Economics II.

- Third mid-term
Norbi Székely

1 Introduction to game theory

• Game theory: Analysis of strategic interactions among rational agents, with a wide range of appli-
cations.
• Assumptions:
– Rationality: Players always try to maximize their payoffs.
– Common knowledge: Rules of the game, all possible actions of all players and all the potential
payoffs of all players.
• Strategy: The various steps that have to be made by the players in every possible point of decision.
• Dominant strategy: No other strategy can give a better payoff whichever strategy the others are
playing.
• Dominated strategy: A strategy which doesn’t result in the optimal outcome in any case, and there
always exist a course of action which results in higher payoff no matter what the opponent does.
• Nash equilibrium: There are games without dominant or dominated strategies. Nash equilibrium is
a concept of game theory where the optimal outcome of a game is one where no player has an incentive
to deviate from his chosen strategy after considering an opponent’s choice.
• Simultaneous game: A type of game where players made their decisions at the same time.
• Sequential game: A type of game where the second player can observe the move of the first player.
• Backward induction: Can solve a sequential game with the following steps:
1. A player knows exactly who did what so far. Based on that the player considers which move gives
the highest payoff.
2. Then the player goes one step back: the player knows exactly what the last choice of the other
player was, so you know your payoff for any decision.
3. Keep stepping back until the very beginning.
• Trust game: The experiment of choice to measure trust in economic decisions. The experiment is
designed to demonstrate trust as basic to economic transactions as self-interest.
• Problem of credible threats: A player can use threats to alter other players’ expectations of his
future actions, and thereby induce them to take actions favorable to him or deter them from making
moves that harm him. This is problematic because when the time comes, it is generally costly to carry
out a threat.
• Repeated games: Playing the same games multiple times. A big advantage is that a player have
information about the choice of his/her opponent in the previous plays.
– Finite horizon (NOT endless repetition): Can be solved with backward induction.
– Infinite horizon (endless number of games): There is a chance to get to the socially optimal
equilibrium. BUT if a player ever observes the other to cheat, then the first player will cheat
forever. And so that can be a large enough punishment for making the other player cooperate.

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2 Strategic interactions
2.1 General features
• Exludability in consumption : Property of a good, a person can be prevented from using a good.

• Rivalry in consumption: Property of a good, one person’s use diminishes other people’s use.
• Types of goods: Private goods (excludable and rival in consumption), Public goods (neither
excludable nor rival in consumption), Common resources (rival in consumption but not excludable),
Natural monopoly (excludable but not rival in consumption).

• Free rider: A person who receives the benefit of a good but avoids paying for it.
• Free rider problem: When the number of beneficiaries is large enough then exclusion of any one of
them is impossible.

• Tragedy of the common resources: Social and private incentives are different, and the “tragedy”
arises due to a negative externality.
• Externalities: Decisions of buyers and sellers may affect people who are not participants in the market
at all.

• Negative externality: An impact on the bystander that is adverse.

• Positive externality: An impact on the bystander that is beneficial.
• Market failure: The inability of some unregulated markets to allocate resources efficiently. Public
policy can potentially remedy the problem and can increase economic efficiency.

• Cost-benefit analysis: Comparing the costs and benefits to society of providing a public good.

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2.2 Oligopoly models
• Assumptions:
– There are just few players in the market and they have some market power but not that much as
a single monopoly.
– The products of the firms are identical and buyers can’t differentiate, so their price will be the
same.
• Characteristics of Simple models:
– Duopoly
– Firms can decide only about the price or about the quantity (not both).
– Simultaneous or sequential decisions.
• Setting the price (simultaneous case): A firm’s optimal quantity will depend on its opponent’s choice
and the first firm can’t influence or observe the second one’s quantity, and the second one’s quantity
will be the response to the first one’s. And so Nash equilibrium arise: there is no incentive to deviate
from the original strategy (from the original quantity).
• Setting the price (sequential case): One can solve this situation with backward induction because
the second mover can observe the quantity produced by the first mover and maximize profits based on
the residual demand.

• Cartel: Collusion1 of multiple firms of manufacturers or suppliers with the purpose of maintaining
prices at a high level and restricting competition. The firms would have a higher level of joint profits
if they agreed that each produced half of the monopolistic quantity. The problem comes from the fact
that each firm has an incentive to deviate from the quantity in equilibrium, because there is higher
profit for one when it produces a little more. Moreover: setting a little lower price than a competitor
will result in that all the consumers will buy from the firm. The competitor, however, has the same
incentive. Both of them continue to decrease the price until they sell at P = M C, so they “compete
away” all the profits. Then they arrive at the competitive outcome, there is no deadweight loss. If
there is asymmetry in the costs, the price will be a little below the higher marginal cost and only the
firm with the lower marginal cost will sell. And so they are better off keeping the price at that level
where P = M C.

1 Collusion: Secret or illegal cooperation or conspiracy in order to deceive others.