WIRTSCHAFTSUNIVERSITÄT WIEN

DEPARTMENT OF STRATEGY AND INNOVATION

INSTITUTE FOR MARKETS AND STRATEGY

SBWL Strategy and Data

Strategic Thinking and Analysis I

Lecture I-3

© WU IMS
 Game Theory
 Extensive form representation
Decision nodes cherry (5,3)
Root 2
chocolate
sprinkles (1,1)
1 Outcomes

cherry (1,1)
vanilla
2

sprinkles (3,5)
Branches

© WU IMS 2
 Game Theory
 Extensive form cherry (5,3)
2
chocolate
sprinkles (1,1)
1
cherry (1,1)
vanilla
2
 Available Strategies?
• Player 1: choco or vanilla sprinkles ( 3 , 5 )
• Player 2:
• if 1 choco, then cherry, if 1 vanilla, then cherry
• if 1 choco, then cherry, if 1 vanilla, then sprinkles
• if 1 choco, then sprinkles, if 1 vanilla, then cherry
• if 1 choco, then sprinkles, if 1 vanilla, then sprinkles
© WU IMS 3
 Game Theory
 Extensive form cherry (5,3)
chocolate 2 sprinkles ( 1 , 1 )
1 cherry (1,1)
vanilla
2 sprinkles ( 3 , 5 )

 Normal form
2
c:cherry- c:cherry- c:sprinkles- c:sprinkles-
v:cherry v:sprinkles v:cherry v:sprinkles

chocolate 5,3 5,3 1,1 1,1

1
vanilla 1,1 3,5 1,1 3,5
© WU IMS 4
 Game Theory
 Extensive form cherry (5,3)
chocolate 2 sprinkles ( 1 , 1 )
1 cherry (1,1)
vanilla
2 sprinkles ( 3 , 5 )

 Normal form
 3 Nash equilibria 2
(choco; c:cherry, v:cherry),
(choco; c:cherry, v:sprinkles) c:cherry- c:cherry- c:sprinkles- c:sprinkles-
(vanilla; c:sprinkl., v:sprinkl.) v:cherry v:sprinkles v:cherry v:sprinkles

chocolate 5*, 3* 5*, 3* 1*, 1 1,1

1
vanilla 1,1 3 , 5* 1*, 1 3*, 5*
© WU IMS 5
 Game Theory
 Extensive form cherry (5,3)
chocolate 2 sprinkles ( 1 , 1 )
1 cherry (1,1)
vanilla
2 sprinkles ( 3 , 5 )

 Normal form
 3 Nash equilibria 2
 But let’s look
at them more c:cherry- c:cherry- c:sprinkles- c:sprinkles-?
closely. v:cherry ? v:sprinkles v:cherry v:sprinkles

chocolate 5*, 3* 5*, 3* 1*, 1 1,1

1
vanilla 1,1 3 , 5* 1*, 1 3*, 5*
© WU IMS 6
 Game Theory
 Subgame perfection: a Nash equilibrium of a game is “subgame
perfect” if it describes a Nash equilibrium in each subgame of the
full game
cherry (5,3)
2
chocolate
sprinkles (1,1)
1 Subgame 1

cherry (1,1)
vanilla
2
Subgame 3
sprinkles (3,5)
Subgame 2

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 Game Theory
 Extensive form – Rollback
Solve this way

cherry (5,3)
2
chocolate
sprinkles (1,1)
1
cherry (1,1)
vanilla
2
 Subgame-perfect
Nash equilibrium: sprinkles ( 3 , 5 )
• Player 1: chocolate
• Player 2: if 1 choco, then cherry, if 1 vanilla, then sprinkles
© WU IMS 8
 Game Theory
 Extensive form cherry (5,3)
chocolate 2 sprinkles ( 1 , 1 )
1 cherry (1,1)
vanilla
2 sprinkles ( 3 , 5 )

 Normal form  3 Nash equilibria

Only this NE 2
is subgame
perfect. c:cherry- c:cherry- c:sprinkles- c:sprinkles-?
v:cherry ? v:sprinkles v:cherry v:sprinkles

chocolate 5*, 3* 5*, 3* 1*, 1 1,1

1
vanilla 1,1 3 , 5* 1*, 1 3*, 5*
© WU IMS 9
 Subgame perfection
 Subgame perfection
• A Nash equilibrium of a game is subgame perfect if it
describes a Nash equilibrium in each subgame of the
original game
• Can be found by backward induction (rollback)
• is a Nash equilibrium refinement
Nash equilibria of a game
Subgame perfect Nash equilibria

