GAME THEORY

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 In the oligopoly market we noted that competition is
intense.
› That is, firms must consider the likely responses of
competitors when they make strategic decisions about
price, advertising, and other variables.
 The actions and reactions of a firm depend on the move
and countermove of the other firm just like a game.
 The development and application of game theory is one of
the most exciting areas in microeconomics.

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 Games are played in business, politics, diplomacy and
wars.
› It deals with trivial pursuits such as gambling and sports,
when the world is full of more weighty matters such as
war, business, education, career and relationships.
 Game theory is a branch of applied mathematics and the
science of rational behavior in interactive situation.
› Game is the science of strategic decision making.
 Any situation in which individuals must make strategic
choices and in which the final outcome will depend on
what each person chooses to do can be viewed as a game.

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 Game is an action where there are two or more mutually
aware players and the outcome for each depends on the
action of all.
 The reason for spending time on game theory is that it is a
tool designed for investigating the behavior of rational
agents in setting for which each agent’s best action
depends upon what other agents are expected to do.
 Game theory will prove to be very useful in investigating
firm behavior in oligopolies and more generally, in
providing insight concerning the strategic behavior of
firms.

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 The strategic form (normal form) of a game describes an economic
setting by three elements:
 Players: Players of a game are participants in the game.
› They can be managers of firms that can make important decisions
in the firms’ day to day activities.
› Each decision maker in a game is called a player. These players
can be individuals (poker game), firms (as in the Oligopolistic
markets), or entire nation (as in the military conflict).
 Strategies: Each course of action open to a player during a game is
called a strategy.
› Strategy is a decision rule of players.
› A strategy tells a player how to behave in the settings being
modeled or is a decision rule that instructs a player how to behave
over the course of the game.
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 Payoffs strategies: The final return to the players of a game at its
conclusion is called “payoffs”.
› Example the Payoffs for the firms can be profit. A player’s payoff
function describes how it evaluates different strategies.
 Payoff matrix: A firm is a table that shows the payoffs accruing to
the firm as a consequence of each possible combination of course of
actions adopted by the firm and by its competitor(s).
 Zero – sum – game: is a kind of game in which the gain earned by
one player is exactly equal in magnitude to the loss incurred by
another player.
 Positive – sum – game: is a kind of game where the gain received by
one of the players is necessarily greater than the loss incurred by the
other player.
 Negative – sum – game: is a type of game in which the loss incurred
by one of the players is necessarily greater than the gain received by
the other player. 6
 Rationality: game theory assumes that players are interested in
maximizing their payoffs.
 Common Knowledge: all players know the structure of the game
and that their opponents are rational.
 The economic games that firms play can be either cooperative or
non-cooperative.
 A game is cooperative if the players can negotiate binding contracts
that allow them to plan joint strategies.
 A game is non cooperative if negotiation and enforcement of a
binding contract are not possible.
 Another cooperative game can be the negotiation of two firms in an
industry for a joint investment to develop a new technology.
 If the firms can sign a binding contract to divide the profits from
their joint investment, a cooperative outcome that makes both parties
better off is possible. 7
 Dominant strategy refers to the optimal choice for a player no
matter what the opponent does or the strategy that is optimal for a
player no matter what an opponent does.
 In any game each player has his own strategy that enables him to win
the game. That means the game’s likely outcome depends on the
strategy the player follows. Thus knowing the strategy help us
determine how the rational behavior of each player will lead to an
equilibrium solution.
 Suppose firms A and B sell competing products and deciding whether
to undertake advertising campaigns. Each firm, however, will be
affected by its competitor’s decision.
 The possible outcomes of the game are illustrated by the payoff
matrix in the table below.
 There are two players (Firm A and Firm B) and two strategies open to
them: Advertise and do not advertise as shown by the following
payoff matrix. 8
 The figures in each cell are the payoffs, which are the outcome of the
strategies chosen by the firms (players).
 The payoffs show the level of profit, the first payoffs stand for the
first player, A and the second payoffs belong to the second player,
firm B.
Firm B

Advertise Don’t Advertise

Advertise 10,5 15,0

Firm A

Don’t Advertise 6,8 10,2

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 The payoff matrix summarizes the possible outcomes of the game; the first
number in each cell is the payoff to firm A and the second is the payoff to firm B.
 We can observe from this payoff matrix that if both firms decide to advertise, firm
A will make profits of 10, and firm B will make profits of 5.

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 Now let us look the dominant strategy of each firm.
 First, consider firm A.
› Firm A should clearly advertise because no matter what firm B
does, firm A does best by advertising (if firm B advertises, A
earns a profit of 10 if it advertises, but only 6 if it doesn’t),
› If B dose not advertise A earns 15 if it advertises, but only 10 if
it doesn’t). Thus, advertising is a dominant strategy for firm A.
 The same is true for firm B:
› No matter what firm A does, firm B does best by advertising.
Therefore, assuming that both firms are rational, we know that
the outcome for this game is that both firms will advertise. This
outcome is easy to determine because both firms have
dominant strategies.

