Game Theory

Game Theory

 

Game theory is a study of strategic decision making. More formally, it is "the study of mathematical models of conflict and cooperation between intelligent rational decision-makers". Game theory is mainly used in economics, political science, and psychology, as well as logic and biology. The subject first addressed zero-sum games, such that one person's gains exactly equal net losses of the other participant(s). Today, however, game theory applies to a wide range of behavioral relations, and has developed into an umbrella term for the logical side of decision science, to include both human and non-humans, like computers.

The games studied in game theory are well-defined mathematical objects. A game consists of a set of players, a set of moves (or strategies) available to those players, and a specification of payoffs for each combination of strategies. Most cooperative games are presented in the characteristic function form, while the extensive and the normal forms are used to define non-cooperative games.

The normal (or strategic form) game is usually represented by a matrix which shows the players, strategies, and pay-offs. More generally it can be represented by any function that associates a payoff for each player with every possible combination of actions.

The extensive form can be used to formalize games with a time sequencing of moves. Games here are played on trees.  In this each vertex (or node) represents a point of choice for a player. The player is specified by a number listed by the vertex. The lines out of the vertex represent a possible action for that player. The payoffs are specified at the bottom of the tree. The extensive form can be viewed as a multi-player generalization of a decision tree.

K percent rule

According to K percent rule the money supply should be increased at a constant percentage rate year in and year out, irrespective of cyclical changes in national income.

According to Milton Friedman "The stock of money [should be] increased at a fixed rate year-in and year-out without any variation in the rate of increase to meet cyclical needs." (Friedman 1960) Giving governments any flexibility in setting money growth will lead to inflation according to Friedman. The main policy to be avoided is countercyclical monetary policy, the standard Keynesian policy recommendation at the time. For this reason, the central bank should be forced to expand the money supply at a constant rate, equivalent to the rate of growth of real GDP.

Deadweight loss

In economics, a deadweight loss is a loss of economic efficiency that can occur when equilibrium for a good or service is not Pareto optimal. In other words, either people who would have more marginal benefit than marginal cost are not buying the product, or people who have more marginal cost than marginal benefit are buying the product. Deadweight loss can be beneficial when there is a negative externality, in which case it can be considered a deadweight gain, as it would help those that the negative externality was hurting.

Causes of deadweight loss can include monopoly pricing, externalities, taxes or subsidies, and binding price ceilings or floors. The term deadweight loss may also be referred to as the "excess burden" of monopoly or taxation.

Free Riding

Free Riding means getting the benefit of a good or service without paying for it. This may be possible because certain types of goods and services are actually hard to charge for--a firework display, for instance. Free riders are those who consume a resource without paying for it, or pay less than the full cost of its production.   However, there can sometimes be a free-rider problem, if the number of people willing to pay for the good or service is not enough to cover the cost of providing it. In this case, the good or service might not be produced, even though it would be beneficial for the economy as a whole to have it. Free riding is usually considered to be an economic "problem" only when it leads to the non-production or under-production of a public good, or when it leads to the excessive use of a common property resource.  Public goods are often at risk of free riding. The free rider problem is the question of how to limit free riding (or its negative effects) in these situations.  The problem can be overcome by financing the good by imposing a tax on the entire population.

Debt swap

Debt swap is a set of transactions in which a firm buys a country's dollar bank debt at a discount and swaps this debt with the central bank for local currency that it can use to acquire local equity.  

A company can undergo some financial restructuring for long term success. One possible way to achieve this goal is to issue a debt/equity or an equity/debt swap. In the case of an equity/debt swap, all specified shareholders are given the right to exchange their stock for a predetermined amount of debt (i.e. bonds) in the same company. A debt/equity swap works the opposite way: debt is exchanged for a predetermined amount of equity (or stock). The value of the swap is determined usually at current market rates, but management may offer higher exchange values to entice share and debt holders to participate in the swap. After the swap takes place, the preceding asset class is cancelled for the newly acquired asset class.

J-curve

The term J-curve is used in several different fields to refer to a variety of unrelated J-shaped diagrams where a curve initially falls, but then rises to higher than the starting point.

In private equity, the J curve is used to illustrate the historical tendency of private equity funds to deliver negative returns in early years and investment gains in the outlying years as the portfolios of companies mature.