 Every dynamic game with a finite number of players, n < 

and a finite set of strategies Si for each player i has at least
one subgame perfect Nash equilibrium in pure or mixed
strategies.
 Excludes threats which are not credible.
© WU IMS 10
 Not credible threat - Example
( 30 , 30 )
Boe accommodate
enter ing
Air ( -10 , 20 )
bus price war
stay out
Boeing ( 0 , 100 )
accommodate price war
if A enters if A enters
30* What if A would enter
20
enter
30* -10 nevertheless? B would
Airbus
100* 100* accomodate. Thus, ‘war’ is a bluff,
out
0 0* it is not credible. ‘War’ is not part
2 Nash equilibria: enter/acc, out/war of the equilibrium in the
But in out/war, ‘out’ is played by A subgame opened by Airbus
because of ‘war’. However, ‘war’ is entering. Thus, war/out is not
never entered, because A stays out. subgame perfect.
© WU IMS 11
 Rollback
 Example 3: Color competition
 In Normal Form we found 3 NE
1. (red; if blue:blue, if red:blue),
2: (blue; if blue:red, if red:blue) Firm 1
3: (blue; if blue:red, if red:red) Blue Red
3 4
If F1 blue, then I choose blue, if F1 red, then I choose blue
3 6
3 2
If F1 blue, then I choose blue, if F1 red, then I choose red
3 2
Firm 2
6 4
If F1 blue, then I choose red, if F1 red, then I choose blue
4 6
6 2
If F1 blue, then I choose red, if F1 red, then I choose red
4 2

© WU IMS 12
 
Rollback
Example 3: Color competition
blue (3,3)

blue 2
red
(6,4)
1

red blue
(4,6)
2
red
(2,2)

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 
Rollback
Example 3: Color competition
Subgame 1 blue (3,3)

Subgame 3 blue 2
red
(6,4)
1

red Subgame 2 blue

(4,6)
2
red
(2,2)
 Only one of the NEs is subgame perfect:
 (Blue ; If F1 blue, then I choose red, if F1 red, then I choose blue)
© WU IMS 14
 Rollback
 Example 3: Color competition
 In Normal Form we found 3 NE
1. (red; if blue:blue, if red:blue),
2: (blue; if blue:red, if red:blue) Firm 1
3: (blue; if blue:red, if red:red) Blue Red
3 4
If F1 blue, then I choose blue, if F1 red, then I choose blue
3 6
3 2
If F1 blue, then I choose blue, if F1 red, then I choose red
3 2
Firm 2
6 4
If F1 blue, then I choose red, if F1 red, then I choose blue
4 6
6 2
If F1 blue, then I choose red, if F1 red, then I choose red
4 2
Only this NE
is subgame
perfect.
© WU IMS 15
 Rollback
 Example 1: Price competition
0.08 ( 12.0 , 12.0 )
2
0.08
0.12 ( 24.0 , 0.0 )
1
0.08 ( 0.0 , 24.0 )
0.12
2

0.12 ( 17.5 , 17.5 )

 Just one big subgame, everything connected through an information
set is in the same subgame.  Any Nash Eq. is subgame-perfect.
  Solve for Nash Equilibria (using Normal Form), these are then also
subgame-perfect.
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 Rollback
 Example: Scissors, Rock, Paper
Scissors ( 0 , 0 )  Just one big
subgame
Scissors 2 Rock ( -1 , 1 )  Everything
Paper connected
( 1 , -1 ) through an
Rock
Scissors ( 1 , -1 ) information
1 Rock set is in the
2 (0,0) same
Paper
Paper ( -1 , 1 ) subgame.
  Solve for
Scissors NEs using
( -1 , 1 )
2 Rock Normal Form.
( 1 , -1 ) All NEs are
Paper
(0,0) subgame-
perfect.
© WU IMS 17
 Nash equilibria and subgame perfection
 Nash equilibrium:
• inspection of all possible strategy combinations for the
complete game
•  NE is strategy combination in which all players’
strategies are best responses to each other
 BUT:
• Some of the equilibrium strategies might involve “not
credible threats”, that means actions
– that would not be taken if the game would arrive at
a certain node
– but which don’t have to be acted on in equilibrium,
because in this equilibrium this node is not reached
  Refinement of NE: subgame perfection: equilibrium
strategies must also be best responses in each subgame of
the game, that means: at each node of the game
© WU IMS 18
 Nash equilibria and subgame perfection
 Thus: to find Nash equilibria:
• Derive all possible strategies and corresponding payoffs
• Write down payoff matrix
• Inspection of payoff matrix
  But some of those equilibria might not be subgame
perfect (might involve not credible threats)

