Game Theory

Copyright 1999 by Harcourt Brace & Company. All rights reserved.

Basic Ideas of Game Theory



Game theory is the general theory of strategic behavior.

y Generally depicted in mathematical form. y Plays an important role in modern economics.

Copyright 1999 by Harcourt Brace & Company. All rights reserved.

Rules, Strategies, Payoffs, and Equilibrium



Economic situations are treated as games.

y The rules of the game state who can do what, and when they can do it. y A player's strategy is a plan for actions in each possible situation in the game.

Copyright 1999 by Harcourt Brace & Company. All rights reserved.

Rules, Strategies, Payoffs, and Equilibrium



Economic situations are treated as games.

y A player's payoff is the amount that the player wins or loses in a particular situation in a game. y A players has a dominant strategy if that player's best strategy does not depend on what other players do.

Copyright 1999 by Harcourt Brace & Company. All rights reserved.

Nash Equilibrium


Occurs when each player's strategy is optimal, given the strategies of the other players.
y A player's best response (or best strategy) is the strategy that maximizes that player's payoff, given the strategies of other players. y A Nash equilibrium is a situation in which each player makes his or her best response.

Copyright 1999 by Harcourt Brace & Company. All rights reserved.

Prisoner's Dilemma


Famous example of game theory.

y Strategies must be undertaken without the full knowledge of what other players will do. y Players adopt dominant strategies, but they don't necessarily lead to the best outcome.

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Prisoners Dilemma

CLYDE Confess Not Confess Confess BONNIE Not Confess

8 years for Bonnie and 1 year for Clyde 4 years each 1 year for Bonnie and 8 years for Clyde 3 years each

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Bonnies Decision Tree

If Clyde Confesses
Bonnie Confess 4 Years in Prison Best Strategy Not Confess 8 Years in Prison

If Clyde Does Not Confess

Bonnie Confess 1 Year in Prison Best Strategy Not Confess 3 Years in Prison

Copyright 1999 by Harcourt Brace & Company. All rights reserved.

Economic Applications of Game Theory

Cheating on a cartel  Trade wars between countries  Advertising  Games without dominant strategies


Copyright 1999 by Harcourt Brace & Company. All rights reserved.

Cheating on a Cartel


Cartel members' possible strategies range from abiding by their agreement to cheating.
y Cartel members can charge the monopoly price or a lower price. y Cheating firms can increase profits. y The best strategy is charging the low price.

Copyright 1999 by Harcourt Brace & Company. All rights reserved.

Cheating on a Cartel
PepsiCo
Cheat on Cartel (Charge Low Pri e) Dont Cheat (Charge Monopol Pri e) Coke earns $ million Pepsi earns $2 million

Coca Cola

Cheat on Cartel

$ million each

Dont Cheat

Coke earns $2 million Pepsi earns $ million

$6 million each

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Decision Tree for the Coca Cola Company

If Pepsi Charges the Low Price
Coke Low Price Monopoly Price $3 million Best Strategy $2 million

If Pepsi Charges the Monopoly Price

Coke Low Price Monopoly Price $8 million $6 million

Best Strategy

Copyright 1999 by Harcourt Brace & Company. All rights reserved.

Trade Wars Between Countries

Free trade benefits both trading countries.  Tariffs can benefit one trading country.


y Imposing tariffs can be a dominant strategy and establish a Nash equilibrium even though it may be inefficient.

Copyright 1999 by Harcourt Brace & Company. All rights reserved.

Effects of a Tariff on Japanese Televisions

Price to Buyers with a Tariff P Supply of Japanese Televisions to U.S. Market

$350 $100 Tariff $300 Price with No Tariff $250 Price to Sellers with a Tariff A B C E U.S. Demand for Japanese Televisions 600 800 Televisions (thousands per year) Q

Copyright 1999 by Harcourt Brace & Company. All rights reserved.

Trade War Payoffs

Japan
Tari N Tari $9 f r U.S. $4 f r Japan $8 ac

Unit d Stat

Tari

5 ac $4 f r U.S. $9 f r Japan

N Tariff

Copyright 1999 by Harcourt Brace & Company. All rights reserved.

Decision Tree for the United States

If Japan Imposes a Tariff
United States Tariff Free Trade $5 million $4 million $9 million $8 million Tariff Free Trade

If Japan Does Not Impose a Tariff

United States

Copyright 1999 by Harcourt Brace & Company. All rights reserved.

Advertising


The prisoner's dilemma applies to advertising.

y All firms advertising tends to equalize the effects. y Everyone would gain if no one advertised.

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Advertising Payoffs

Maxwell H u e
Adverti e Advertise Dont Adverti e

Folgers

$0 each

$4 for Folgers -$5 for Maxwell House $1 each

Dont Advertise

-$5 for Folgers $4 for Maxwell House

Copyright 1999 by Harcourt Brace & Company. All rights reserved.

