Topic 12

Game Theory

Topics to be Discussed
Game Theory
Dominant Strategy, Nash Equilibrium, and Maximin
Strategy
The Prisoners Dilemma
Cartel Cheating

Game Theory
Game is any situation in which players (the participants) make
strategic decisions.
Ex: firms competing with each other by setting prices, group of
consumers bidding against each other in an auction

Game theory tries to determine optimal strategy for each

player.
Game theory is the study of how people make decisions in
situations in which attaining their goals depends on their
interactions with others.
It is a subfiled of economics that analyzes the choices made by
rival firms, people, and even government when they are trying
to maximize their own well-being while anticipating and
reacting to the actions of others in their environment.

Some important Game Theory Terms

Players: decision makers, 2 or more oligopolists.
Actions: all the possible moves a player
can make.
Information: how much each players knows at each
point in the game.
strategies: rules telling each player which action to
choose at each point in the game.

Some Important Game Theory Terms

Payoff: profit, expected profit, or utility the player
receive after all the players have picked strategies and
the games has been played out.
Outcomes: all possible results of all the possible
results of the strategies that the players can select; that
is, the set of all possible game payoff.
Equilibrium: strategic combination consist of the best
strategy for each player in the game.

Gaming and Strategic Decisions

If I believe that my competitors are rational and act
to maximize their own profits, how should I take their
behavior into account when making my own profitmaximizing decisions?

Noncooperative v. Cooperative Games

Cooperative Game

Players negotiate binding contracts that allow them to

plan joint strategies
Example: Buyer and seller negotiating the price of a good
or service or a joint venture by two firms (i.e. Microsoft
and Apple)
Binding contracts are possible

Cooperative equilibrium is one in which players in a

game cooperate to increase their mutual payoff.
Collusion is an agreement among firms to collude,
eg. charging the same price or other wise not to
compete.

Noncooperative v. Cooperative Games

Noncooperative Game
Negotiation and enforcement of binding contracts between
players is not possible
Example: Two competing firms assuming the others behavior
determine, independently, pricing and advertising strategy to gain
market share
Binding contracts are not possible

Non-cooperative equilibrium is one in which players

dont cooperate but pursue their own self-interest.

Noncooperative v. Cooperative Games

It is essential to understand your opponents point of view and to deduce his or her
likely responses to your actions.

The strategy design is based on understanding your

opponents point of view, and (assuming you
opponent is rational) deducing how he or she is likely
to respond to your actions
Note that the fundamental difference between cooperative and noncooperative
games lies in the contracting possibilities. In cooperative games, binding contracts are
possible; in noncooperative games, they are not.

Dominant Strategies
Dominant Strategy is one that is optimal
no matter what an opponent does.

A dominant strategy is one that is best for a player, no

matter what strategies other players use.
An Example

A & B sell competing products

They are deciding whether to undertake advertising
campaigns
Their decision is interdependence on other firm
decision.

Dominant Strategies
Payoff Matrix for Advertising Game: (A,B)

Firm B
Advertise
A

Firm A

Advertise

10, 5

Dont
Advertise

15, 0

What strategy should each firm choose?

Dont
Advertise

A B

6, 8

10, 2

Dominant Strategies
Firm A:
If firm B does advertise, Firm A will earn a profit of
10 if it also advertise and 6 if it doesnt.
Thus, firm A should advertise if firm B advertise.
If firm B doesnt advertise, firm A would earn profit
of 15 if it advertise and 10 if it doesnt.
Thus, firm A should advertise whether firm B
advertise or not
Advertising is the dominant strategy for Firm A

Dominant Strategies
Firm B:
If firm A does advertise, Firm B will earn a profit of 5 if
it also advertise and 0 if it doesnt.
Thus, firm B should advertise if firm A advertise.
If firm A doesnt advertise, firm B would earn profit of
8 if it advertise and 2 if it doesnt.
Thus, firm B should advertise whether firm A advertise
or not
Advertising is the dominant strategy for Firm B

Payoff Matrix for Advertising Game

Observations

A: regardless of B,
advertising is the best
B: regardless of A,
advertising is best

Firm B Dont
Advertise
Advertise

Advertise

10, 5

15, 0

6, 8

10, 2

Firm A

Both firms with advertise.

Dont
Advertise

Payoff Matrix for Advertising Game

Observations

Dominant strategy
for A & B is to
advertise
Do not worry about
the other player
Equilibrium in
dominant strategy

Firm B Dont
Advertise
Advertise

Advertise

10, 5

15, 0

6, 8

10, 2

Firm A
Dont
Advertise

Dominant Strategies
Equilibrium in dominant strategies
Outcome of a game in which each firm is doing the
best it can regardless of what its competitors are doing
Optimal strategy is determined without worrying about
actions of other players

However, not every game has a dominant strategy for

each player

Dominant Strategies
Game Without Dominant Strategy
The optimal decision of a player without a dominant
strategy will depend on what the other player does.
Revising the payoff matrix we can see a situation
where no dominant strategy exists

Modified Advertising Game

Firm B
Advertise

Firm A

Advertise

10, 5

Dont
Advertise

15, 0

What strategy should each firm choose?