In economics, the 'J curve' refers to the trend of a country’s trade balance following a devaluation or depreciation under a certain set of assumptions. A devalued currency means imports are more expensive, and on the assumption that the volume of imports and exports change little immediately, this causes a depreciation of the current account (a bigger deficit or smaller surplus). After some time, though, the volume of exports may start to rise because of their lower more competitive prices to foreign buyers, and domestic consumers may buy fewer of the costlier imports. Eventually, if this happens, the trade balance may improve on what it was before the devaluation. If there is a currency revaluation or appreciation the same reasoning leads to an inverted J-curve.

Law of diminishing returns

In economics, diminishing returns (also called diminishing marginal returns) refers to progressive decrease in the marginal (per-unit) output of a production process as the amount of a single factor of production is increased, while holding the amounts of all other factors of production constant.

The law of diminishing returns states that in all productive processes, adding more of one factor of production, while holding all others constant, will at some point yield lower per-unit returns. The law of diminishing returns does not imply that adding more of a factor will decrease the total production, a condition known as negative returns, though in fact this is common.

Learning curve

A learning curve is a graphical representation of the changing rate of learning (in the average person) for a given activity or tool. Typically, the increase in retention of information is sharpest after the initial attempts, and then gradually evens out, meaning that less and less new information is retained after each repetition.

The learning curve can also represent at a glance the initial difficulty of learning something and, to an extent, how much there is to learn after initial familiarity.

In economics, learning curve is a curve showing how a firm's costs of producing at a given rate of output fall as the total amount produced increases over time as a result of accumulated learning of how to make the product efficiently using given equipment.

The Harmonized Commodity Description and Coding System

The Harmonized Commodity Description and Coding System (HS) of tariff nomenclature is an internationally standardized system of names and numbers for classifying traded products developed and maintained by the World Customs Organization (WCO) (formerly the Customs Co-operation Council), an independent intergovernmental organization with over 170 member countries based in Brussels, Belgium.

Under the HS Convention, the contracting parties are obliged to base their tariff schedules on the HS nomenclature, although parties set their own rates of duty. The system begins by assigning goods to categories of crude and natural products, and from there proceeds to categories with increasing complexity. The codes with the broadest coverage are the first four digits, and are referred to as the heading. The HTS therefore sets forth all the international nomenclature through the 6-digit level and, where needed, contains added subdivisions assigned 2 more digits, for a total of 8 at the tariff-rate line (legal) level. Two final (non-legal) digits are assigned as statistical reporting numbers if warranted, for a total of 10 digits to be listed on entries.

To ensure harmonization, the contracting parties must employ all 4- and 6-digit provisions and the international rules and notes without deviation, but are free to adopt additional subcategories and notes.

Price skimming

A product pricing strategy by which a firm charges the highest initial price that customers will pay. As the demand of the first customers is satisfied, the firm lowers the price to attract another, more price-sensitive segment.

The skimming strategy gets its name from skimming successive layers of "cream," or customer segments, as prices are lowered over time. It allows the firm to recover its sunk costs quickly before competition steps in and lowers the market price.

Price skimming is sometimes referred to as riding down the demand curve. The objective of a price skimming strategy is to capture the consumer surplus.

It is effective only when the firm is facing an inelastic demand curve. Skimming encourages the entry of competitors. When other firms see the high margins available in the industry, they will quickly enter.

Price skimming occurs in mostly technological markets as firms set a high price during the first stage of the product life cycle. The top segments of the market which are willing to pay the highest price are skimmed of first. When the product enters maturity the price is lowered.

Perverse demand curve

A perverse demand curve is one which slopes upwards from left to right. Therefore an increase in price leads to an increase in demand. This may happen where goods are strongly affected by price expectations or in the case of Giffen goods.

Narrow Money

Narrow Money is a measure of money supply that includes all physical money like coins and currency along with demand deposits and other liquid assets held by the central bank. This is called narrow money because it applies the most restrictive definition of money.

Behavioral economics

A branch of economics that concentrates on explaining the economic decisions people make in practice, especially when these conflict with what conventional economic theory predicts they will do. Behaviorists try to augment or replace traditional ideas of economic rationality with decision-making models borrowed from psychology.

Behavioral economics use social, cognitive and emotional factors in understanding the economic decisions of individuals and institutions performing economic functions, including consumers, borrowers and investors, and their effects on market prices, returns and the resource allocation. The fields are primarily concerned with the bounds of rationality of economic agents.

Behavioral analysts are not only concerned with the effects of market decisions but also with public choice, which describes another source of economic decisions with related biases towards promoting self-interest.

