Threats and Promises

Abdul Quadir
XLRI

31 December, 2019
Reading: Dixit and Skeath, Chapter 9.
Threats and Promises

I Note that threats are response rule.

I Athreat is a response rule that leads to a bad outcome for the
other players if they act contrary to your interests.
I Thus, you try to force the other to act in such way that is
favourable to you by issuing threat.
I A promise is a response rule by which you offer to create a
good outcome for other players if they act in a way that
promote your own interest.
I Thus, they either try to deter the other players to deter or
induce the other players to take a particular action.
Example of Threat
I Let us consider the trade war game between Japan and USA.
I Both the countries can either choose an open or closed
economic system.
I In (Open, Closed) first entry is USA’s action and second entry
is Japanese action.
I USA preferences are give as:

(Open, Open)  (Open, Closed)  (Closed, Open)  (Closed, Closed

I Japanese preferences are given as:

(Open, Closed)  (Open, Open)  (Closed, Closed)  (Closed, Open

I We can depict this game as:

Open Closed
Open 4,3 3,4
Closed 2,1 1,2
Example of Threat
I Let us consider the trade war game between Japan and USA.
I Both the countries can either choose an open or closed
economic system.
I In (Open, Closed) first entry is USA’s action and second entry
is Japanese action.
I USA preferences are give as:

(Open, Open)  (Open, Closed)  (Closed, Open)  (Closed, Closed

I Japanese preferences are given as:

(Open, Closed)  (Open, Open)  (Closed, Closed)  (Closed, Open

I We can depict this game as:

Open Closed
Open 4,3 3,4
Closed 2,1 1,2
Example of Threat

I USA’s dominant strategy is play ‘Open’ and Japanese

dominant strategy is to play ‘Closed’.
I Thus, Nash equilibrium is (Open, Closed) and the
corresponding payoff is (3,4).
I Note that Japan is getting its best payoff so it does not have
any incentive to try any strategic moves.
I On the other hand USA can try to use strategic moves.
I Note that USA’s unconditional strategic move commitment
will not work.
I Now suppose USA uses the following strategic move “We will
close our market if you close yours”.
I This makes this game two stage game.
Example of Threat

Open Closed
Open 4,3 3,4
No Threat Closed 2,1 1,2

USA

1,2
Threat
Japan Closed

Open
4,3

If Japan plays Closed, then USA will play Closed. If Japan plays
Open, then the USA’s threat works and it will keep its economy
opened.
Example of Threat

Open Closed
Open 4,3 3,4
No Threat Closed 2,1 1,2

USA

1,2
Threat
Japan Closed

Open
4,3

If Japan plays Closed, then USA will play Closed. If Japan plays
Open, then the USA’s threat works and it will keep its economy
opened.
Remarks

1. Japan does not follow its dominant strategy.

I This is because the idea of dominance is relevant only in the
context of simultaneous move game.
2. Credibility of the threat is problematic because what if Japan
test USA by keeping its market closed.
I Better to issue a warning.
I Credible threat will inflict mutual harm for credibility which
missing here.
3. The threat “We will close our market if you close yours” does
cot completely specify the US strategy.
I USA has to specify what it will do if Japan does not comply.
I The following sentence “and we will keep our market open if
you keeps your open” complete its strategy.
I This part is known as the implicit promise that is a part of a
threat.
Promises
I Recall the example where two restaurants x and y are fixing
their prices simultaneous facing the following demand:

Qx = 44 − 2px + py
Qy = 44 − 2py + px

I Nash equilibrium prices are px∗ = py∗ = 20.

I The joint best price is 26.
I Let us consider these two prices only calling them Low and
High.
I We can depict them in the following game matrix:
20 (Low) 26 (High)
20 (Low) 28800,28800 36000,21600
26 (High) 21600,36000 32400, 32400
I Nash equilibrium is (Low , Low ) without any strategic moves.
Promises
I Recall the example where two restaurants x and y are fixing
their prices simultaneous facing the following demand:

Qx = 44 − 2px + py
Qy = 44 − 2py + px

I Nash equilibrium prices are px∗ = py∗ = 20.

