Risk Dominance - Formal Definition

Formal Definition

The game given in Figure 2 is a coordination game if the following payoff inequalities hold for player 1 (rows): A > B, D > C, and for player 2 (columns): a > b, d > c. The strategy pairs (H, H) and (G, G) are then the only pure Nash equilibria. In addition there is a mixed Nash equilibrium where player 1 plays H with probability p = (d-c)/(a-b-c+d) and G with probability 1–p; player 2 plays H with probability q = (D-C)/(A-B-C+D) and G with probability 1–q.

Strategy pair (H, H) payoff dominates (G, G) if A ≥ D, a ≥ d, and at least one of the two is a strict inequality: A > D or a > d.

Strategy pair (G, G) risk dominates (H, H) if the product of the deviation losses is highest for (G, G) (Harsanyi and Selten, 1988, Lemma 5.4.4). In other words, if the following inequality holds: (C – D)(c – d)≥(B – A)(b – a). If the inequality is strict then (G, G) strictly risk dominates (H, H).2(That is, players have more incentive to deviate).

If the game is symmetric, so if A = a, B = b, etc., the inequality allows for a simple interpretation: We assume the players are unsure about which strategy the opponent will pick and assign probabilities for each strategy. If each player assigns probabilities ½ to H and G each, then (G, G) risk dominates (H, H) if the expected payoff from playing G exceeds the expected payoff from playing H: ½ B + ½ D ≥ ½ A + ½ C, or simply B + D ≥ A + C.

Another way to calculate the risk dominant equilibrium is to calculate the risk factor for all equilibria and to find the equilibrium with the smallest risk factor. To calculate the risk factor in our 2x2 game, consider the expected payoff to a player if they play H: (where p is the probability that the other player will play H), and compare it to the expected payoff if they play G: . The value of p which makes these two expected values equal is the risk factor for the equilibrium (H, H), with the risk factor for playing (G, G). You can also calculate the risk factor for playing (G, G) by doing the same calculation, but setting p as the probability the other player will play G. An interpretation for p is it is the smallest probability that the opponent must play that strategy such that the person's own payoff from copying the opponent's strategy is greater than if the other strategy was played.