Fiscal drag

Fiscal drag refers to a situation when the government's net fiscal position (spending minus taxation) fails to cover the net savings desires of the private economy, also called the private economy's spending gap (earnings minus spending and private investment). The resulting lack of aggregate demand leads to deflationary pressure, or drag, on the economy, essentially due to lack of state spending or to excess taxation.

One cause of fiscal drag is the consequence of expanding economies with progressive taxation. In general, individuals are forced into higher tax brackets as their income rises. The greater tax burden can lead to less consumer spending. For the individuals pushed into a higher tax bracket, the proportion of income as tax has increased, resulting in fiscal drag. It refers to the weight of higher taxes on higher incomes so that after-tax incomes do not reflect the extent of a wage rise.

When people's money income rises, dragging them into higher tax brackets. Fiscal drag is therefore referring to the effect inflation has on average tax rates. If tax allowances are not increased in line with inflation, and people's incomes increase with inflation then they will be moved up into higher tax bands and so their tax bill will go up. However, they are actually worse off because inflation has cancelled out their pay rise and their tax bill is higher.

Veblen Goods

Veblen goods are a group of commodities for which people's preference for buying them increases as a direct function of their price, as greater price confers greater status, instead of decreasing according to the law of demand. A Veblen good is often also a positional good. The Veblen effect is named after economist Thorstein Veblen, who first pointed out the concepts of conspicuous consumption and status-seeking.

Some types of high-status goods, such as high-end wines, designer handbags and luxury cars are Veblen goods, in that decreasing their prices decreases people's preference for buying them because they are no longer perceived as exclusive or high status products.

Business Cycle

The term business cycle (or economic cycle) refers to economy-wide fluctuations in production or economic activity over several months or years. These fluctuations occur around a long-term growth trend, and typically involve shifts over time between periods of relatively rapid economic growth (an expansion or boom), and periods of relative stagnation or decline (a contraction or recession).

The usual pattern of the business cycle is: bust, recovery, boom and recession. The levels of economic growth, employment, and inflation are directly affected in each of the phases of the business cycle. The business cycle has an impact also on corporate earnings and cash flows.

Business cycles are usually measured by considering the growth rate of real gross domestic product. Despite being termed cycles, these fluctuations in economic activity do not follow a mechanical or predictable periodic pattern.

Many developments and indicators are cited as causes of the business cycles. The most common ones, however, are: over-investment, under-consumption, fluctuations in agricultural output, the interaction of the multiplier and accelerator, war and international politics.

Absolute advantage theory

Absolute advantage theory is introduced by the Scottish economist Adam Smith (1723-1790).

Adam Smith, in The Wealth of Nations, postulated that under free trade, each nation should specialize in producing those goods that it could produce most efficiently. Some of these would be exported to pay for the imports of goods that could be produced more efficiently elsewhere.

The theory of absolute advantage is based on the assumption that the nation is absolutely better (i.e., more efficient) at production of certain goods than are its trading partners.

Smith argued that it was impossible for all nations to become rich simultaneously by following mercantilism because the export of one nation is another nation’s import and instead stated that all nations would gain simultaneously if they practiced free trade and specialized in accordance with their absolute advantage.

Giffen good

A Giffen good is an extreme type of inferior good. A good that is so inferior and so heavily consumed at low incomes that the demand for it rises when its price rises The negative income effect of changes in price of a Giffen good is actual stronger than the substitution effect. An inferior good for which the negative income effect outweighs the substitution effect so that the demand curve is positively sloped.

Sacrifice ratio

Sacrifice ratio measures the costs associated with slowing down economic output to change inflationary trends. Sacrifice ratio is the number of percentage points of annual output lost in the process of reducing inflation by 1 percentage point.

The ratio is calculated by taking the cost of lost production and dividing it by the percentage change in inflation, and its quotient gives the loss of output per 1% change in inflation:

Sacrifice ratio = Dollar Cost of Production Loss/Percentage Change in Inflation

Pareto optimal allocation of resources

Given an initial allocation of goods among a set of individuals, a change to a different allocation that makes at least one individual better off without making any other individual worse off is called a Pareto improvement. An allocation is defined as "Pareto efficient" or "Pareto optimal" when no further Pareto improvements can be made.

Pareto efficiency is a minimal notion of efficiency and does not necessarily result in a socially desirable distribution of resources, as it makes no statement about equality or the overall well-being of a society.