Econ E1010 Game Theory Handout Z.M.

Fall 2019

Game theory is the study of how people behave in strategic situations.

Strategic situation – refers to any situation in which each person, when deciding what actions to take, must consider
how others might respond to that action.

In the context of game theory, a game is a description of a strategic environment where two or more individuals
engage in strategic decision-making.

Individuals who participate in a game are called players.

If we want to describe any “game”, we must specify the following:

(i) who or how many players are playing the game,

(ii) what the rules of the games are,
(iii) what the outcomes are depending on any set of actions, and how players value different outcomes.

Action refers to a choice that a player can make.

Action set refers to the entire set of action available to the player.

Example 1:

Matching Pennies – Version 1: We have two players, Tom and Jerry. Simultaneously, each player picks Heads or
Tails. If they pick the same, Tom pays Jerry $5; if they pick different, Jerry pays Tom $5. Thus, the result (who pays
whom) depends on both their outcomes.

Example 2:

Matching Pennies – Version 2: Two players, Tom and Jerry. First, Tom picks either Heads or Tails. Upon observing
his choice, Jerry then picks either Heads or Tails. If they pick the same, Tom pays Jerry $5; if they pick different, Jerry
pays Tom $5.

Decisions versus (Strategic) Games:

Decisions can involve situations individuals can choose their actions without concern for reaction or response from
others.

Strategic games involve interactions between mutually aware players where each player knows his/her decision
affects the other player.

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Types of Games:

There are many types of games and there are different classifications of games.

Three ways of classifying strategic games –

(1) Simultaneous games/sequential games –

Simultaneous games are situations when players make their choices simultaneously.

Sequential games are situations when players make their choices sequentially. The first player makes a choice. The
second player sees the first player’s choice and then makes his/her choice.

(2) One shot game/ Repeated games –

One-shot game – Players play the game only for only one round. That means each player gets to choose a strategy only
once.

Repeated games – There are multiple rounds played. Therefore, each player will be choosing strategies more than once.
In this class, since we are learning game theory to understand oligopolistic market structures, we will learn about specific
types of games that help us to understand a few oligopolistic markets.

Note, there can be many other types of games that we would learn in a class focused solely on game theory.

(3) Non-cooperative/Cooperative games –

Non-cooperative games – players make their decisions unilaterally without having the chance to negotiate with each
other (no opportunity to strike a deal!)

Cooperative games – players can negotiate with binding contracts (often involving threats/penalties) that allow them to
plan “joint” strategies.

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The Prisoners’ Dilemma:

Prisoners’ Dilemma is an important “game” that helps us to understand why firms fail to “collude” to produce
monopoly profits even when they know that they will be better off by earning more if they cooperated than if they made
their decisions independently.

Two prisoners: Police caught Bonnie and Clyde for a crime.

The police have enough evidence to convict Bonnie and Clyde of the minor crime of carrying an unregistered gun, so
that each would spend a year in jail.

The police also suspect that the two criminals have committed a bank robbery together, but they lack hard evidence to
convict them of this major crime. Therefore, the cops need Bonnie and Clyde to confess.

“Right now, we can lock you up for 1 year. If you confess to the bank robbery and implicate your partner, however,
we will give you immunity and you can go free. Your partner will get 20 years in jail. But if you both confess to the
crime, we won’t need your testimony and we can avoid the cost of a trial, so you will each get an intermediate
sentence of 8 years.”

Each prisoner has two strategies: confess or remain silent.

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 How to construct a 2 by 2 payoff matrix that we will use to solve a simultaneous choice game?

Step 1: From the scenario given to you, first identify the players and the strategies each player has available to her.

Step 2: Draw the payoff matrix.

Player 2

Strategy 1 Strategy 2

Strategy 1 8, 6

Player 1

3,7
Strategy 2

Step 3: Put the payoffs of each player in the right position.

What are “payoffs”?

Payoffs are numbers that represent the motivations of the players. For example, payoffs can be firms’ profits, quantity
etc.
In the Prisoner’s Dilemma, the “years spent in jail” indicate the payoffs. Fewer years in jail is better.

The first number in each cell belongs to player 1 and the second number belongs to player 2.
Make sure you follow this rule consistently.
For in cell 1x1, we have the numbers 8 and 6. This means when player 1 plays Strategy 1 and player 2 plays Strategy
1, player 1 receives 8 and player 2 gets 6.
In cell 2x2, we have the numbers 3 and 7. This means when player 1 plays Strategy 2 and player 2 plays Strategy 2,
player 1 receives 3 and player 2 receives 7.

Step 4: Check to see your payoff matrix is complete or not. Each cell must have the payoffs for each player
corresponding to their strategy choices.

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The Prisoner’s Dilemma:

Bonnie’s Decision

Confess Remain Silent

Confess 8 years, 8 years 0 years, 20 years

Clyde’s Decision

20 years, 0 years 1 year, 1 year

Remain Silent

Note in this situation, the Prisoner’s Dilemma game is a one shot, non-cooperative, simultaneous choice game.

How to solve a simultaneous choice game to find a market equilibrium solution?

The best way to learn to solve games is by working with some examples.

Example: Oligopolies with Prisoner’s Dilemma

Two countries – A and B sell crude oil.
Each country has two strategies: High Production (HP), Low Production (LP)
(i) If both countries choose High Production, they each make $40 billion.
(ii) If both countries choose Low Production, they each make $50 billion.
(iii) If country A chooses Low Production and country B chooses High Production, the A makes $30 billion and B
makes $60 billion
(iv) If country A chooses High Production and country B chooses Low Production, the A makes $60 billion and B
makes $30.

