The essential nature of game theory is that it involves strategic behavior, which means interdependent decision-making

PLAYERS: These are the relevant decision-making identities, whose utilities are interdependent. STRATEGIES: These are complete plans of action for playing the game. PAYOFFS: These represent changes in welfare or utility at the end of the game, and are determined by the choices of strategy of each player.

To illustrate this, let us consider the situation Of Coke and Pepsi. At any given time period each firm has to decide whether to maintain their existing price or to offer a discount to the retailers who buy from them.

PEPSI Maintain Price Maintain Price COKE Discount 50 50 Discount -10 70

70

-10

10

10

Strategy pair (self/other)

Defect/co-operate Co-operate/co-operate Defect/defect Co-operate/defect

Name of payoff
Temptation (70) Reward (50) Punishment (10) Suckers payoff (10)

 Co-operative

and non-cooperative games Two-player and multi-player games Zero-sum and non-zero-sum games Perfect and imperfect information Static and dynamic games Discrete and continuous strategies One-off and repetitive games

The nature of this type of game raises the following questions:

How does a firm determine strategy in this type of situation? What do we mean by an equilibrium strategy? Is there anything that firms can do to change the equilibrium to a more favorable one, meaning to ensure co-operation?

We can now consider three types of equilibrium and appropriate strategies in situations involving different payoffs.
Dominant

strategy equilibrium, Iterated dominant strategy equilibrium, Nash equilibrium

Strictly dominant strategy in a situation, will always give at least as high a payoff as any other strategy, whatever player other does

PEPSI Maintain Price Maintain Price COKE Discount 50 50 Discount -10 70

70

-10

10

10

This means that there is some other outcome where at least one of the players is better off while no other player is worse off.

What would happen if one firm did not have a dominant strategy?

PEPSI

Maintain Price
Maintain Price 80 50 -10

Discount
70

COKE

Discount

70

-10

10

10

The situation becomes more complicated when neither player has a dominant strategy.

PEPSI Maintain Price Maintain Price 60 50 15 Discount 10

COKE
Discount 75 10 10 15

 If

Coke maintains price, Pepsi will discount; and, given this best response, Cokes best reply is to maintain price. If Coke discounts, Pepsi will maintain price; and, given this best response, Cokes best reply is to discount.

The same equilibrium could also be expressed from Pepsis point of view:
If

Pepsi discounts, Coke will maintain price; and, given this best response, Pepsis best reply is to discount.
If Pepsi maintains price, Coke will discount; and, given this best response, Pepsis best reply is to maintain price

 Cournot

model Bertrand model Contestable markets model

 There

are few firms in the market and many buyers.

firms produce homogeneous products; therefore each firm has to charge the same market price (the model can be extended to cover differentiated products).

The

Competition is in the form of output, meaning that each firm determines its level of output based on its estimate of the level of output of the other firm.
firm believes that its own output strategy does not affect the strategy of its rival(s). Barriers to entry exist. Each firm aims to maximize profit, and assumes that the other firms do the same.

Each

 There

are few firms in the market and many buyers. firms produce homogeneous or differentiated products; therefore each firm has to charge the same market price in the case of homogeneous products, but there is some scope for charging different prices for differentiated products.

The

Competition is in the form of price, meaning that each firm determines its level of price based on its estimate of the level of price of the other firm. Each firm believes that its own pricing strategy does not affect the strategy of its rival(s). Barriers to entry exist. Each firm has sufficient capacity to supply the whole market. Each firm aims to maximize profit, and assumes that the other firms do the same.

 There

are an unlimited number of potential firms that can produce a homogeneous product, with identical technology. Consumers respond quickly to price changes. Incumbent firms cannot respond quickly to entry by reducing price. Entry into the market does not involve any sunk costs. Firms are price-setting Bertrand competitors.

Many business scenarios tend to involve sequential moves rather than simultaneous moves.
Example: Decision to invest in new plant

 Dynamic

games are best examined by drawing a game tree.

An

extensive-form game not only specifies the players, possible strategies, and payoffs, as in the normal-form game, but also specifies when players can move, and what information they have at the time of each move.

 In

order to analyze this game tree we must derive the sub game perfect Nash equilibrium (SPNE).

This

is the situation where each player selects an optimal action at each stage of the game that it might reach, believing the other player(s) will act in the same way.

FIRM B Expand Expand 50 20 85 No change 25

FIRM A
No change 70 40 95 30

 As

game theory applications have become more widespread throughout economics and the other social and natural sciences, certain criticisms have arisen regarding the validity of its conclusions