 To find subgame perfect Nash equilibria:

• Write down extensive form
• Rollback: inspection of each node (each subgame),
beginning from the end of the game tree
 Rollback always gives you the subgame perfect Nash
equilibria (if the game is finite and if at each node each
player knows where he is (single node information sets)).
© WU IMS 19
 Nash equilibria and subgame perfection
 There is always a unique subgame perfect Nash
equilibrium if the game is of perfect information and
there are no indifferences at some nodes.

 If an equilibrium is subgame perfect, then it cannot

involve a not credible threat, as the strategies involve best
responses at all possible nodes of the game

 In simultaneous move games (all players make only one

decision, all at the same time): all NE are SPNE
 In sequential move games: Nb. NE >= Nb. SPNE
Nash equilibria of a game
Subgame perfect Nash equilibria
© WU IMS 20
 Equilibrium exists in full strategies!
(1,1)
Lager
Light beer 2
White (5,5)
1 Stout
(0 , 7 )
Strong beer 2
Pale Ale (7,0)
If you just say “The equilibrium is (Light beer, White)”, then there is important
information missing.
Player 1 is choosing “Light” only because Player 2 would choose “Stout” if Player 1
would choose “Strong”. So, that part of Player 2’s strategy (that he would choose
“Stout” if Player 1 chooses “Strong”) is an essential to understand this equilibrium.
So the equilibrium is:
Player 1 chooses Light beer,
Player 2 chooses “White” if P1 chooses “Light”, and “Stout” if P1 chooses ”Strong”.
21
 Experiment 4
 Monopoly
a) What kind of experiment is this: sequential or
simultaneous? What is the best approach to solve the
game?
b) Determine the optimal strategy of each buyer, and
the optimal strategy of the seller. Take into account
the order of play. Assume that if a buyer is indifferent
between buying or not buying (i.e. he makes the
same profit in either case), he would buy.
c) Is what you found a Nash equilibrium? Is it the only
Nash equilibrium?

© WU IMS 22
 Experiment 4
 Monopoly: only one seller, can set the price alone
 Sequential game: monopolist moves first, buyers follow
 Solve backwards:
• What will buyers do depending on price?
• Which price will monopolist set?

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 Experiment 4
 Extensive Form 100 200
Subgame 2 Subgame 1

Quantity
S Price Bv (Price, Value)

0 0
Solve backwards

 What will buyers do depending on price and their value?

 Given this: which price will the monopolist set given the
optimal strategies and values of the buyers?
© WU IMS 24
 Experiment 4
 Buyers should buy if they make profit by buying from the
monopolist and selling to their customers
 In particular:
• Buyer 1 should buy 200 if price < E$4, is indifferent if
price = E$4, and should not buy if price > E$4
• Buyer 2 should buy 200 if price < E$14, is indifferent if
price = E$14, and should not buy if price > E$14
• Buyer 3 should buy 200 if price < E$34, is indifferent if
price = E$34, and should not buy if price > E$34
• Buyer 4 should buy 200 if price < E$54, is indifferent if
price = E$54, and should not buy if price > E$54
• Buyer 5 should buy 200 if price < E$74, is indifferent if
price = E$74, and should not buy if price > E$74
© WU IMS 25
 Experiment 4
 What prospects does the monopolist have?
 Assume buyers do buy if indifferent. Then:
• If he sets a price E$ 4, he will sell 1000 bottles.
• If he sets a price  E$14, he will sell 800 bottles.
• If he sets a price  E$34, he will sell 600 bottles.
• If he sets a price  E$54, he will sell 400 bottles.
• If he sets a price  E$74, he will sell 200 bottles.
 Thus, profits are
• P=E$ 4  =$E 4 * 1000 = E$ 4000
• P=E$ 14  =$E14 * 800 = E$ 11200
• P=E$ 34  =$E34 * 600 = E$ 20400
• P=E$ 54  =$E54 * 400 = E$ 21600
• P=E$ 74  =$E74 * 200 = E$ 14800
© WU IMS 26
 Experiment 4
 So the (subgame perfect) Nash equilibrium which we
found by rollback is:
• Buyer 1: buy if p<=4, don’t buy if p>4
• Buyer 2: buy if p<=14, don’t buy if p>14
• Buyer 3: buy if p<=34, don’t buy if p>34
• Buyer 4: buy if p<=54, don’t buy if p>54
• Buyer 5: buy if p<=74, don’t buy if p>74
• Seller: offer price of 54