I The joint best price is 26.
I Let us consider these two prices only calling them Low and
High.
I We can depict them in the following game matrix:
20 (Low) 26 (High)
20 (Low) 28800,28800 36000,21600
26 (High) 21600,36000 32400, 32400
I Nash equilibrium is (Low , Low ) without any strategic moves.
Promises
I Suppose restaurant x makes the promise “I will charge high
price if you do”.
I This is depicted in the following game tree:

20 (Low) 26 (High)
20 (Low) 28800,28800 36000,21600
No promise 26 (High) 21600,36000 32400,32400

28800,28800
Promise Low
y

High
32400,32400
Promises
I Suppose restaurant x makes the promise “I will charge high
price if you do”.
I This is depicted in the following game tree:

20 (Low) 26 (High)
20 (Low) 28800,28800 36000,21600
No promise 26 (High) 21600,36000 32400,32400

28800,28800
Promise Low
y

High
32400,32400
Credibility of Promises
I Restaurant x has to move second in the second stage to make
the promise credible.
I Similarly restaurant y moves first in stage 2.
I This is because first move is observable and irreversible.
I But how can restaurant y will believe that restaurant x will
not rebege from its promise?
I One way to do that restaurant can hand over the pricing
decision to a local manager with written instruction.
I Other way could be restaurant x can develop a reputation for
keeping promises.
I Note the difference between promise and threat.
I In threat if desirable action is achieved from the other player,
then there is not to carry it out.
I In promise if desirable action is achieved, then you have to
keep the promise fulfilled.
Credibility of Promises
I Restaurant x has to move second in the second stage to make
the promise credible.
I Similarly restaurant y moves first in stage 2.
I This is because first move is observable and irreversible.
I But how can restaurant y will believe that restaurant x will
not rebege from its promise?
I One way to do that restaurant can hand over the pricing
decision to a local manager with written instruction.
I Other way could be restaurant x can develop a reputation for
keeping promises.
I Note the difference between promise and threat.
I In threat if desirable action is achieved from the other player,
then there is not to carry it out.
I In promise if desirable action is achieved, then you have to
keep the promise fulfilled.
Applications
Tragedy of Commons

I Commons refer to those scarce resources that every one has

access to them and they deplete when used.
I In short, commons have two important features:
I access to nearly everyone.
I resource depletability.
I Some example of “commons” are:
I International water and the fish in them.
I Environment.
I Bandwidth sharing.
I Advertising.
I Pasture land etc.
I Tragedy of commons refer to the tensions which arises
between individual selfish interest and the common good in
the usage of commons.
I This was first studied by Garrett Hardin (1968).
Pollution Game

I Let us consider n countries who are interesting in passing the

law to control the pollution or not pass a law.
I Assume that pollution control has cost 3 for the country, but
all countries that pollute add 1 to the cost of all countries.
I Suppose k countries among n did not pass a law, then their
cost is k.
I The cost for the remaining n − k countries is k + 3.
I It is the dominant strategy for each country not to pass law to
control pollution.
I Thus, the total cost to a country is n.
I However, if they control pollution by passing a law, then the
cost to each country is 3.
Pollution Game

I Let us consider n countries who are interesting in passing the

law to control the pollution or not pass a law.
I Assume that pollution control has cost 3 for the country, but
all countries that pollute add 1 to the cost of all countries.
I Suppose k countries among n did not pass a law, then their
cost is k.
I The cost for the remaining n − k countries is k + 3.
I It is the dominant strategy for each country not to pass law to
control pollution.
I Thus, the total cost to a country is n.
I However, if they control pollution by passing a law, then the
cost to each country is 3.
Pollution Game

I Let us consider n countries who are interesting in passing the

law to control the pollution or not pass a law.
I Assume that pollution control has cost 3 for the country, but
all countries that pollute add 1 to the cost of all countries.
I Suppose k countries among n did not pass a law, then their
cost is k.
I The cost for the remaining n − k countries is k + 3.
I It is the dominant strategy for each country not to pass law to
control pollution.
I Thus, the total cost to a country is n.
I However, if they control pollution by passing a law, then the
cost to each country is 3.
Pollution Game

I Let us consider n countries who are interesting in passing the

law to control the pollution or not pass a law.
I Assume that pollution control has cost 3 for the country, but
all countries that pollute add 1 to the cost of all countries.
I Suppose k countries among n did not pass a law, then their
cost is k.
I The cost for the remaining n − k countries is k + 3.
I It is the dominant strategy for each country not to pass law to
control pollution.
I Thus, the total cost to a country is n.
I However, if they control pollution by passing a law, then the
cost to each country is 3.
Sharing a Bandwidth

I Suppose that n people would like to have part of a shared

resource.
I For example, each player wants to send information over a
shared network.
I It has a maximum capacity of 1.
Formulation of Problem

I There are n players.

