Game Theory in experimental applications

And an introduction to Behavioral Game Theory

Traditional Game Theory

Game theory is the analysis of the mathematical models where two or more rational entities
participate in decision making to find an optimum strategy in competitive or conflicting situations,
taking into consideration that the outcomes of the choices of each entity depend, also, on the
decisions of other entities.
For the purpose of simplification of real world problems into mathematically solvable ones so
that they fit into theoretical models, it makes assumptions. And the functionality of game theory
is very strongly correlated with these assumptions.
One of the assumptions is, rationality of the players, that is players always act on decisions that
maximizes their utility and other is common knowledge, each player knows that every other
player is also rational, also, each knows that every player knows that every other player is
rational and so on ad infinitum.
These concepts contribute to finally obtaining a strategy which achieves a mathematical
equilibrium.

Bounded Rationality

Allais Paradox
Let us consider the following experiments shown in the table1 below. Given the choice, the
reader is requested to choose a gamble from Experiment 1. And now, another from
Experiment2.

Experiment 1 Experiment 2

Gamble 1A Gamble 1B Gamble 2A Gamble 2B

Winnings Chance Winnings Chance Winnings Chance Winnings Chance

$1 million 89% Nothing 89%

$1 million 100% Nothing 90%

Nothing 1% $1 million 11%

1
https://en.wikipedia.org/wiki/Allais_paradox
 $5 million 10% $5 million 10%

Considering the cases individually, several experiments2 have supported the assertion that the
gamble 1A will be statistically preferred over 1B while 2B is more likely to be selected than 2A.
According to expected utility theory, however, the choice should be either 1A and 1B or 2A and
2B. Thus, we don’t act rationally while choosing 1A and 2B, this is where the concept of
‘bounded rationality’ comes into the picture.
Bounded rationality states that the rationality of a decision maker is limited by restricted
information they have, cognitive limitations of their mind and the amount of time they have. Thus
at such an instance they decide on a satisfactory course of action rather than an optimal one.
Here, the choice of one part of the gamble may affect the choice of another part of the gamble,
for instance the 1% chance of disappointment of losing in 1B versus the 100% chance of
winning in 1A, leads to the decision of choosing 1A.

Social preferences

Ultimatum Game
Instructions:
○ Ultimatum game is designed for two players and a predetermined divisible prize.
○ The first player proposes a ratio for the division of the said prize.
○ The second player decides whether to accept or reject the proposal.
○ If the proposal is accepted the prize is divided as per the accepted ratio, otherwise none
of the players get anything.
The Subgame Perfect Nash equilibrium of the Ultimatum game is that the proposer essentially
gets almost the complete prize.
However, experiments point otherwise, a study3 conducted between members of a shared
social group showed that people usually choose equally distributed ratio, and that proposals
below 30% are rejected.
Though not formally a game by game theory jargon, Dictator game also offers such contrasting
results, here the receiver has no say and the proposer can propose any ratio which the receiver
will have to accept. Again experiments4 showed that the ‘dictators’ chose a non zero share for
the receivers contrasting to the expected zero share, due to the underlying principle of inequity
aversion.
Thus the results of a game are also affected by something termed as social preferences.
Social preferences are preferences related to the concepts of interpersonal altruism, fairness,
reciprocity, and inequity aversion.

2
Machina, Mark (1987). "Choice Under Uncertainty: Problems Solved and Unsolved". The Journal of Economic Perspectives. 1
(1): 121–154.
3
Sanfey, Alan; Rilling; Aronson; Nystrom; Cohen (13 June 2003). "The Neural Basis of Economic Decision-Making in the
Ultimatum Game". Science. 300 (5626): 1755–1758.
4
Henrich, et al. (2004) Foundations of Human Sociality: Economic Experiments and Ethnographic Evidence from Fifteen Small-
Scale Societies. Oxford University Press
Behavioral Game theory

Behavioral game theory is the mathematical modeling of an individual’s behavior in strategic

Conclusions

Traditional game theory assumes that the players of the games are perfectly emotionless and
rational beings who always seek to maximize their utility or minimize their losses, but these
assumptions hinder the application of the principles of game theory to the real world problems.
Factors such as vengeance, moral obligations, inequity aversion, fairness and more affect
decisions of rational individuals too, and the study of this is behavioral game theory.