 Remember: When stating the NE, we name each player’s

equilibrium strategy.

© WU IMS 27
 Experiment 4
 Compare to competition experiments:
• Add E$26 constant variable costs to all prices, divide all
by 100  costs 0.26, prices 0.30, 0.40, 0.60, 0.80, 1.00
• Multiply demand with 0.6, and you get 120, 240, 360,
480, 600.
  That’s our experiment 2 from last lecture!!!
 Only that in experiment 2, 5 firms were interacting in the
market, simultaneously announcing prices and trying to
undercut each other, while here they are all “aggregated”
to one firm, which makes one single decision.
 Price in competition: E$ 0.30 (= $E 4 here in experiment 4)
 Monopoly price: E$ 0.80 (= $E 54 here in experiment 4)
 The monopoly price is the price at which firms would
coordinate if they could effectively collude.
© WU IMS 28
 Experiment 4
 This is the only subgame perfect equilibrium in this game.
But that there are many other Nash equilibria.
 Assume, for example, the following strategies:
• Buyer 1: buy if p<=4, don’t buy if p>4
• Buyer 2: buy if p<=4, don’t buy if p>4
• Buyer 3: buy if p<=4, don’t buy if p>4
• Buyer 4: buy if p<=4, don’t buy if p>4
• Buyer 5: buy if p<=4, don’t buy if p>4
• Seller: offer price of 4
 The best response of the monopolist is to offer a price of
E$4. To the offer of $E4, the buyers’ strategies described
above is one of the best responses.
 So we have a Nash equilibrium.
© WU IMS 29
 Experiment 4
• Buyer 1: buy if p<=4, don’t buy if p>4
• Buyer 2: buy if p<=4, don’t buy if p>4
• Buyer 3: buy if p<=4, don’t buy if p>4
• Buyer 4: buy if p<=4, don’t buy if p>4
• Buyer 5: buy if p<=4, don’t buy if p>4
• Seller: offer price of 4

 But:
• The threat of buyers 2, 3, 4 and 5 to only buy at $4 is not
credible if they are selfish and rational. If they were
offered a higher price > $E 4, some of them would still
buy.
• Thus, the monopolist should not believe the threat. This
Nash Equilibrium is not subgame perfect.
© WU IMS 30
 Experiment 4
 Data
d) Analyze the data set. What can you tell about the
behavior of buyers and seller? Do they behave as your
analysis above suggested? Is there a change in
behavior over time, in the different rounds of the
market?

© WU IMS 31
 Experiment 4

© WU IMS 32
 Experiment 4
Society’s profit = sum of seller’s and buyer’s profit

Welfare/
efficiency
loss due to
monopoly

© WU IMS 33
 Experiment 5
 Stackelberg competition
a) What kind of game is this: sequential or
simultaneous? What is the best approach to solve the
game?
b) Try to find the Nash equilibrium of the game using the
payoff table provided in the instructions. Take into
account the order of play. Which quantity should the
first mover announce? Which quantity should the
second mover choose? Is this the only Nash
equilibrium in this game? Can you derive the Nash
equilibrium mathematically?
© WU IMS 34
 Experiment 5
 Again, we have a player who moves before the other
player.
 Thus, the second mover will condition her behavior on
whatever the first mover does.
 Specifically, the second mover will choose her best
response given the choice of the first mover she observes.

