  to	
  exert	
  effort	
  at	
  the	
  social	
  
planners	
  ideal	
  value:	
  Robert	
  exerting	
  1	
  effort	
  unit:	
  1.67	
  payoff	
  acting	
  
independently	
  and	
  exerting	
  1	
  effort	
  unit:	
  4	
  payoff	
  acting	
  socially	
  optimally;	
  Stuart	
  
exerting	
  1	
  effort	
  unit:	
  9.5	
  payoff	
  acting	
  independently	
  and	
  exerting	
  1	
  effort	
  unit:	
  
6.3	
  payoff	
  acting	
  socially	
  optimally.	
  	
  
	
  
	
  
	
  
	
  
	
  
	
  
	
  
	
  
	
  
	
  
	
  
	
  
	
  
	
  
	
  
	
  
	
  
	
  
	
  
	
  
	
  
	
  
	
  
  8	
  
	
  
It	
  is	
  evident	
  that	
  the	
  addition	
  of	
  the	
  social	
  planner	
  to	
  the	
  game	
  can	
  result	
  in	
  effort	
  
levels	
  chosen	
  that	
  will	
  increase	
  the	
  total	
  payoff	
  function	
  for	
  the	
  players.	
  The	
  
choice	
  for	
  players	
  is	
  whether	
  to	
  cooperate	
  with	
  the	
  social	
  planners	
  ideal	
  outcome	
  
or	
  whether	
  to	
  defect	
  with	
  the	
  belief	
  that	
  their	
  opponent	
  will	
  cooperate.	
  As	
  Kollock	
  
(1998)	
  identified,	
  the	
  best	
  outcome	
  of	
  a	
  Prisoner’s	
  Dilemma	
  is	
  unilateral	
  defection	
  
of	
  the	
  first	
  person,	
  followed	
  by	
  mutual	
  cooperation,	
  mutual	
  defection,	
  and	
  the	
  
worst	
  outcome	
  is	
  the	
  first	
  person’s	
  unilateral	
  cooperation.	
  The	
  following	
  analysis	
  
calculates	
  the	
  payoffs	
  of	
  Robert	
  and	
  Stuart	
  if	
  1)	
  Robert	
  cooperates	
  and	
  Stuart	
  
defects	
  and	
  2)	
  if	
  Stuart	
  cooperates	
  and	
  Robert	
  defects	
  from	
  the	
  social	
  ideal.	
  
	
  
	
  
	
  
Normal	
  Form:	
  
	
  
	
  
	
  
	
  
	
  
	
  
	
  
	
  
The	
  final	
  normal	
  form	
  presents	
  the	
  payoffs	
  to	
  each	
  individual	
  based	
  on	
  the	
  range	
  
of	
  scenarios	
  presented	
  throughout	
  this	
  example.	
  The	
  Nash	
  equilibrium	
  is	
  
defection	
  against	
  the	
  social	
  planners	
  ideal	
  as	
  it	
  the	
  dominant	
  strategy	
  for	
  both	
  
players.	
  	
  
	
  
	
  
R/S	
   C	
   D	
  
	
  
C	
  
	
  
11.4,	
  9.09	
  
	
  
2.5,	
  14.7	
  
	
  
D	
  
	
  
13,	
  3.6	
  
	
  
7.0,	
  6.5	
  
When	
  Robert	
  cooperates	
  with	
  socially	
  optimal	
  input	
  (
𝟐𝟓
𝟏𝟏
)	
  and	
  Stuart	
  defects:	
  
Y	
  =	
  
!  !  
𝟐𝟓
𝟏𝟏
!
	
  
Y	
  =	
  0.91	
  
	
  
Joint	
  value	
  of	
  project:	
  5((
𝟐𝟓
𝟏𝟏
)	
  +	
  (0.91))	
  +	
  (
𝟐𝟓
𝟏𝟏
)(0.91)	
  =	
  18	
  
Payouts:-­‐	
  	
   Robert:	
  18	
  –	
  3(
𝟐𝟓
𝟏𝟏
)2	
  =	
  2.5	
  
	
   	
   Stuart:	
  18	
  –	
  4(0.91)2	
  =	
  14.7	
  
When	
  Stuart	
  cooperates	
  with	
  socially	
  optimal	
  input	
  (
𝟐𝟎
𝟏𝟏
)	
  and	
  Robert	
  defects:	
  
X	
  =	
  
!  !  
𝟐𝟎
𝟏𝟏
!
	
  
X	
  =	
  1.14	
  
	
  
Joint	
  value	
  of	
  project:	
  5((1.14	
  +	
  (
𝟐𝟎
𝟏𝟏
))	
  +	
  (1.14)(  
𝟐𝟎
𝟏𝟏
)	
  =	
  16.9	
  
Payouts:	
  	
   Robert:	
  16.9	
  –	
  3(1.14)2	
  =	
  13	
  
	
   	
   Stuart:	
  16.9	
  –	
  4(
!"
!!
)2	
  =	
  3.6	
  
	
  
  9	
  
	
  
This	
  example	
  is	
  similar	
  to	
  the	
  prisoners’	
  dilemma.	
  The	
  dilemma	
  is	
  clear	
  when	
  
noticing	
  that	
  mutual	
  cooperation	
  is	
  superior	
  and	
  yields	
  a	
  better	
  outcome	
  than	
  
mutual	
  defection	
  of	
  both	
  players.	
  This	
  results	
  in	
  mutual	
  defection	
  not	
  being	
  a	
  
rational	
  outcome	
  because	
  the	
  choice	
  to	
  cooperate	
  is	
  more	
  rational	
  from	
  a	
  self-­‐
interested	
  point	
  of	
  view.	
  	