I Every one has infinite strategies, for each i, xi ∈ [0, 1] is his or
her strategy.
I Payoff:
( P
0 if xj > 1
ui (xi , x−i ) = P j P
xi (1 − j xj ) if j xj < 1
Formulation of Problem

I There are n players.

I Every one has infinite strategies, for each i, xi ∈ [0, 1] is his or
her strategy.
I Payoff:
( P
0 if xj > 1
ui (xi , x−i ) = P j P
xi (1 − j xj ) if j xj < 1
Formulation of Problem

I There are n players.

I Every one has infinite strategies, for each i, xi ∈ [0, 1] is his or
her strategy.
I Payoff:
( P
0 if xj > 1
ui (xi , x−i ) = P j P
xi (1 − j xj ) if j xj < 1
Solution
P
Let us take t = j6=i xj < 1. Then, we can write the optimization
problem of agent 1 as:

max x(1 − t − x).

x

Using some calculus, we have

1−t
x= .
2
A set of strategies is stable if all players are playing their optimal
selfish strategy, given the strategies of all other players. Therefore,
P
(1 − j6=i xj )
xi = .
2
Solution

Solving the above equation, we have

1 − (n − 1)x
x= .
2
which implies that:
1
x= .
n+1

I Why this solution is a tragedy?

I Total value of this solution is extremely low.
Solution

Solving the above equation, we have

1 − (n − 1)x
x= .
2
which implies that:
1
x= .
n+1

I Why this solution is a tragedy?

I Total value of this solution is extremely low.
Solution

I Value for agent i is

1
.
(n + 1)2
I Sum of total values over all the players is
n 1
2
≈ .
(n + 1) n

Now suppose total bandwidth used is i xi = 21 .

P
I
1
I Then every one is going to use xi = 2n .
I Thus, the total value will be 41 , mush higher than than the
previous total value.
Stackelberg Competition

I There are two firms 1 and 2.

I Firm 1 moves first (known as leader). Then firm 2 moves
(known as follower).
I They would like to produce some quantity of a product.
I The order of moves might matter and rational actors will take
into account.
I This was developed by Heinrich von Stackelberg and known as
stackelberg competition.
I Suppose that demand is given by p = 100 − (q1 + q2 ) and
they incur 10 rupees as per unit cost.
Stackelberg Competition

I We can write the profit function of firm i as:

πi = (100 − qi − qj )qi − 10qi

I Given other quantity level we can compute the best response

function of each firm.
I Thus each i solves

max(100 − qi − qj )qi − 10qi

qi

I The best response function is

90 − qj
qi = .
2
Stackelberg Competition

I Since we know that firm 1 is leader so it will choose its

production level first.
I Then firm 2 will observe the production level of firm 1 and
take its production decision.
I We will use backward induction to solve the equilibrium
production level of each firms.
I Thus, firm 2 maximizes its profit when q1 is already known.
I Therefore, it is clear that firm 2 will follow its best response
function
90 − q1
q2 = .
2
I Now in first stage firm 1 knows that firm 2 is rational so it
will play its best response.
Stackelberg Competition

I Thus, firm 2 will replace fixed quantity q2 of firm 2 with its

best response function and maximizes its profit
  
90 − q1
max 100 − q1 − q1 − 10q1
q1 2
I FOC implies that

100 − 2q1 − 45 + q1 − 10 = 0

I This implies that q1 = 45.

I Using this we get q2 = 22.5
I The resulting profit is π1 = 1012.5 and π2 = 506.25.
I Compare this the Cournot competition q1 = q2 = 30 and
π1 = π2 = 900.