© WU IMS 35
 Experiment 5
 Extensive Form 600 600
Subgame 2 Subgame 1
Payoffs:
Quantity 2 f1 (q1,q2)
F1 Quantity 1 F2 (Quantity 1) f2 (q1,q2)

0 Solve backwards 0

 What will the second mover do depending on the quantity

set by the first mover?
 Which quantity will the first mover set, given the optimal
response function of the second mover?
© WU IMS 36
 2nd
payoff Second mover’s best responses
1st payoff
Experiment 5 Choose 500 – 0.5 Q1
0 50 100 130 170 210 250 290 333 367 400 430 500 600
0 48 90 113 141 166 188 206 222 232 240 245 250 240
0
0 0 0 0 0 0 0 0 0 0 0 0 0 0
0 45 85 107 133 155 175 191 205 214 220 224 225 210
50
48 45 43 41 39 37 35 33 31 29 28 26 23 18
0 43 80 100 124 145 163 177 189 196 200 202 200 180
100
90 85 80 77 73 69 65 61 57 53 50 47 40 30
0 41 77 96 119 139 155 168 179 185 188 189 185 162
130
113 107 100 96 91 86 81 75 70 65 61 57 48 35
0 39 73 91 112 130 145 157 166 170 172 172 165 138
170
141 133 124 119 112 105 99 92 84 79 73 68 56 39
0 37 69 86 105 122 135 145 152 155 156 155 145 114
210
166 155 145 139 130 122 113 105 96 89 82 76 61 40
0 35 65 81 99 113 125 133 139 141 140 138 125 90
250
First 188 175 163 155 145 135 125 115 104 96 88 80 63 38
mover 290
0 33 61 75 92 105 115 122 126 126 124 120 105 66
206 191 177 168 157 145 133 122 109 99 90 81 61 32
0 31 57 70 84 96 104 109 111 110 107 102 84 40.2
333
222 205 189 179 166 152 139 126 111 100 89 79 56 22
0 29 53 65 79 89 96 99 100 98 93 87 67 19.8
367
232 214 196 185 170 155 141 126 110 98 86 75 49 12
0 28 50 61 73 82 88 90 89 86 80 73 50 0
400
240 220 200 188 172 156 140 124 107 93 80 68 40 0
0 26 47 57 68 76 80 81 79 75 68 60 35 0
430
245 224 202 189 172 155 138 120 102 87 73 60 30 0
0 23 40 48 56 61 63 61 56 49 40 30 0 0
500
250 225 200 185 165 145 125 105 84 67 50 35 0 0
0 18 30 35 39 40 38 32 22 12 0 0 0 0
600
© WU IMS 240 210 180 162 138 114 90 66 40 20 0 0 0 370
 Experiment 5
 Now,
• anticipating that the second mover will play a best
response,
• the first mover can just choose the strategy which gives
him the best payoff given that best response.

© WU IMS 38
 2nd
payoff Second mover’s best responses
1st payoff
Experiment 5
0 50 100 130 170 210 250 290 333 367 400 430 500 600
0 48 90 113 141 166 188 206 222 232 240 245 250 240
0
0 0 0 0 0 0 0 0 0 0 0 0 0 0
0 45 85 107 133 155 175 191 205 214 220 224 225 210
50
48 45 43 41 39 37 35 33 31 29 28 26 23 18
0 43 80 100 124 145 163 177 189 196 200 202 200 180
100
90 85 80 77 73 69 65 61 57 53 50 47 40 30
0 41 77 96 119 139 155 168 179 185 188 189 185 162
130
113 107 100 96 91 86 81 75 70 65 61 57 48 35
0 39 73 91 112 130 145 157 166 170 172 172 165 138
170
141 133 124 119 112 105 99 92 84 79 73 68 56 39
0 37 69 86 105 122 135 145 152 155 156 155 145 114
210
166 155 145 139 130 122 113 105 96 89 82 76 61 40
0 35 65 81 99 113 125 133 139 141 140 138 125 90
250
First 188 175 163 155 145 135 125 115 104 96 88 80 63 38
mover 290
0 33 61 75 92 105 115 122 126 126 124 120 105 66
206 191 177 168 157 145 133 122 109 99 90 81 61 32
0 31 57 70 84 96 104 109 111 110 107 102 84 40.2
333
222 205 189 179 166 152 139 126 111 100 89 79 56 22
0 29 53 65 79 89 96 99 100 98 93 87 67 19.8
367
232 214 196 185 170 155 141 126 110 98 86 75 49 12
0 28 50 61 73 82 88 90 89 86 80 73 50 0
400
240 220 200 188 172 156 140 124 107 93 80 68 40 0
0 26 47 57 68 76 80 81 79 75 68 60 35 0
430
245 224 202 189 172 155 138 120 102 87 73 60 30 0
0 23 40 48 56 61 63 61 56 49 40 30 0 0
500
250 225 200 185 165 145 125 105 84 67 50 35 0 0
0 18 30 35 39 40 38 32 22 12 0 0 0 0
600
© WU IMS 240 210 180 162 138 114 90 66 40 20 0 0 0 390
 Experiment 5
 So the (subgame perfect) Nash Equilibrium which we
found by rollback is:
• Producer 1: Choose 500.
• Producer 2: Choose 500 – 0.5 Q1.