  The	
  value	
  of	
  the	
  project	
  suffers	
  as	
  partners	
  only	
  care	
  
about	
  their	
  own	
  costs	
  and	
  benefits	
  and	
  they	
  do	
  not	
  consider	
  the	
  benefit	
  of	
  their	
  
labor	
  to	
  the	
  rest	
  of	
  the	
  firm.	
  	
  
	
  
The	
  success	
  of	
  the	
  enterprise	
  requires	
  cooperation	
  and	
  shared	
  responsibility	
  of	
  
the	
  individuals.	
  In	
  this	
  example,	
  there	
  are	
  limits	
  on	
  external	
  enforcement	
  as	
  the	
  
partners	
  cannot	
  write	
  a	
  contract	
  and	
  have	
  no	
  way	
  of	
  verifying	
  the	
  levels	
  of	
  effort	
  
exerted	
  by	
  each	
  individual.	
  Even	
  if	
  the	
  players	
  had	
  the	
  ability	
  to	
  communicate	
  
before	
  the	
  game	
  and	
  decide	
  on	
  a	
  collective	
  decision,	
  there	
  is	
  no	
  incentive	
  for	
  a	
  
rational	
  player	
  to	
  follow	
  through	
  on	
  the	
  agreement	
  as	
  individuals	
  could	
  maximize	
  
by	
  defecting.	
  Players	
  understand	
  that	
  increasing	
  effort	
  and	
  therefore	
  the	
  value	
  of	
  
the	
  joint	
  project	
  will	
  result	
  in	
  them	
  only	
  gaining	
  a	
  fraction	
  of	
  the	
  joint	
  benefit	
  
therefore	
  the	
  players	
  are	
  less	
  willing	
  to	
  provide	
  effort.	
  The	
  individuals	
  therefore	
  
expend	
  less	
  effort	
  than	
  is	
  best	
  from	
  the	
  social	
  point	
  of	
  view	
  and	
  because	
  both	
  
players	
  do	
  so,	
  they	
  both	
  end	
  up	
  worse	
  off.	
  As	
  this	
  example	
  only	
  considered	
  a	
  
single	
  play	
  game,	
  choosing	
  to	
  cooperate	
  is	
  not	
  optimal	
  for	
  players.	
  If	
  the	
  example	
  
incorporated	
  repeated	
  game	
  analysis,	
  including	
  the	
  punishment	
  of	
  the	
  opponent	
  
for	
  defecting	
  would	
  reduce	
  the	
  payoffs.	
  This	
  could	
  result	
  in	
  players	
  choosing	
  to	
  
cooperate	
  if	
  costs	
  >	
  benefits	
  by	
  defecting.	
  
	
  
	
  
	
   	
  
  10	
  
As	
  individuals’	
  indifference	
  curves	
  depend	
  on	
  other	
  people	
  (Buchanan,	
  1962),	
  this	
  
game	
  results	
  in	
  the	
  players	
  imposing	
  external	
  effects	
  on	
  their	
  opponent	
  based	
  on	
  
the	
  decision	
  they	
  choose.	
  Externalities	
  are	
  defined	
  as	
  an	
  indirect	
  consequence	
  of	
  
an	
  activity,	
  which	
  affect	
  agents	
  other	
  than	
  the	
  originator	
  without	
  intension	
  
(Laffont,	
  2008).	
  In	
  this	
  example,	
  Robert	
  and	
  Stuart’s	
  payoff	
  depends	
  on	
  the	
  effort	
  
exerted	
  by	
  the	
  other	
  player,	
  which	
  is	
  an	
  example	
  of	
  a	
  positive	
  externality	
  or	
  
external	
  benefit	
  to	
  the	
  other	
  player.	
  As	
  players	
  increase	
  their	
  effort,	
  the	
  value	
  of	
  
the	
  overall	
  project	
  increases	
  which	
  increases	
  the	
  payoffs	
  to	
  both	
  players.	
  	
  
	
  
When	
  calculating	
  the	
  effort	
  to	
  payoff	
  ratio,	
  there	
  is	
  a	
  2.8	
  payoff	
  difference	
  when	
  
Robert	
  and	
  Stuart	
  exert	
  one	
  unit	
  of	
  effort:	
  Robert	
  gains	
  6.7	
  payoffs	
  and	
  Stuart	
  
gains	
  9.5	
  payoffs.	
  It	
  is	
  clear	
  that	
  Stuart	
  benefits	
  more	
  from	
  exerting	
  one	
  unit	
  of	
  
effort	
  and	
  therefore	
  Robert	
  exerts	
  a	
  higher	
  positive	
  externality	
  on	
  Stuart.	
  	
