Chapter 11

Game Theory
and
Asymmetric
Managerial Economics:
Economic Tools for
Information
Today’s Decision
Makers, 5/e By Paul
Keat and Philip Young
 Game Theory and
Asymmetric Information
• Game Theory
• Games of Particular Relevance in Economics
• Game Theory and Auctions
• Strategy and Game Theory
• Asymmetric Information
• Markets with Asymmetric Information
• Market Responses to Asymmetric Information
• Reputation
• Standardization
• Market Signaling

2006 Prentice Hall Business Publishing Managerial Economics, 5/e Keat/Young

 Learning Objectives
• Define game theory, and explain how it helps to
better understand mutually interdependent
management decisions
• Explain the essential dilemma faced by
participants in the game called Prisoners’
Dilemma
• Explain the concept of a dominant strategy and
its role in understanding how auctions can help
improve the price for sellers, while still
benefiting buyers
2006 Prentice Hall Business Publishing Managerial Economics, 5/e Keat/Young
 Learning Objectives
• Explain the key problems that arise in a market
where buyers and sellers do not have the same
information about a product
• Briefly explain the concepts of “adverse
selection” and “moral hazard” and why they
exist in the type of market described in the
previous objective
• Explain how “market signaling” can help market
participants make better economic decisions
when asymmetric information exists between
buyers and sellers
2006 Prentice Hall Business Publishing Managerial Economics, 5/e Keat/Young
 Game Theory
• Optimization has two shortcomings when applied to actual
business situations
• Assumes factors such as reaction of competitors or tastes and preferences
of consumers remain constant.
• Managers sometimes make decisions when other parties have more
information about market conditions.
• Game theory is concerned with “how individuals make decisions
when they are aware that their actions affect each other and when
each individual takes this into account.”
• Types of games
• Zero-Sum or Non-Zero-Sum
• Cooperative or Non-Cooperative
• Two-Person or N-Person
• All solutions involve an equilibrium condition.

2006 Prentice Hall Business Publishing Managerial Economics, 5/e Keat/Young

 Games of Particular
Relevance in Economics
• Prisoners’ Dilemma
• Two-Person, Non-Zero-
Sum, Non-cooperative
• Always has a dominant
strategy
• Equilibrium is stable
• Confessing is a dominant
strategy for each player.
• Best strategy no matter
what other player chooses
• Each player has no
incentive to unilaterally
change his strategy.
2006 Prentice Hall Business Publishing Managerial Economics, 5/e Keat/Young
 Games of Particular
Relevance in Economics
• Another Example of
Prisoners’ Dilemma
• (Low/Low) is a stable
equilibrium. No incentive
for either firm to deviate.
• Better off at (High/High)
but it is not stable. Each
firm has an incentive to
deviate.
• (High/High) would be an
equilibrium if the firms
were allowed to
cooperate.

2006 Prentice Hall Business Publishing Managerial Economics, 5/e Keat/Young

 Games of Particular
Relevance in Economics
• Beach Kiosk Game
• Two-Person, Zero-Sum, Non-cooperative
• Example: two companies provide snacks and
sunscreen on a beach.
• Beachgoers spread themselves out evenly along
the beach.
• Both companies ultimately locate at the midpoint
of the beach, otherwise the other company has an
advantage (closer to more beachgoers)
• Real life example: location of gas stations
2006 Prentice Hall Business Publishing Managerial Economics, 5/e Keat/Young
 Games of Particular
Relevance in Economics
• Repeated Game: game is played
repeatedly over a period of time.
• In a repeated game, equilibria that are not
stable may become stable due to the threat
of retaliation.

2006 Prentice Hall Business Publishing Managerial Economics, 5/e Keat/Young

 Games of Particular
Relevance in Economics
• Repeated Game: game is played many times, and equilibria that
are not stable may become stable due to the threat of retaliation.
• Assume (High, High) equilibrium reached and both firms start off
charging the high price.
• In the next period, if one firm cheats (charges low price), it
receives 600 in that period.
• Other firm will change to low prices in the next period to
“retaliate” and both will end up at (Low, Low) equilibrium.
• Thus, incentive exists not to “cheat” in a repeated game and
(High, High) is a viable equilibrium, though it is not in a single-
period game.
• If number of periods are fixed, both firms will have incentive to
cheat (charge low price) in the last period due to lack of threat of
retaliation, which will then allow them to cheat in all periods.
2006 Prentice Hall Business Publishing Managerial Economics, 5/e Keat/Young
 Games of Particular
Relevance in Economics
• Simultaneous games are games in which
players make their strategy choices at the
same time.
• Sequential games are games in which
players make their decisions sequentially.
• In sequential games, the first mover may
have an advantage.

2006 Prentice Hall Business Publishing Managerial Economics, 5/e Keat/Young

 Games of Particular
Relevance in Economics
• Consider the following payoff matrix in which
firms choose their capacity, either high or low.
• Suppose firm C has the ability to move first.
• C would choose Low, then D would choose High.

2006 Prentice Hall Business Publishing Managerial Economics, 5/e Keat/Young

 Game Theory and Auctions
• Non-cooperative, non-zero-sum game
• Seller wants to sell at highest price, buyer wants to buy
at lowest price.
• Dutch Auction
• All product sold at the highest price that clears the market
• Each buyer describes the quantity demanded and price to pay
• Starting at highest price, sum quantity demanded up to the
quantity available. The associated price for the last quantity
added is the price for all products.
• In an auction with a time limit, every player has a
dominant strategy to bid as late as possible.
2006 Prentice Hall Business Publishing Managerial Economics, 5/e Keat/Young
 Strategy and Game Theory
• In Prisoners’ Dilemma, players have a dominant strategy
that leads to suboptimal results.
• Commitment, explicit or implicit, can be used to achieve
preferred outcomes.
• Commitment must be credible to have effect.
• To make a commitment credible:
• Burn bridges behind you.
• Establish and use a reputation.
• Write contracts.
• Incentives also can be used to change the game to
achieve preferred outcomes.
2006 Prentice Hall Business Publishing Managerial Economics, 5/e Keat/Young
 Strategy and Game Theory
• Fundamental aspects of game theory
• Players are interdependent
• Uncertainty: other players’ actions are not entirely predictable
• PARTS: paradigm for studying a situation, predicting
players’ actions, making strategic decisions
• Players: Who are players and what are their goals?
• Added Value: What do the different players contribute to the
pie?
• Rules: What is the form of competition? Time structure of the
game?
• Tactics: What options are open to the players? Commitments?
Incentives?
• Scope: What are the boundaries of the game?
2006 Prentice Hall Business Publishing Managerial Economics, 5/e Keat/Young
 Asymmetric Information
• Asymmetric Information: market situation
in which one party in a transaction has
more information than the other party.
• Leads to many problems in markets.
• Too much or too little production
• Difficult contracting
• Possible fraud
• Market may dissappear
2006 Prentice Hall Business Publishing Managerial Economics, 5/e Keat/Young
 Markets with
Asymmetric Information
• Adverse Selection: prior to transaction, one
party may know more about the value of a
good than the other.
• Moral Hazard: transaction changes the
incentives of a party because it cannot be
monitored after the transaction.

2006 Prentice Hall Business Publishing Managerial Economics, 5/e Keat/Young

 Market Responses to
Asymmetric Information
• Obtaining information from third parties
• Relying on reputation of the seller
• Standardization of products
• Market Signaling: demonstrated success in
one activity provides information about
success/quality in another.

2006 Prentice Hall Business Publishing Managerial Economics, 5/e Keat/Young