Wednesday, July 15, 2009

When Game Theory Isn't Enough, Try Institutions!

Fabio Rojas:

Game theory is a strange thing. On the one hand, there are deep results – every finite game has a Nash equilibrium. On the other hand, there’s a fundamental ambiguity about these deep results: you might have mutliple equilibria.

There are two solutions to this issue. The first is to define more sophisticated equilibrium concepts. This is usually a problem in applications in that it’s often very hard to convince yourself that typical people will actually find solutions in that way. If your grad students have problems solving the game, then how will your grandma figure out the perfect Bayesian equilibrium?

The second solution is to go beyond traditional game theory. For example, one might view life in evolutionary terms. Poor strategies are weeded out, survivors converge on the strategies predicted by some fancy solution concept.

But here’s my favorite way to get beyond game theory 101 ambiguities – institutions. Let’s say some common interaction has multiple equilibria, some of them bad. Then people can set up rules that force particular outcomes. The skeptics might retort “free riders,” but I don’t see that as a huge problem. There’s often someone who has a disproportional stake in the game and is willing to invest the time and energy to monitor the game. Some people seem to have a taste for creating and enforcing rules, the traditionalists in any society.

The skeptic might say that I’ve just created a bigger, more complicated game – a game about the institution’s creation, then a game about enforcement, then the original game. True, this is more complex, but conceptually it’s just a chain of simple games. It’s easier for me to believe that people work at solving each game via simple solution concepts and try to make them fit together (often unsuccessfully), rather than invoke some very esoteric solution concept.

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