  
	
  
The	
  existence	
  of	
  externalities	
  can	
  cause	
  market	
  failure	
  if	
  the	
  price	
  mechanism	
  
does	
  not	
  take	
  into	
  account	
  the	
  full	
  social	
  costs	
  and	
  benefits	
  of	
  production	
  and	
  
consumption.	
  In	
  this	
  game,	
  there	
  is	
  a	
  difference	
  between	
  the	
  marginal	
  private	
  
benefit	
  and	
  marginal	
  social	
  benefit	
  resulting	
  in	
  the	
  MSB	
  curve	
  lying	
  above	
  MPB.	
  
The	
  effort	
  exerted	
  and	
  therefore	
  the	
  market	
  output	
  is	
  less	
  than	
  the	
  socially	
  
optimal	
  output	
  as	
  shown	
  in	
  Appendix	
  1	
  -­‐	
  society	
  could	
  be	
  better	
  off	
  and	
  welfare	
  
increased	
  by	
  encouraging	
  increased	
  provision.	
  There	
  is	
  therefore	
  community	
  
pressure	
  to	
  make	
  individuals	
  pull	
  their	
  weight	
  to	
  bring	
  the	
  effort	
  levels	
  to	
  the	
  
socially	
  optimal	
  ideal.	
  A	
  method	
  of	
  creating	
  this	
  pressure	
  is	
  to	
  provide	
  a	
  subsidy	
  
to	
  the	
  individuals	
  or	
  reward	
  the	
  individuals	
  to	
  provide	
  at	
  this	
  point	
  [Appendix	
  2]	
  
bringing	
  MSB	
  =	
  MPB.	
  
	
  
	
   	
  
  11	
  
REFERENCES	
  
	
  
Buchanan,	
  J.	
  &	
  Stubblebine,	
  W.	
  (1962).	
  Externality.	
  Economica.	
  29	
  (116),	
  371-­‐384.	
  
	
  
Dawes,	
  R.	
  (1980).	
  Social	
  Dilemmas.	
  Annual	
  Review	
  of	
  Psychology.	
  31,	
  169-­‐193.	
  
	
  
Gibbons,	
  R	
  (1992).	
  A	
  Primer	
  in	
  Game	
  Theory.	
  London:	
  Pearson	
  Education	
  Limited.	
  
	
  
Kollock,	
  P.	
  (1998).	
  Social	
  Dilemmas:	
  The	
  Anatomy	
  of	
  Cooperation.	
  Annual	
  Review	
  
of	
  Sociology.	
  24	
  (1),	
  183-­‐214.	
  
	
  
Laffont,	
  J.	
  (2008).	
  Externalities.	
  The	
  New	
  Palgrave	
  Dictionary	
  of	
  Economics.	
  2.	
  
	
  
Rapoport,	
  A	
  (1965).	
  Prisoner's	
  Dilemma:	
  A	
  Study	
  in	
  Conflict	
  and	
  Cooperation.	
  USA:	
  
The	
  University	
  of	
  Michigan	
  Press.	
  
	
  
Varian,	
  H.;	
  1987;	
  “Intermediate	
  Microeconomics	
  –	
  A	
  Modern	
  Approach;	
  Norton,	
  
Chapter	
  27	
  pp.	
  508	
  
	
  
Vicarick.	
  (2011).	
  Externalities	
  Graphs:	
  How	
  I	
  Understand	
  Them.	
  Available:	
  
http://www.slideshare.net/vicarick/externalities-­‐graphs-­‐how-­‐i-­‐understand-­‐
them.	
  Last	
  accessed	
  14th	
  Nov	
  2014.	
  
	
  
Watson,	
  J	
  (2013).	
  Strategy:	
  An	
  Introduction	
  to	
  Game	
  Theory.	
  3rd	
  ed.	
  New	
  York:	
  W.	
  
W.	
  NORTON	
  &	
  COMPANY.	
  
	
  
	
  
ADDITIONAL	
  BIBLIOGRAPHY	
  
	
  
Carmichael,	
  F	
  (2005).	
  A	
  Guide	
  to	
  Game	
  Theory.	
  ENGLAND:	
  Pearson	
  Education	
  
Limited.	
  
	
   	
  
Dixit,	
  A.,	
  Skeath,	
  S.	
  &	
  Reiley,	
  D	
  (2009).	
  Games	
  of	
  Strategy.	
  3rd	
  ed.	
  New	
  York:	
  W.	
  W.	
  
Norton	
  &	
  Co.	
  
	
  
Osborne,	
  M	
  (2004).	
  An	
  introduction	
  to	
  game	
  theory.	
  New	
  York:	
  Oxford	
  University	
  
Press.	
  
