Opportunity Costs Vis-A-Vis Game Theory

Mr Rajiv after getting a good percentile in XAT, and clearing the rest processes, makes his way to study at XLRI. On the first day of classes, each of his professors distributes a course syllabus and explains that the final exam will be graded on a curve. As a result, performance on the final exam will be measured relative to the others in the class. If Rajiv outperforms most of his peers, he will earn a "good" grade. If he studies about the same amount, he will get an "average" grade, and if he doesn't study much, he is sure that he will fail the course. Rajiv considers himself about average relative to his peers. As a result, good grades will give him a strong sense of accomplishment and bolster his grade point average. However, Rajiv knows, it will take a lot of studying to perform well in the course. On a 0 to 10 scale, Rajiv rates receiving an A in any course as a 10, an average grade as 5 and a failing grade as 0. On the other hand, the costs (in terms of money spent at XLRI and free time) of studying on the same 0-to-10 scale are 4 for studying a little and 7 for studying a lot.

Rajiv assumes that the rest of the class (at least on average) faces a similar set of decisions and has similar costs and benefits. If Rajiv's assumptions are correct and if he makes his decision without observing the choice of his classmates (and vice versa), how much should he study per week: a lot or a little?

ANALYSIS: The case in the normal form is set up as follows:

THE AVERAGE PERSON IN THE CLASS.

STUDY A LITTLE STUDY A LOT

STUDY A LITTLE (1;1) (-4;3)

STUDY A LOT (3;-4) (-2;-2)

RAJIV

There is a single pure strategy Nash equilibrium where everyone studies a lot and the payoffs are average grades with a lot of work, yielding net benefits of -2 for everyone.

This simple example allows us to illustrate several key economic concepts. For example, the concept of rational decision-making can be conveyed by defining the alternatives of each of the decision-makers as well as through the use of net benefit calculations as payoffs. The process of determining the Nash Equilibrium also requires evaluating opportunity costs and utilizing marginal analysis. As an example, considering the scenario where the "average" person in the class studies a little, Rajiv must choose the option with the highest marginal benefit, which in this case is to study a lot, since the marginal net benefit of this alternative, is 2 (or 3-1). But, by definition, marginal analysis also incorporates opportunity cost. In this scenario the opportunity cost of studying a lot is the net benefit of studying a little, which is 1.

Using a game theoretic approach to present and discuss