GAME THEORY

Prisoner Dilemma & Collusion

Some important definitions:

● A game includes:
○ Players: individuals who make decisions
○ Strategies: The planned decisions of the players
○ The payoffs to the players: the profits or losses that result from the strategies
● The order in which players make decisions:
● Simultaneous-move game: Game in which each player makes decisions without
knowledge of the other players’ decisions.
● Sequential-move game: Game in which one player makes a move after observing the
other player’s move.
● One-shot games vs. repeated games:
○ One-shot game: Game in which the underlying game is played only once.
○ Repeated game: Game in which the underlying game is played more than once.
○ Oligopolists are likely to participate in the non-price competition: competition
among the few strategic competition
○ Strategic competition is analyzed using game theory
○ Interdependency between oligopolists implies strategic decision making

Dominant Strategies
● Always provide the best outcome no matter what decisions rivals make
● When one exists, the rational decision-maker always follows its dominant strategy
● Predict rivals will follow their dominant strategies if they exist
● Dominant strategy equilibrium: Exists when all decision-makers have dominant strategies

Dominated Strategies
● Never the best strategy, so never would be chosen & should be eliminated
● Successive elimination of dominated strategies should continue until none remain
● Search for dominant strategies first, then dominated strategies, and eliminate them, so
we can be left with the best strategy
● When neither form of strategic dominance exists, employ a different concept for making
simultaneous decisions
 PRISONERS’ DILEMMA
● All rivals have dominant strategies
● In dominant strategy equilibrium, all are worse off than if they had cooperated in making
their decisions

If you are Jane If you are Bill

If Bill doesn’t confess, she will be prisoned If Jane doesn’t confess, he will be prisoned
for 2 years if she doesn’t confess and 1 year if for 2 years if he doesn’t confess and 1 year if
she confesses. he confesses.
=> Confessing is better off. => Confessing is better off.

If Bill confesses, if she doesn’t confess, she
will be prisoned for 12 years, but if she
confesses, she will be prisoned for only 6
years.
=> Confessing is better off.
If Jane confesses, if he doesn’t confess, he will
be prisoned for 12 years, but if he confesses,
he will be prisoned for only 6 years.
=> Confessing is better off.

We can see that whether or not Bill chooses We can see that whether or not Jane chooses
to confess, Jane will always choose to confess to confess, Bill will always choose to confess
because she will be better off. Hence, because he will be better off. Hence,
confessing is the dominant strategy for Jane. confessing is the dominant strategy for Bill.

Consistent with the dominant strategy => Result of the game is dominant equilibrium => Both
will confess and both will be prisoned for 6 years
=> Dominant equilibrium = Nash equilibrium = 6 years

Jane and Bill do not trust each other and each has a better incentive to betray the other, so the
cooperation will not be sustainable. The equilibrium in this strategy is called the dominant
equilibrium or the nash equilibrium.
 SUCCESSIVE ELIMINATION OF DOMINATED STRATEGIES
(Example: Pricing Strategies between the 2 hotels)

Strategy If you are Castle If you are Palace

Eliminating the dominated strategy

High first column first row

1,000 if high; 1,100 if medium; 1,200 if low 1,000 if high; 1,100 if medium; 1,200 if low
=> highest payoff = 1,200 => highest payoff = 1,200
=> choose low pricing strategy => choose low pricing strategy

Medium second column second row

900 if high; 800 if medium; 500 if low 400 if high; 800 if medium; 500 if low
=> highest payoff = 900 => highest payoff = 800
=> choose high pricing strategy => choose medium pricing strategy

Low third column third row

500 if high; 450 if medium; 400 if low 300 if high; 350 if medium; 400 if low
=> highest payoff = 500 => highest payoff = 400
=> choose high pricing strategy => choose low pricing strategy

Castle does not have a dominant strategy.
Castle’s dominated strategy is the high
pricing strategy because it is never chosen
by Palace
=> Eliminate high pricing strategy of
Palace
=> Castle: only low and high
Palace does not have a dominant strategy.
Palace’s dominated strategy is the medium
strategy because it is never chosen by
Castle.
=> Eliminate medium pricing strategy of
Castle
=> Palace: only low and medium

Find dominant strategy of each => Nash equilibrium

 High N/A 1,100 if medium; 1,200 if low
=> Low

Medium 900 if high; 500 if low N/A

=> High

Low 500 if high; 400 if low 350 if medium; 400 if low

=> High => Low

Nash equilibrium = (500;1200)

=> No one will have incentive to deviate from this equilibrium.
 SEQUENTIAL GAME
Entry barriers and entry deterrence
Exercise 1.1:
The aircraft companies Boeing and Airbus are involved in a strategic game, in this example,
Airbus moves first
● Airbus has to decide whether to invest in a new plane or not i.e. a new product line/market
● Boeing is also deciding whether to invest in a new plane but because of lags in its
production process it has to make its decision after Airbus has made its decision
The firms’ payoffs reflect the following:
Despite high development costs, there is a market for the new plane which could be supplied
profitably. But the market for aircraft is limited and there is only room for one company to supply a
new plane profitably. If both companies supply a new plane they would be in direct competition
with each other and both would make lower profits due to undercutting. And large economies of
scale means that high levels of output are needed to make profits.
→ SO THE MARKET IS NOT COMPETITIVE