© WU IMS 40
 Experiment 5
 In math:
• 2nd movers profit 2 = P * Q2 = (1-0.001(Q1+Q2)) Q2
• max 2  0 = 1 - 0.001 Q1 - 0.002 Q2*
•  Q2* = 500 – 0.5 Q1 (best reply function)

• 1st movers profit 1 = P * Q1 = (1-0.001(Q1+Q2)) Q1

• First mover can count on 2nd movers best response
•  1 = P * Q1 = (1-0.001(Q1+(500 – 0.5 Q1 ))) Q1
= 0.5 Q1 -0.0005 Q1Q1
• max 1  0 = 0.5 - 0.001 Q1*
•  Q1* = 500  Q2* = 500 – 0.5 Q1* = 250
  First mover chooses higher quantity than second
mover and makes more profit
© WU IMS 41
 Experiment 5
 There are many other (not subgame perfect) NEs.
 Assume the following strategies:
• 2nd mover: choose “430” if 1st mover plays “100”, and
“600” otherwise.
• 1st mover: choose “100”.
 Playing “100” is the best answer of the 1st mover to the
2nd mover’s strategy.
 Playing the 2nd mover’s strategy is one of the best
responses of the 2nd mover if the 1st mover plays “100”.
  So we have a Nash equilibrium, but it is not subgame
perfect. The “600 otherwise” part of the 2nd mover’s
strategy is not credible. The 2nd mover should not do that
when the 1st mover chooses something else than ”100”.
So the 1st mover should not believe it.
© WU IMS 42
 Experiment 5
 Note, however, that while this is the only subgame perfect
equilibrium in this game, there are many other (not
subgame perfect) Nash equilibria.
 Assume, for example, that the 2nd mover plays the
strategy “430” if 1st mover plays “100”, and “600”
otherwise.
• Playing “100” is the best answer of the 1st mover to this
strategy.
• Playing this strategy is one of the best responses of the
2nd mover conditional that the 1st mover plays “100”.
• This constitutes a Nash equilibrium, but it is not
subgame perfect.
• The “600 otherwise” is not credible. The 2nd mover
should not do that when he is at play. So the 1st mover
should not believe it.
© WU IMS 43
 2nd
payoff Second mover’s “threat” response
1st payoff
Experiment 5
0 50 100 130 170 210 250 290 333 367 400 430 500 600
0 48 90 113 141 166 188 206 222 232 240 245 250 240
0
0 0 0 0 0 0 0 0 0 0 0 0 0 0
0 45 85 107 133 155 175 191 205 214 220 224 225 210
50
48 45 43 41 39 37 35 33 31 29 28 26 23 18
0 43 80 100 124 145 163 177 189 196 200 202 200 180
100
90 85 80 77 73 69 65 61 57 53 50 47 40 30
0 41 77 96 119 139 155 168 179 185 188 189 185 162
130
113 107 100 96 91 86 81 75 70 65 61 57 48 35
0 39 73 91 112 130 145 157 166 170 172 172 165 138
170
141 133 124 119 112 105 99 92 84 79 73 68 56 39
0 37 69 86 105 122 135 145 152 155 156 155 145 114
210
166 155 145 139 130 122 113 105 96 89 82 76 61 40
0 35 65 81 99 113 125 133 139 141 140 138 125 90
250
First 188 175 163 155 145 135 125 115 104 96 88 80 63 38
mover 290
0 33 61 75 92 105 115 122 126 126 124 120 105 66
206 191 177 168 157 145 133 122 109 99 90 81 61 32
0 31 57 70 84 96 104 109 111 110 107 102 84 40.2
333
222 205 189 179 166 152 139 126 111 100 89 79 56 22
0 29 53 65 79 89 96 99 100 98 93 87 67 19.8
367
232 214 196 185 170 155 141 126 110 98 86 75 49 12
0 28 50 61 73 82 88 90 89 86 80 73 50 0
400
240 220 200 188 172 156 140 124 107 93 80 68 40 0
0 26 47 57 68 76 80 81 79 75 68 60 35 0
430
245 224 202 189 172 155 138 120 102 87 73 60 30 0
0 23 40 48 56 61 63 61 56 49 40 30 0 0
500
250 225 200 185 165 145 125 105 84 67 50 35 0 0
0 18 30 35 39 40 38 32 22 12 0 0 0 0
600
© WU IMS 240 210 180 162 138 114 90 66 40 20 0 0 0 440
 Experiment 5
 Data
c) Analyze the data set of experiment 5. What can you
tell about the behavior of participants? Do they
behave as your analysis above suggested? Is there a
change in behavior over time, in the different rounds
of the markets?