	
   	
  
  12	
  
APPENDICES	
  
	
  
Appendix	
  1	
  
	
  
	
  
(Vicarick,	
  2011)	
  
	
  
Appendix	
  2	
  
	
   	
   	
  
	
   	
   	
   	
   	
   	
   (Vicarick,	
  2011)	
  

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Game Theory Assignment

  • 1.   EC403:  Microeconomics  4   Assessed  Essay                                 Katherine  Anne  Gilbert  (201135988)     Word  Count:  1992  |  17th  November  2014  
  • 2.   2   This  essay  focuses  on  the  theme  of  social  dilemmas  where  the  rational  behavior  of   an  individual  leads  to  a  suboptimal  outcome  from  the  collective  standpoint   (Kollock,  1988).  Robyn  Dawes  (1980)  describes  the  theory  as  having  two  unique   properties:  1)  an  individual  will  receive  a  higher  payoff  if  they  defect  against  the   cooperative  choice  and  2)  all  individuals  will  receive  a  higher  payoff  if  they  all   choose  to  cooperate  than  if  they  all  choose  to  defect.  This  theme  will  be  discussed   through  the  example  of  Robert  and  Stuart  where  a  model  will  be  adopted  to   analyze  their  strategic  situation  through  a  simple  yet  insight-­‐rich  process.  The   game  is  played  regarding  the  level  of  effort  Robert  and  Stuart  both  choose  to  exert   into  a  joint  project.       Game  theory  is  defined  as  the  interaction  between  people  in  society  where   interdependent  behaviors  cause  the  action  of  one  person  to  affect  another   person’s  well  being,  either  positively  or  negatively  (Watson,  2013).  In  this   example,  the  effort  level  that  Robert  chooses  to  exert  will  have  an  impact  on  the   value  of  the  project  which  in  turn  affects  the  payoff  to  Stuart  and  vice  versa.  This   interdependence  shows  a  game  is  being  played.    When  acting  independently,   individuals  are  assumed  to  act  rationally  with  the  incentive  to  maximize  their  own   payout.    Rational  behavior  has  two  unique  properties:  1)  from  experience  or   knowledge,  a  belief  is  formed  regarding  the  expected  strategies  of  opponents  2)   given  this  belief;  a  strategy  is  selected  to  maximize  the  expected  payoff  (Watson,   2013).       When  analyzing  mixed  strategies,  the  beliefs  that  are  formed  are  a  probability   distribution  over  opponent’s  possible  effort  level.  As  this  example  is  a  non-­‐ cooperative  simultaneous-­‐move  game,  players  do  not  fully  internalize  their   chosen  value  of  effort  and  individuals  are  unsure  what  their  opponents  will   choose  therefore  beliefs  are  central  to  individuals  decision  making  process.  The   characteristics  of  this  game  show  there  is  information  asymmetry  in  the  game,  as   players  cannot  observe  opponents  decision  before  taking  theirs.     This  game  will  begin  through  a  discrete  example  of  Robert  and  Stuart  selecting   from  a  finite  choice  of  either  1  or  2  units  of  effort  to  exert  into  the  joint  project.   The  project  value  is  calculated  by  subtracting  the  individual  cost  function  of   Robert  and  Stuart  from  the  value  function,  which  measures  the  cost  minus  the   benefit  from  exerting  a  particular  unit  of  effort.  The  x  value  measures  the  effort   expended  by  Robert  and  the  y  value  measures  the  effort  expended  by  Stuart.       Project  value:  V  (x,  y)  =  5(x  +  y)  +  xy     Project  value  depends  on  the  level  of  effort  exerted  by  Robert  (x)  and  Stuart  (y).     As  Robert’s  cost  function  is  3x2  à  Payoff  function  =  5(x  +  y)  +  xy  –  3x2   As  Stuart’s  cost  function  is  4y2  à  Payoff  function  =  5(x  +  y)  +  xy  –  4y2  