If Airbus does not supply the new plane, Boeing will supply the plane. If Airbus supplies the new
plane, Boeing will not supply the plane. Therefore, Boeing’s threat to supply the new plane is not
credible, so it does not deter Airbus. Backward induction implies that Airbus will supply the new
plane and Boeing will not. Airbus will make higher profits if it has a first-mover advantage and
takes the pre-emptive investment choice

Exercise 1.2: Government intervention

The aircraft industry is considered to be strategically important by both the USA and the EU and
therefore worth protecting by subsidizing or using tariffs (see Allen Chapter 16)
There are ongoing disputes between the USA and the EU regarding the ‘unfair’ subsidization of
Boeing and Airbus in developing aircraft
Construct a game tree and use backward induction to predict the outcome of the game if Boeing
receives a subsidy of the equivalent of £12m from the US government if and only if it builds the
plane
In the new version of the game is Boeing’s threat to build the new plane credible?
Government intervention changes the outcome of the strategic game by making Boeing’s
threat credible, hence, can change the trans transnational strategic games played by
oligopolists. Whether Airbus supply the new plan or not, Boeing will supply the new plane.
Backward induction implies that Boeing will supply the new plane and Airbus will not.

Making the threat to fight credible

Firms can take costly pre-emptive actions to make a psychological barrier credible e.g.:
● Excess capacity for increasing output (lowers prices)
● Holding patents or products as a backup if there is an entry
● Choosing high fixed cost (economies of large scale) technologies – so needs to protect
market share
● Investing in the ability to retaliate in other markets
○ i.e. some make some unrecoverable ‘sunk’ cost that makes fighting optimal
■ There is a commitment cost (c) but a reward (d) if there is an entry and the
monopolist fights
Psychological barrier
● Firms can make tangible and costly investments (commitments) that make psychological
entry barriers credible – but costs (c) can’t be too high and gains (d) need to be sufficiently
large so that:
○ The payoff from deterring entry with the investment cost (8-c) is greater than the
payoff without incurring the commitment (4)
○ An increase in payoff from fighting with commitment (d) needs to be large enough
so that fighting is optimal
Uncertainty and reputation
● The costly commitment to fight might not even need to be made if there is:
○ Uncertainty e.g. about whether the commitment has been made or not e.g. if the
probability of fighting is high enough
 ○ And/or the scenario is repeated (indefinitely or infinitely) and the cartel has or can
gain a reputation for fighting entry – it’s worth a costly fight initially in order to
create a reputation for fighting
■ Previous aggressive behaviour – reputation: E.g. Procter & Gamble deterred
Union Carbide from entry into the disposable diaper industry by making it
look like it was up for a fight with a series of price-cutting strategies.
● Analysis of repeated prisoners’ dilemma suggests that oligopolists may be able to sustain
collusion in order to extract monopoly profits
● And sequential game theory shows that they may be able to protect their collusive
agreements through psychological entry barriers e.g. threatening to fight entry - as long
as this is credible
● But the creation of entry barriers and entry deterring strategies are often illegal……….

Exercise 2: Entry deterrence and reputation

E = Potential market entrant - first mover
M = Incumbent monopolist (or oligopoly cartel – effectively a monopoly) making monopoly profits

Threat to fight is not credible – there will be entry followed by concession unless the monopolist
(or cartel) can make the threat to fight credible by pre-committing to fight.
The monopolist (or cartel) invests in some unrecoverable ‘sunk’ cost that makes fighting optimal:
● Commitment cost = c
● Generates reward if fights entry = d.
The threat to fight is credible only if:
(payoff from fighting) 1 + d > 4 – c (payoff from concession)
or -c < 1+ d - 4 (divide through by -1)
or c > 3-d (1)
But the commitment will only be made if payoff in game without commitment (4) is greater than
8-c:
8–c>4
or c < 4 (2)
Combining (1) and (2): The cartel will invest in the commitment and entry will be deterred if:
4 > c > 3 –d (3)
If d = 2 and c = 3 both conditions are satisfied
(1) 1+d = 3, 4-c = 1 so 1=d >4-c and (2) 8-c = 5 > 4
This must mean that 4 > c (= 3) > 3-d (= 1), then the cartel will invest in the commitment and
entry to fight.

Exercise 3:
The same kind of analysis might be applicable to a situation of industrial conflict – see e.g.
Washington Post cases - what’s your prediction? Concede???

Threat to fight is not credible – there will be entry followed by concession unless the Employer
can make the threat to fight credible by pre-committing to fight.
The Employer invests in some unrecoverable ‘sunk’ cost that makes fighting optimal:
● Commitment cost = c
● Generates reward if fights entry = d.
The threat to fight is credible only if:
(payoff from fighting) -150 +d > -500 - c (payoff from concession)
or c > -350 - d (1)
But the commitment will only be made if payoff in-game without commitment (-500) is greater
than 200 - c:
200 - c > -500
c < 700 (2)
Combining (1) and (2): The Employer will invest in the commitment and entry will be deterred if:
700 > c > -350 - d

Exercise 4:
This game-theoretic model could also be used to analyse some international relations scenarios:
Is the USA’s threat to invade credibly – this depends on what the small country does if the USA
invades – what will it do?

If the US invades, the small country will give in. Therefore, the US will invade. Its threat is
credible.

Exercise 5:
Robbing a bank: Is Bert’s threat to blow himself and Angela up credible?
● B = Bert the bank robber
● A = Angela the bank cashier; S =surrender; NS = not surrender
● - (infinite) implies infinite pain and suffering and/or death

When Bert demands money, if Angela does not surrender, Bert will not detonate.