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 An equilibrium concept is a solution to a game. The
equilibrium concept identifies, out of the set of all possible
strategies, the strategies that players are actually likely to
play.
 Solving equilibrium is similar to making a prediction about
how the game will be played.
 In real world, not all games do have dominant strategy for
each player. This can be noted from the following payoff
matrix.
 Although there are several ways to formalize equilibrium
concepts in game theory, the most commonly used
approach was originally proposed by Cournot’s in the 19th
century and generalized in the early 1950s by John Nash.
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 Under Nash’s procedure, a pair of strategies, say, (a*, b*), is defined
to be an equilibrium.
 If a* represents player A’s best strategy when B plays b*, and
b* represent B’s best strategy when A plays a*.
 Assuming that players are rational, a player chooses the strategy that
gives him his highest payoff.
› In deciding which strategy is best, a player must take in to account
the strategies that he expects that other players to choose.
› To capture this interdependence, the concept of Nash Equilibrium
was developed.
› It should be noted that by identifying the dominant strategies it is
possible to arrive the outcome of the game because dominant
strategies are stable.
› Not every game has a dominant strategy for each player. If we
change the payoff (10, 2) in the bottom right - hand corner into
(20, 2) in the above table, firm A will not have a dominant
strategy but B does have. 13
 › A's optimal decision depends on what firm B does. If B
advertises, then A does best by advertising; but if B does not
advertise, A does best by not advertising.
› Since firm B has a dominant strategy- advertises, A
concludes that B will advertise then a will advertise.
› The equilibrium is again that both firms will advertise. It is
the logical outcome of the game because firm A is doing the
best it can , given firm B's decision; and firm B is doing the
best it can , given firm A's decision, this is called Nash
equilibrium.
Firm B

Advertise Don’t Advertise

Advertise
10,5 15,0
Firm A
Don’t Advertise
6,8 20,2
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Firm A has no Dominant Strategy to maximize its payoffs.
 On the other hand, in many games one or more players do not have a
dominant strategy.
 We therefore need a more general solution concept the Nash
equilibrium.
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 Nash equilibrium again is a set of strategies (or actions) such
that each player believes (correctly) that it is doing the best it
can, given the actions of its opponents.
 Since each player has no incentive to deviate from its Nash
strategy, the strategies are stable. In the example shown in table
above, the Nash equilibrium is that both firms advertise.
 If you remember in Cournot’s equilibrium, each firm sets output
or price while taking the output or price of its competitors as
fixed.
 Once the firms have reached Cournot’s equilibrium, no firm has
an incentive to change its output or price unilaterally because
each firm is doing the best it can give the decisions of its
competitors.
 Therefore, Cournot’s equilibrium is also Nash equilibrium. Note
that dominant strategy equilibrium is a special case of Nash
equilibrium. 16
 A classic example in game theory, called the prisoners’ dilemma,
illustrates the problem oligopolistic firms’ face.
› It goes as follows: two prisoners have been accused of
collaborating in a crime. They were in separate jail cells and
cannot communicate with each other. Each has been asked to
confess to the crime.
 The payoff matrix in table below summarizes the possible outcomes.
Table showing the pay-off matrix for prisoners’ dilemma.
Person B

Confess Don’t confess

Confess -5, -5 -1, -10

Person A

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Don't Confess -10, -1 -2, -2
 The payoffs are negatives because they show the number of
years one will spend in prison.
 Obviously, in numeric example -1 is greater than -10 (i.e,-
1> -10) implies spending one year in prison is preferred to
spending 10 years in prison.

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 Dominant Strategy of Prisoner A is to Confess. Now let us look the
game.
 If both prisoners confess, each will receive a term of five years. On
the other hand, if one prisoner confesses and the other does not, the
one who confesses will receive a term of only one year, while the
other will go to prison for ten years.
› If you were one of these prisoners, what would you do- confess or
not confess?
 It is very difficult to determine. As the table shows these prisoners
face a dilemma.
› If they could only both agree not to confess, then each would go to
jail for only two years. But they can't talk to each other, and even
if they could, can they trust each other?
› If prisoner A does not confess, s/he risks being taken advantage of
by his/her former accomplice.
 After all, no matter what prisoner A does, prisoner B comes out ahead
by confessing. 19
 Similarly, prisoner A always comes out ahead by confessing, so
prisoner B must worry that by not confessing, s/he will be taken
advantage off. Therefore, both prisoners will probably confess, and
go to jail for five years.
 Oligopolistic firms often find themselves in a prisoner's dilemma.
 They must decide whether to compete aggressively, attempting to
capture a larger share of the market at the competitors' expense, or to
"cooperate" and compete more passively, i.e. they can set high prices
and limiting output, they will make higher profits than if they
compete aggressively.
 Let us look the following game that is played by firm 1 and firm 2.
Firm 2

Charge Birr 4 Charge Birr6

Charge Birr 4 12,12 20,4

Firm 1
Charge Birr 6 4,20 16,16
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 Now let us assume that both firms have reached the agreement to
cooperate by charging birr 6 for a product they sell and each one will
receive birr16 Profits.
 However, if one firm cheats the other by charging 4 (the other
charged as before 6) it would increase its profit while the profit of the
other will fall down.
› That is, if firm 1 charge 4 and firm 2 keeps its promise (charging
6) firm 1 will increase its profit from 16 to 20.
 On the other round, if firm 2 cheats firm 1 by charging 4 it increases
its profit from 16 to 20 while the profit of firm 1 falls down from 16
to 4.
 Since both have the strong incentive to cheat the other, the final
outcome will be to charge 4 and both will have a profit of 12 which is
less than the cooperative profits, 16.

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