Dont
Advertise

6, 8

20, 2

Modified Advertising Game

Observations

A: No dominant
strategy; depends on
Bs actions
B: Dominant strategy
is to Advertise
Firm A determines Bs
dominant strategy and
makes its decision
accordingly

Advertise

Advertise

Firm B Dont
Advertise

10, 5

15, 0

6, 8

20, 2

Firm A
Dont
Advertise

Nash Equilibrium Revisited

In order for firm A to
determine whether to advertise,
firm A must first try to
determine what firm B will do.
If firm B advertises, firm A
earns a profit of 10 if it
advertises and 6 if it does not.
If firm B does not advertise,
firm A earns a profit of 15 if it
advertises and 20 if it does not.
Thus, firm A should advertise if
firm B advertise, and it should
not advertise if firm B doesnt.

Firm B Dont
Advertise
Advertise

Advertise

10, 5

15, 0

6, 8

20, 2

Firm A
Dont
Advertise

Nash Equilibrium Revisited

Firm A has to determines Bs
dominant strategy and makes
its decision accordingly.
Firm Bs dominant strategy is
to advertise, therefore, the
optimal strategy for firm A is
also to advertise. This is Nash
equilibrium.
Only when each player has
chose its optimal strategy
given the strategy of the
other player do we have
Nash equilibrium.

Firm B Dont
Advertise
Advertise

Advertise

10, 5

15, 0

6, 8

20, 2

Firm A
Dont
Advertise

Nash Equilibrium Revisited

A Nash equilibrium is a situation in which each
player chooses the best strategy, in light of the
strategies chosen by the other player or players
A dominant strategy is stable, but in many games one or more
party does not have a dominant strategy.
A more general equilibrium concept is the Nash Equilibrium
introduced in chapter 10
A set of strategies (or actions) such that each player is doing the best
it can given the actions of its opponents

None of the players have incentive to deviate from its Nash

strategy, therefore it is stable
In the Cournot model, each firm sets its own price assuming the
other firms outputs are fixed. Cournot equilibrium is a Nash
Equilibrium

Nash Equilibrium Revisited

Dominant Strategy
Im doing the best I can no matter what you do.
Youre doing the best you can no matter what I do.

Nash Equilibrium
Im doing the best I can given what you are doing.
Youre doing the best you can given what I am doing.

Dominant strategy is special case of Nash

equilibrium

Nash Equilibrium Revisited

Two cereal companies face a market in which two
new types of cereal can be successfully introduced
provided each type is introduced by only one firm
Product Choice Problem

Market for one producer of crispy cereal

Market for one producer of sweet cereal
Each firm only has the resources to introduce one cereal
Noncooperative

Product Choice Problem

Firm 2
Crispy

Firm 1

Crispy

-5, -5

Sweet

10, 10

What strategy should each firm choose?

Sweet

10, 10

-5, -5

Product Choice Problem

If firm 1 hears firm 2 is
introducing a new sweet
cereal, its best action is to
make crispy

Firm 2
Crispy

Crispy

Sweet

-5, -5

10, 10

10, 10

-5, -5

Bottom left corner is Nash

Firm 1
equilibrium
Sweet

What is other Nash

Equilibrium?
Upper right-hand corner.

THE BEACH LOCATION GAME

FIGURE 13.1
BEACH LOCATION GAME

You (Y) and a competitor (C) plan to sell soft drinks on a beach.
If sunbathers are spread evenly across the beach and will walk to the closest vendor,
the two of you will locate next to each other at the center of the beach. This is the only
Nash equilibrium.
If your competitor located at point A, you would want to move until you were just to
the left, where you could capture three-fourths of all sales.
But your competitor would then want to move back to the center, and you would do the
same.

Nash Equilibrium Revisited

Maximin Strategies maximizing minimum gain
Scenario
Two firms compete selling file-encryption software
They both use the same encryption standard (files
encrypted by one software can be read by the other advantage to consumers)
Firm 1 has a much larger market share than Firm 2
Both are considering investing in a new encryption
standard

Maximin Strategy
Firm 2

Firm 1

Dont
invest

Dont invest

Invest

0, 0

-10, 10

What strategy should each firm choose?

Invest

-100, 0

20, 10

Maximin Strategy
Observations
Dominant strategy Firm
2: Invest
Firm 1 should expect firm
2 to invest
Nash equilibrium
Firm 1: invest
Firm 2: Invest

This assumes firm 2

understands the game and
is rational

Firm 2
Dont invest

Dont invest

Invest

0, 0

-10, 10

-100, 0

20, 10

Firm 1
Invest

Maximin Strategy
Observations
If Firm 2 does not
invest, Firm 1 incurs
significant losses (100)
Firm 1 might play
dont invest
Minimize losses to 10
maximin strategy

Firm 2
Dont invest

Dont invest

Invest

0, 0

-10, 10

-100, 0

20, 10

Firm 1
Invest

Maximin Strategy
If both are rational and informed
Both firms invest
Nash equilibrium

If Player 2 is not rational or completely informed

Firm 1s maximin strategy is to not invest
Firm 2s maximin strategy is to invest.
If Firm 1 knows Firm 2 is using a maximin strategy,
Firm 1 would invest

Maximin Strategy
If firm 1 is unsure about what firm 2 will do, it can
assign probabilities to each possible action
Could use a strategy that maximizes its expected payoff
Firm 1s strategy depends critically on its assessment of
probabilities for firm 2

Prisoners Dilemma
Prisoner B
Confess

Prisoner A

Confess

5, 5

Dont Confess

1, 10

Would you choose to confess?