  • 3.   3   When  calculating  the  payoffs  to  each  player  from  each  chosen  effort  combination,   the  effort  values  are  substituted  into  the  individual’s  cost  function:     For  V  (1,  1)  !  5(1  +  1)  +  (1  x  1)  =  11        For  V  (2,  1)  !  5(2  +  1)  +  (2  x  1)  =  17     For  V  (1,  2)  !  5(1  +  2)  +  (1  x  2)  =  17        For  V  (2,  2)  !  5(2  +  2)  +  (2  x  2)  =  24     Constructing  the  normal  form  for  this  game  summarizes  the  players  in  the  game,   strategies  available  and  payoff  received  to  each  individual  based  on  the  strategy   combination  the  player’s  choose  (Gibbons,  1992).  The  columns  correspond  to  the   strategies  of  Stuart  and  the  rows  correspond  to  the  strategies  of  Robert.       Normal  Form:                   The  underlining  method  identifies  the  rational  best  response  made  by  individuals   if  their  opponent  chooses  a  particular  effort  level.  By  constructing  the  normal   form,  the  Nash  equilibrium  can  be  identified:  Robert  chooses  1  unit  of  effort  and   Stuart  chooses  1  unit  of  effort  at  V(1,  1).  The  Nash  equilibrium  represents  a  point   in  the  game  where  players  have  no  incentive  to  change  their  strategy  and  have   mutually  consistent  best  responses.  For  both  players,  strategy  1  is  the  dominant   strategy  therefore  we  can  predict,  due  to  rational  behavior,  that  neither  player   will  select  strategy  2  (Gibbons,  1992).  The  identification  of  the  best  response  in   this  game  shows  that  both  players  have  the  incentive  to  underperform  and  reduce   their  individual  effort  to  gain  a  higher  payout.       When  analyzing  the  Nash  equilibrium  and  normal  form  of  this  game,  it  is  apparent   that  the  rational  behavior  of  Robert  and  Stuart  does  not  necessarily  imply   coordinated  behavior,  as  the  Nash  equilibrium  is  inefficient  with  both  players  able   to  gain  a  higher  payoff  by  playing  differently.  The  players  realize  they  are  jointly   better  off  if  they  select  1  unit  of  effort,  however  individual  incentives  result  in   individuals  defecting  against  this  choice:  Robert  can  gain  a  payoff  of  13  instead  of   7  and  Stuart  can  gain  a  payoff  of  14  instead  of  8.  In  this  game,  individuals  gain   from  being  non-­‐cooperative  and  have  the  incentive  to  free  ride  on  the   contributions  of  others.         R/S   1   2     1     8,  7     14,  1     2     5,  13     12,  8   V  (1,  1)  à     Robert  =  11  –  3  (1)2  =  8       Stuart  =  11  –  4  (1)2  =  7   V  (1,  2)  à     Robert  =  17  –  3  (1)2  =  14       Stuart  =  17  –  4  (2)2  =  1   V  (2,  1)  à     Robert  =  17  –  3  (2)2  =  5       Stuart  =  17  –  4  (1)2  =  13   V  (2,  2)  à     Robert  =  24  –  3  (2)2  =  12       Stuart  =  24  –  4  (2)2  =  8  
  • 4.   4   This  result  is  similar  to  the  Prisoner’s  dilemma  where  individual  incentives   interfere  with  the  interests  of  the  group  (Rapoport,  1965)  resulting  in  group  loss   –  this  concept  will  be  analysed  later  in  the  game.       When  opponents  have  complete  freedom  over  their  effort  choices,  the  players  no   longer  choose  from  a  finite  set  of  strategies  and  can  undertake  a  continuous   strategy.  As  the  strategy  spaces  are  continuous  in  this  game,  the  game  can  be   analysed  by  calculating  best  responses  as  opposed  to  through  a  payoff  matrix.     This  is  calculated  by  differentiating  the  individual’s  payoff  functions  and  re-­‐ arranging  for  x  and  y  respectively.  The  derivative  is  set  to  0  to  find  where  the   slope  of  this  function  is  maximized  at  zero,  which  is  the  best  response  for  each   individual.       Substituting  the  best  response  function  for  y  into  the  x  function  will  find  the   payoff  for  Robert  and  substituting  the  best  response  function  for  x  into  the  y   function  will  find  the  payoff  for  Stuart.       The  Nash  equilibrium  is  at  point  ( 𝟒𝟓 𝟒𝟕 ,   𝟑𝟓 𝟒𝟕 ),  which  represents  the  set  of  effort  choices   for  Robert  and  Stuart  where  both  players  are  maximizing  their  payoff  given  the   actions  of  the  other  player  (Varian,  1987).  Under  this  equilibrium,  Robert  will   exert   !" !"  units  of  effort  and  Stuart  will  exert   !" !" units  of  effort.   Robert:   f(x)  =  5(x  +  y)  +  xy  –  3x2       f(x)  =  5x  +  5y  +  xy  –  3x2     Differentiate  with  respect  to  x:     f’(x)  =  5  +  y  –  6x     Set  f’(x)  =  0  to  find  optimal  point:   0  =    5  +  y  –  6x       6x  =  5  +  y       x  =   𝟓!𝒚 𝟔   BRr(x)  =   𝟓!𝒚 𝟔   Stuart:   f(y)  =  5(x  +  y)  +  xy  –  4y2       f(y)  =  5x  +  5y  +  xy  –  4y2     Differentiate  with  respect  to  y:     f’(y)  =  5  +  x  –  8y     Set  f’(y)  =  0  to  find  optimal  point:   0  =    5  +  x  –  8y       8y  =  5  +  x       y  =   𝟓!𝒙 𝟖   BRs(y)  =   𝟓!𝒙 𝟖   Substitute  y  into  equation  x:   X  =  (5  +   !!! ! ! )   6x  =  5  +   !!! !   48x  =  40  +  5  +  x   47x  =  45   x  =   𝟒𝟓 𝟒𝟕   Substitute  x  into  equation  y:   Y  =   !!   𝟒𝟓 𝟒𝟕 !   8y  =  5  +   𝟒𝟓 𝟒𝟕   376y  =  235  +  45   376y  =  280   y  =   !"# !"#   y  =   𝟑𝟓 𝟒𝟕  