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Given these strategies and payoffs, can we find out the outcome of this game?

Country B’s Decision

HP LP

HP 40, 40 60, 30

Country A’s Decision

LP
30, 60 50, 50

Dominant Strategy refers to a strategy that proves to be optimal for the player, no matter which strategy the opponent
chooses.
In the classic prisoner’s dilemma game with the prisoners, the numbers (years in jail) are given by the police in a way
that “confess” ends up being the dominant strategy even when both prisoners knew that remaining silent together would
be the better option for both of them.
In the above example, HP ends up being the dominant strategy even though both individuals end up being off together
if they both stuck to LP.

Pure Strategy Nash Equilibrium (PSNE): A PSNE indicates an equilibrium outcome that shows a set of strategy for
each player such that no player will benefit by unilaterally changing his/her strategy.
Thus, in a PSNE, all players are playing their optimal strategies.

A PSNE may or may not involve a dominant strategy for each player. Thus, a dominant strategy equilibrium is always
a Nash equilibrium but all Nash equilibria are not dominant strategy equilibria.

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Practice game theory problems (One-shot simultaneous choice games):

1. Consider two firms that sell an identical product. Each has two pricing strategies: (1) to charge a ‘normal price’ or
(2) to put the product on sale and charge a ‘sale price’ for it. Some buyers in the market do not shop around and will
always buy the item at the normal price. Other buyers are ‘bargain shoppers’ and will only buy the item if it is on sale.
Because of market behavior, if both firms charge the normal price, each earns a profit of $75. However, if one charges
the sale price while the other charges the normal price, the firm charging the sale price will earn $85 in profit, while the
firm charging the normal price will still earn $75. However, if both charge the sale price, each earns a profit of only
$55.

(a) Write this game in the form of a payoff matrix. Be sure to label the matrix carefully. (5 points)
(b) Find a Nash equilibrium for this game. Is there more than one Nash equilibrium? (5 points)

Now suppose that all shoppers compare price before buying. If one firm puts the product on sale while the other firm
does not, everyone will buy from the firm that is offering the sale. The firm offering the sale will earn $110 while the
firm that does not offer the sale will earn $0. If neither has the product on sale (i.e. both charge the normal price), they
continue to earn $75 each (as above). If both charge the sale price, they continue to earn only $55 each (as above).

(c) Write this game in the form of a payoff matrix. Again, be careful to label the matrix carefully. (5 points)
(d) Find a Nash equilibrium for this game. Is there more than one Nash equilibrium? (5 points)

2. Charlie Harper and Alan Harper are brothers. One Saturday evening they find they have no dates (strange for Charlie,
not so much for Alan) and decide to have a brothers’ night out. Charlie wants to go to a boxing match while Alan wants
to spend the evening going to an opera. Irrespective of the final choice, the brothers want to spend their evening together,
in spite of the fact that Charlie finds Alan a nagging little brother and Alan does not approve Charlie’s way of living.

If Charlie and Alan go together to a boxing match, Charlie gets utility/happiness worth 2 units and Alan gets
utility/happiness worth 1 unit.

If they both end up at the opera (Alan is so happy), Alan gets 2 units of happiness and Charlie gets 1.

They both get 0 units of utility if they end up going to two different places alone.

(a) Construct the payoff matrix for this problem. Label the matrix correctly with player names and their strategies.
(2 pts)

(b) Find all the pure strategy Nash equilibria this game might have and write down the equilibrium strategies.
(3 pts)

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3. Two firms (firms 1 and 2) are in the chocolate market. Each can choose to go for the high end of the market
(high quality) or the low end (low quality).

When both firms choose low, firm 1 gets $-20 and firm 2 gets $-30.

When firm 1 chooses low and firm 2 chooses high, firm 1 earns $900 and firm 2 gets $600.

When firm 1 chooses high and firm 2 chooses low, firm 1 earns $100 and firm 2 earns $800.

When both firm chooses high, each gets $50. Both firms make the choice simultaneously.

(i) Set up the payoff matrix. Label everything clearly.

(ii) Find the Nash equilibria, if any.

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An example of a one-shot sequential game involving two players
Player 1 gets to make her choice first. Once player 1 has made her choice, player 2 gets to observe the choice made by
player 2, and then make the choice.
Each player will choose with an aim to maximize her payoff.
Player 1 options: L, R
Player 2 options: A, B
If player 1 chooses L and player 2 chooses A, then player 1 will receive 3 and player 2 will receive 1.
If player 1 chooses L and player 2 chooses B, then player 1 will receive 1 and player 2 will receive 2.
If player 1 chooses R and player 2 chooses A, then player 1 will receive 2 and player 2 will receive 1.
If player 1 chooses R and player 2 chooses B, then player 1 will receive 0 and player 2 will receive 0.

Even though the players will play the game in a forward-moving direction, i.e., player 1 will choose first and then
player 2 will choose, we will solve the game to find the equilibrium solution in a backward-moving direction by
reasoning backwards, a technique commonly as backward induction.
We will first solve player 2’s games by identifying the strategy that will maximize her payoff given any strategy
chosen by player 1 before her. We will then figure out player 1’s best strategy.