Dont
Confess

10, 1

2, 2

Prisoners Dilemma

What is the dominant strategy for each prisoner?

What is the Nash Equilibrium?

What is maximin strategy?

The ideal outcome is one in which neither prisoner confesses, so that both get
two years in prison.
Confessing, however, is a dominant strategy for each prisonerit yields a
higher payoff regardless of the strategy of the other prisoner.
Dominant strategies are also maximin strategies. The outcome in which both
prisoners confess is both a Nash equilibrium and a maximin solution. Thus, in a
very strong sense, it is rational for each prisoner to confess.

Prisoners Dilemma
A situation in which pursuing dominant strategies
results in non-cooperation that leaves everyone worse
off.
The concept of the prisoners dilemma can be used to
analyze price and non-price competition in
oligopolistic markets, as well as the incentive to cheat
in a cartel (i.e., the tendency to secretly cut prices or
to sell more than the allocated quota.

Prisoners Dilemma
Firm B
Low Price

Firm A

Low Price

2, 2

High Price

5, 1

What strategy should each firm choose?

High Price

1, 5

3, 3

Prisoners Dilemma
Firm A:
If firm B charged a low price (say $6), firm A would
earn a profit of 2 if it also charged the low price ($6) and
1 if it charge a high price (say, $8).
If firm B charged the high price ($8), firm A would earn
a profit of 5 if it charged the low price and 3 if it charged
the high price.
Thus, firm A should adopt its dominant strategy of
charging the low price.

Prisoners Dilemma

Firm B:
If firm A charged a low price (say $6), firm B would
earn a profit of 2 if it also charged the low price ($6) and
1 if it charge a high price (say, $8).
If firm A charged the high price ($8), firm B would earn
a profit of 5 if it charged the low price and 3 if it charged
the high price.
Thus, firm B should adopt its dominant strategy of
charging the low price.

Prisoners Dilemma
Firm B
Low Price

Firm A

Low Price

High Price

High Price

2, 2

5, 1

1, 5

3, 3

Prisoners Dilemma
However, both firms could do better (i.e., earn higher
profit of 3) if they cooperated and both charged the
higher price (the bottom right cell).
Thus, both firms are in a prisoners dilemma:
Each firm will charge the lower price and earn a smaller
profit because if it charges the high price, it cannot trust its
rival to also charge the high price.

Prisoners Dilemma
Firm B
Low Price

Firm A

Low Price

High Price

High Price

2, 2

5, 1

1, 5

3, 3

Prisoners Dilemma

Suppose that firm A charged the high price with the

expectation that firm B would also charge the high piece
(so that each firm would earn a profit of 3).
Given that firm A has charged the higher, however, firm
B now has an incentive to charge the low price, because
by doing so it can increase its profits to 5.

Prisoners Dilemma
Firm B
Low Price

Firm A

Low Price

High Price

High Price

2, 2

5, 1

1, 5

3, 3

Prisoners Dilemma
Suppose that firm B charged the high price with the
expectation that firm A would also charge the high piece
(so that each firm would earn a profit of 3).
Given that firm B has charged the higher, however, firm
A now has an incentive to charge the low price, because
by doing so it can increase its profits to 5.

Prisoners Dilemma
The net result is that each firm charges the low price and
earns a profit of only 2.
Only if the two firms cooperate and both charge the high
price will they earn the highest profit of 3 (and
overcome their dilemma)
The concept of the prisoners dilemma can be used to
analyze price and non-price competition in oligopolistic
markets, as well as the incentive to cheat in a cartel (i.e.,
the tendency to secretly cut prices or to sell more than
the allocated quota.

Can Firms Escape the Prisoners Dilemma?

Price leadership A form of implicit collusion in which one
firm in an oligopoly announces a price change and the other
firms in the industry match the change.

Eg. through 1970s, General Motors would announce a price

change at the beginning if a model year, and Ford and Chrysler
would match GMs price change.

Cartel Cheating

Firm A

Cheat

Dont cheat

Firm B

Cheat

Dont cheat

2, 2

5, 1

1, 5

3, 3

Cartel Cheating
Each firm adopts its dominant strategy of cheating earns
a profit of 2.
Buy not cheating, each member of the Cartel would earn
the highest profit of 3.
The Cartel members then face the prisoners dilemma.
A Cartel can prevent or reduce the probability of
cheating by monitoring the sales of each member and
punishing cheaters.