  • 5.   5   Substituting  the  x  and  y  values  into  individual  payoff  functions  and  subtracting   the  effort  costs,  each  partner  receives  the  following  payoff:                 From  the  reaction  functions  calculated,  the  relationship  can  be  diagrammatically   presented  by  finding  points  on  Robert  and  Stuart’s  reaction  function.  This  is   calculated  by  setting  the  x  and  y  values  of  Robert  and  Stuart’s  reaction  function  to   0  as  follows:     The  following  graph  depicts  the  best-­‐response  functions  of  the  two  players.  When   calculating  the  equilibrium,  the  dominated  strategies  are  removed  and  the  lower   and  upper  bounds  converge  to  the  point  where  the  players’  best  response   functions  cross,  which  is  where  the  equilibrium  point  lies.  These  response   functions  are  positively  sloped  as  they  are  a  complementary  strategy  set.         Robert:  x  =   𝟓!𝒚 𝟔     To  calculate  reaction  function:     When  y  =  0,  x  =   !!! !  =   ! !   When  x  =  0,  0  =   !!! !  =  -­‐5     Points  on  reaction  function:     (5/6,  0)  and  (0,  -­‐5)   Stuart:  y  =   𝟓!𝒙 𝟖     To  calculate  reaction  function:     When  y  =  0,  x  =   !!! !  =  -­‐5   When  x  =  0,  y=   !!! !  =   ! !     Points  on  reaction  function:     (-­‐5,  0)  and  (0,  5/8)   Payoff  Robert:     5x  +  5y  +  xy  -­‐  3x2   5( 𝟒𝟓 𝟒𝟕 )  +  5( 𝟑𝟓 𝟒𝟕 )  +  ( 𝟒𝟓 𝟒𝟕 )(   𝟑𝟓 𝟒𝟕 )  –  3( 𝟒𝟓 𝟒𝟕 )2   =  6.47   Payoff  Stuart:   5x  +  5y  +  xy  –  4y2   5( 𝟒𝟓 𝟒𝟕 )  +  5( 𝟑𝟓 𝟒𝟕 )  +  ( 𝟒𝟓 𝟒𝟕 )(   𝟑𝟓 𝟒𝟕 )  –  4( 𝟑𝟓 𝟒𝟕 )2   =  7.00   ( 𝟒𝟓 𝟒𝟕 ,   𝟑𝟓 𝟒𝟕 )   Robert’s  Effort  Level  (x)   Stuart’s  Effort  Level  (y)  
  • 6.   6   Game-­‐theoretic  analysis  generally  assumes  that  each  player  behaves  rationally   according  to  his  preferences  however;  it  does  not  take  into  account  other   motivations  such  as  that  of  the  altruistic  player.  Tony  will  be  introduced  to  this   example  as  the  social  planner  who  has  the  main  objective  of  maximizing  the  total   payoff  of  the  project,  which  is  then  split  between  Robert  and  Stuart.     The  function  used  to  consider  this  game  of  social  welfare  is  the  project  value   function  of  both  Robert  and  Stuart  (5(x  +  y)  +  xy  +  5(x  +  y)  +  xy)  minus  the  two   cost  functions  of  Robert  (3x2)  and  Stuart  (4y2)  to  calculate  the  best  responses  to   maximize  the  total  payoffs  from  the  game.     !  V  (x,  y)  =  5(x  +  y)  +  xy  +  5(x  +  y)  +  xy  –  3x2  –  4y2   !  V  (x,  y)  =  10(x  +  y)  +  2xy  -­‐  3x2  –  4y2       The  x  and  y  effort  values  are  calculated  by  substituting  the  x  and  y  figures  into  one   another  as  before.                   Robert:     f(x)  =  10(x  +  y)  +  2xy  –  3x2  –  4y2       f(x)  =  10x  +  10y  +  2xy  –  3x2  –  4y2     Differentiate  with  respect  to  x:     f’(x)  =  10  +  2y  –  6x       Set  f’(x)  =  0  to  find  optimal  point:   0  =  10  +  2y  –  6x       6x  =  10  +  2y       x  =   𝟏𝟎!𝟐𝒚 𝟔   Stuart:   f(y)  =  10(x  +  y)  +  2xy  –  3x2  -­‐  4y2       f(y)  =  10x  +  10y  +  2xy  –  3x2  -­‐  4y2     Differentiate  with  respect  to  y:     f’(y)  =  10  +  2x  –  8y     Set  f’(y)  =  0  to  find  optimal  point:   0  =  10  +  2x  –  8y       8y  =  10  +  2x       y  =   𝟏𝟎!𝟐𝒙 𝟖   Substitute  y  into  equation  x:   X  =   !"  !  ! !"!!! ! !   6x  =  10  +  2( !"!!! ! )   48x  =  80  +  20  +  4x   44x  =  100   x  =   !"" !!   x  =   𝟐𝟓 𝟏𝟏     Substitute  x  into  equation  y:   Y  =   !"  !  ! !"!!! ! !   8y  =  10  +  2( !"!!! ! )   48y  =  60  +  20  +  4y   48y  =  80  +  4y   44y  =  80   y  =   !" !!   y  =   𝟐𝟎 𝟏𝟏  