Games Without Dominant Strategies



In many games the players have no dominant strategy.

y Often a player's strategy depends on the strategies of others. y If a player's best strategy depends on another player's strategy, he has no dominant strategy.

Copyright 1999 by Harcourt Brace & Company. All rights reserved.

A Game With No Dominant Strategy

Pa
Confess Not Confess 5 years for Ma 3 years for Pa years for Ma 2 years for Pa

Ma

Confess

6 years for Ma 1 year for Pa years for Ma 0 years for Pa

Not Confess

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Mas Decision Tree

If Pa Confesses Ma Confess Not Confess 6 Years in Prison Best Strategy 8 Years in Prison

If Pa Does Not Confess Ma Not Confess Confess 4 Years in Prison 5 Years in Prison Best Strategy

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Multiple Equilibria


Some games have more than one Nash equilibrium.

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Multiple Equilibria


Multiple Nash equilibria means game theorists require extra information to predict what will happen when playing the game.

Copyright 1999 by Harcourt Brace & Company. All rights reserved.

Payoffs in a Game with Multiple Equilibria

Mark
Party Movie Eac l s s 2 units Car l n ts unit ark ts 2 units

Carolyn

Party

Car l n ark Eac

ts 2 units ts unit ts 2 units

Movie

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Sequential Games and Credibility



Some games are sequential.

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Sequential Games and Credibility



A sequential game is a game in which players make at least some of their decisions at different times.

Copyright 1999 by Harcourt Brace & Company. All rights reserved.

Sequential Games and Credibility



When the players are a monopoly and a new firm, the new firm faces a number of decisions beginning with whether to enter the industry.

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Sequential Games and Credibility

Entry decision determines which side of the decision tree is applicable.  In the second half of the game, the monopoly has the dominant strategy.


Copyright 1999 by Harcourt Brace & Company. All rights reserved.

Sequential Games and Credibility

A subgame perfect Nash equilibrium is a Nash equilibrium in which every player's strategy is credible.  No player makes incredible threats.


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A Sequential Game
New Firm Chooses

New Firm Enters Monopoly Chooses High Price Monopoly gets $3, New firm gets $2 Low Price

New Firm Does Not Enter Monopoly Chooses High Price Low Price Monopoly gets $2, New firm gets $0

Monopoly gets Monopoly gets $0, New firm $5, New firm gets $1 ($ millions) gets $0
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Payoffs in a Sequential Game of Entry

New Firm
Enter o Not Enter Monopoly gets $5 New firm gets $0 Monopoly gets $2 New firm gets $0

Monopol

i h Price Low Price

Monopoly gets $3 New firm gets $2 Monopoly gets $0 New firm gets $1

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Commitments


Commitments are valuable.

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The Benefit of Commitments



People can benefit from being able to limit their future actions so that they cannot do what they would want to do in the future.

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The Benefit of Commitments



A person commits to a future action if they do something now to limit future options or change future incentives so that they will have an incentive to take that action in the future.

Copyright 1999 by Harcourt Brace & Company. All rights reserved.

The Benefit of Commitments



Commitments can provide valuable benefits by restricting future choices in a way that changes other people's actions to one's own benefit.

Copyright 1999 by Harcourt Brace & Company. All rights reserved.

Commitment Mechanisms
Committing to future action is often difficult.  The law, social pressures, etiquette, promises and honor all contribute to helping people commit.


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Excess Capacity as Commitment



A monopoly firms excess capacity may deter the entry of a new firm.

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Game With Monopoly Investing in Additional Capacity

New Firm Chooses

New Firm Enters Monopoly Chooses High Price Monopoly gets $3, New firm gets $2 Low Price

New Firm Does Not Enter Monopoly Chooses High Price Low Price Monopoly gets $4, New firm gets $0

Monopoly gets Monopoly gets $4, New firm $5, New firm gets $3 ($ millions) gets $0
Copyright 1999 by Harcourt Brace & Company. All rights reserved.

Commitment in Other Games

Factors such as the capacity to produce help firms honor commitments.  Firms can commit to future actions by convincing government to regulate them.


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Repeated Games


A repeated game is a game that the same players play more than once.

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Repeated Games
Repeated games differ form one-shot games because people's current actions can depend on the past behavior of other players.  Cooperation is encouraged.


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Analysis Of Repeated Games

In the tit-for-tat strategy, players cooperate unless one of them fails to cooperate in some round of the game.  The others do in the next round what the uncooperative player did to them in the last round.


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Experimental Evidence On TitFor-Tat

Evidence indicates tit-for-tat is a winning strategy.  The success of tit-for-tat strategy may lie behind customs and etiquette.


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