Macroeconomics For Dummies®, uk edition Published by: John Wiley & Sons, Ltd

Adding payoffs

But we’re missing an important ingredient: the payoffs. Without them, we can’t possibly say how the players in the game will act. Payoffs reveal how good or bad a player thinks an outcome is.

In this game, we have three possible outcomes:


Outcome A: Banks take on a moderate amount of risk. Everything in the financial system is hunky-dory. Policy makers can relax.


Outcome B: Banks take on excessive risk. The government comes to the rescue with a bailout but at great cost to the taxpayer.


Outcome C: Banks take on excessive risk. The government refuses to bail out the financial sector, and the result is widespread bank failures. In short, all hell breaks loose.

We look first at these outcomes from the perspective of the banks:

Outcome C is clearly by far the worst. Most if not all banks fail. We

assign the payoff of –£100 billion.

Outcome A is a decent outcome for the banks. They go about their activities and make a reasonable profit, say £10 billion.


Outcome B is particularly enticing for the banks. If the risk-taking works out in their favour, they get to keep their large profits, and if it doesn’t, the government absorbs their losses (‘heads we win, tails you lose’). On average, we say that this outcome makes the banks £50 billion.

Now look at the outcomes from the perspective of the government:

Outcome C is clearly by far the worst. The banks fail, companies can’t borrow money and thus go bust, people lose their jobs and savings, salaries aren’t paid, the country comes to a halt, widespread looting takes place, armed gangs roam the streets, you get the idea… . Quantifying just how bad things get is difficult, but a conservative number may be –£1,000 billion.


Outcome A is certainly the best for the government. It doesn’t have to do anything and probably even raises some taxes from the banks: £5 billion would be a reasonable guess.

Outcome B is pretty bad for the government. It has to use substantial taxpayer funds to bail out the banks: –£50 billion may be enough.

We add these payoffs to Figure 15-3 to complete the game (see Figure 15-4).


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Figure 15-4: Extensive form game with payoffs.