  • 7.   7   Payoff  Robert:     5x  +  5y  +  xy  -­‐  3x2   5( 𝟐𝟓 𝟏𝟏 )  +  5( 𝟐𝟎 𝟏𝟏 )  +  ( 𝟐𝟓 𝟏𝟏 )(   𝟐𝟎 𝟏𝟏 )  –  3( 𝟐𝟓 𝟏𝟏 )2   =  9.09     Payoff  Stuart:   5x  +  5y  +  xy  –  4y2   5( 𝟐𝟓 𝟏𝟏 )  +  5( 𝟐𝟎 𝟏𝟏 )  +  ( 𝟐𝟓 𝟏𝟏 )(   𝟐𝟎 𝟏𝟏 )  –  4( 𝟐𝟎 𝟏𝟏 )2   =  11.36     Acting  independently,  Robert  can  gain  a  payoff  of  6.47  and  Stuart  can  gain  a   payoff  of  7,  however,  when  adding  an  altruistic  player  to  maximize  social  welfare,   Robert  can  gain  a  larger  payoff  of  9.09  and  Stuart  can  gain  a  larger  payoff  of  11.36.   This  would  suggest  that  Robert  and  Stuart  should  optimally  act  together  to  ensure   they  both  gain  larger  payoffs  than  if  they  were  acting  independently.     When  comparing  the  effort  levels  of  each  player  to  the  Nash  equilibrium   calculated  when  acting  independently,  the  social  planner  states  the  players  should   exert  more  than  double  the  effort  that  the  players  would  exert  when  acting   independently.  Analysing  in  terms  of  the  effort  to  payoff  ratio,  the  individuals  gain   more  from  acting  independently  than  if  they  were  to  exert  effort  at  the  social   planners  ideal  value:  Robert  exerting  1  effort  unit:  1.67  payoff  acting   independently  and  exerting  1  effort  unit:  4  payoff  acting  socially  optimally;  Stuart   exerting  1  effort  unit:  9.5  payoff  acting  independently  and  exerting  1  effort  unit:   6.3  payoff  acting  socially  optimally.                                                  
  • 8.   8     It  is  evident  that  the  addition  of  the  social  planner  to  the  game  can  result  in  effort   levels  chosen  that  will  increase  the  total  payoff  function  for  the  players.  The   choice  for  players  is  whether  to  cooperate  with  the  social  planners  ideal  outcome   or  whether  to  defect  with  the  belief  that  their  opponent  will  cooperate.  As  Kollock   (1998)  identified,  the  best  outcome  of  a  Prisoner’s  Dilemma  is  unilateral  defection   of  the  first  person,  followed  by  mutual  cooperation,  mutual  defection,  and  the   worst  outcome  is  the  first  person’s  unilateral  cooperation.  The  following  analysis   calculates  the  payoffs  of  Robert  and  Stuart  if  1)  Robert  cooperates  and  Stuart   defects  and  2)  if  Stuart  cooperates  and  Robert  defects  from  the  social  ideal.         Normal  Form:                   The  final  normal  form  presents  the  payoffs  to  each  individual  based  on  the  range   of  scenarios  presented  throughout  this  example.  The  Nash  equilibrium  is   defection  against  the  social  planners  ideal  as  it  the  dominant  strategy  for  both   players.         R/S   C   D     C     11.4,  9.09     2.5,  14.7     D     13,  3.6     7.0,  6.5   When  Robert  cooperates  with  socially  optimal  input  ( 𝟐𝟓 𝟏𝟏 )  and  Stuart  defects:   Y  =   !  !   𝟐𝟓 𝟏𝟏 !   Y  =  0.91     Joint  value  of  project:  5(( 𝟐𝟓 𝟏𝟏 )  +  (0.91))  +  ( 𝟐𝟓 𝟏𝟏 )(0.91)  =  18   Payouts:-­‐     Robert:  18  –  3( 𝟐𝟓 𝟏𝟏 )2  =  2.5       Stuart:  18  –  4(0.91)2  =  14.7   When  Stuart  cooperates  with  socially  optimal  input  ( 𝟐𝟎 𝟏𝟏 )  and  Robert  defects:   X  =   !  !   𝟐𝟎 𝟏𝟏 !   X  =  1.14     Joint  value  of  project:  5((1.14  +  ( 𝟐𝟎 𝟏𝟏 ))  +  (1.14)(   𝟐𝟎 𝟏𝟏 )  =  16.9   Payouts:     Robert:  16.9  –  3(1.14)2  =  13       Stuart:  16.9  –  4( !" !! )2  =  3.6    
  • 9.   9     This  example  is  similar  to  the  prisoners’  dilemma.  The  dilemma  is  clear  when   noticing  that  mutual  cooperation  is  superior  and  yields  a  better  outcome  than   mutual  defection  of  both  players.  This  results  in  mutual  defection  not  being  a   rational  outcome  because  the  choice  to  cooperate  is  more  rational  from  a  self-­‐ interested  point  of  view.    The  value  of  the  project  suffers  as  partners  only  care   about  their  own  costs  and  benefits  and  they  do  not  consider  the  benefit  of  their   labor  to  the  rest  of  the  firm.       The  success  of  the  enterprise  requires  cooperation  and  shared  responsibility  of   the  individuals.  In  this  example,  there  are  limits  on  external  enforcement  as  the   partners  cannot  write  a  contract  and  have  no  way  of  verifying  the  levels  of  effort   exerted  by  each  individual.  Even  if  the  players  had  the  ability  to  communicate   before  the  game  and  decide  on  a  collective  decision,  there  is  no  incentive  for  a   rational  player  to  follow  through  on  the  agreement  as  individuals  could  maximize   by  defecting.  Players  understand  that  increasing  effort  and  therefore  the  value  of   the  joint  project  will  result  in  them  only  gaining  a  fraction  of  the  joint  benefit   therefore  the  players  are  less  willing  to  provide  effort.  The  individuals  therefore   expend  less  effort  than  is  best  from  the  social  point  of  view  and  because  both   players  do  so,  they  both  end  up  worse  off.  As  this  example  only  considered  a   single  play  game,  choosing  to  cooperate  is  not  optimal  for  players.  If  the  example   incorporated  repeated  game  analysis,  including  the  punishment  of  the  opponent   for  defecting  would  reduce  the  payoffs.  This  could  result  in  players  choosing  to   cooperate  if  costs  >  benefits  by  defecting.          
  • 10.   10   As  individuals’  indifference  curves  depend  on  other  people  (Buchanan,  1962),  this   game  results  in  the  players  imposing  external  effects  on  their  opponent  based  on   the  decision  they  choose.  Externalities  are  defined  as  an  indirect  consequence  of   an  activity,  which  affect  agents  other  than  the  originator  without  intension   (Laffont,  2008).  In  this  example,  Robert  and  Stuart’s  payoff  depends  on  the  effort   exerted  by  the  other  player,  which  is  an  example  of  a  positive  externality  or   external  benefit  to  the  other  player.  As  players  increase  their  effort,  the  value  of   the  overall  project  increases  which  increases  the  payoffs  to  both  players.       When  calculating  the  effort  to  payoff  ratio,  there  is  a  2.8  payoff  difference  when   Robert  and  Stuart  exert  one  unit  of  effort:  Robert  gains  6.7  payoffs  and  Stuart   gains  9.5  payoffs.  It  is  clear  that  Stuart  benefits  more  from  exerting  one  unit  of   effort  and  therefore  Robert  exerts  a  higher  positive  externality  on  Stuart.       The  existence  of  externalities  can  cause  market  failure  if  the  price  mechanism   does  not  take  into  account  the  full  social  costs  and  benefits  of  production  and   consumption.  In  this  game,  there  is  a  difference  between  the  marginal  private   benefit  and  marginal  social  benefit  resulting  in  the  MSB  curve  lying  above  MPB.   The  effort  exerted  and  therefore  the  market  output  is  less  than  the  socially   optimal  output  as  shown  in  Appendix  1  -­‐  society  could  be  better  off  and  welfare   increased  by  encouraging  increased  provision.  There  is  therefore  community   pressure  to  make  individuals  pull  their  weight  to  bring  the  effort  levels  to  the   socially  optimal  ideal.  A  method  of  creating  this  pressure  is  to  provide  a  subsidy   to  the  individuals  or  reward  the  individuals  to  provide  at  this  point  [Appendix  2]   bringing  MSB  =  MPB.        
  • 11.   11   REFERENCES     Buchanan,  J.  &  Stubblebine,  W.  (1962).  Externality.  Economica.  29  (116),  371-­‐384.     Dawes,  R.  (1980).  Social  Dilemmas.  Annual  Review  of  Psychology.  31,  169-­‐193.     Gibbons,  R  (1992).  A  Primer  in  Game  Theory.  London:  Pearson  Education  Limited.     Kollock,  P.  (1998).  Social  Dilemmas:  The  Anatomy  of  Cooperation.  Annual  Review   of  Sociology.  24  (1),  183-­‐214.     Laffont,  J.  (2008).  Externalities.  The  New  Palgrave  Dictionary  of  Economics.  2.     Rapoport,  A  (1965).  Prisoner's  Dilemma:  A  Study  in  Conflict  and  Cooperation.  USA:   The  University  of  Michigan  Press.     Varian,  H.;  1987;  “Intermediate  Microeconomics  –  A  Modern  Approach;  Norton,   Chapter  27  pp.  508     Vicarick.  (2011).  Externalities  Graphs:  How  I  Understand  Them.  Available:   http://www.slideshare.net/vicarick/externalities-­‐graphs-­‐how-­‐i-­‐understand-­‐ them.  Last  accessed  14th  Nov  2014.     Watson,  J  (2013).  Strategy:  An  Introduction  to  Game  Theory.  3rd  ed.  New  York:  W.   W.  NORTON  &  COMPANY.       ADDITIONAL  BIBLIOGRAPHY     Carmichael,  F  (2005).  A  Guide  to  Game  Theory.  ENGLAND:  Pearson  Education   Limited.       Dixit,  A.,  Skeath,  S.  &  Reiley,  D  (2009).  Games  of  Strategy.  3rd  ed.  New  York:  W.  W.   Norton  &  Co.     Osborne,  M  (2004).  An  introduction  to  game  theory.  New  York:  Oxford  University   Press.      
  • 12.   12   APPENDICES     Appendix  1       (Vicarick,  2011)     Appendix  2                     (Vicarick,  2011)