© WU IMS 45
 Experiment 5

Firm 2’s
Best reply function

© WU IMS 46
 Experiment 6
 Stackelberg competition II – first mover can revise
decision
d) Does your analysis and conclusions above change if
the rules of the game are changed as in experiment 6
(producer 1 can revise her quantity while producer 2
decides)?
– Which quantity should the first mover announce?
– Which quantity should the second mover choose?
– Should the first mover revise her quantity?
– What should she choose?
– Is this the only Nash equilibrium in this game?

© WU IMS 47
 Experiment 6
 Is having an additional opportunity a good thing?
 Not in this case:
• the commitment to produce quantity of 500 is credible
in experiment 5: the first mover cannot change his
decision, thus the second mover has to take it as given
• In experiment 6 the commitment is not credible, since
the 1st mover can revise it while the 2nd decides
 Specifically, the 1st mover thinks what the 2nd mover will
answer, and will choose a best reply to that expectation
 The 2nd mover will anticipate that and will choose a best
reply to this 1st movers behavior
 The 1st mover of course will expect that and choose a best
response to that
 Etc. etc.
© WU IMS 48
 Experiment 5
600 Subgame 1
600 600
Subgame 2

Quantity 2
F1 Quantity 1a F2 (Quantity 1a) F1 Quantity 1b

0 0 0
Payoffs: f1 (q1b,q2) ; f2 (q1b,q2)
Solve backwards

 Firm 1/Firm 2 cannot condition on Quantity 2 / Quantity 1b

 simultaneous Subgame 1  solve with Normal Form
 Payoffs do not depend on Quantity 1a  q1a irrelevant
© WU IMS 49
 2nd
payoff Second mover’s best responses
1st payoff
Experiment 5 Choose 500 – 0.5 Q1
0 50 100 130 170 210 250 290 333 367 400 430 500 600
0 48 90 113 141 166 188 206 222 232 240 245 250 240
0
0 0 0 0 0 0 0 0 0 0 0 0 0 0
0 45 85 107 133 155 175 191 205 214 220 224 225 210
50
48 45 43 41 39 37 35 33 31 29 28 26 23 18
0 43 80 100 124 145 163 177 189 196 200 202 200 180
100
90 85 80 77 73 69 65 61 57 53 50 47 40 30
0 41 77 96 119 139 155 168 179 185 188 189 185 162
130
113 107 100 96 91 86 81 75 70 65 61 57 48 35
0 39 73 91 112 130 145 157 166 170 172 172 165 138
170
141 133 124 119 112 105 99 92 84 79 73 68 56 39
0 37 69 86 105 122 135 145 152 155 156 155 145 114
210
166 155 145 139 130 122 113 105 96 89 82 76 61 40
0 35 65 81 99 113 125 133 139 141 140 138 125 90
250
First 188 175 163 155 145 135 125 115 104 96 88 80 63 38
mover 290
0 33 61 75 92 105 115 122 126 126 124 120 105 66
206 191 177 168 157 145 133 122 109 99 90 81 61 32
0 31 57 70 84 96 104 109 111 110 107 102 84 40.2
333
222 205 189 179 166 152 139 126 111 100 89 79 56 22
0 29 53 65 79 89 96 99 100 98 93 87 67 19.8
367
232 214 196 185 170 155 141 126 110 98 86 75 49 12
0 28 50 61 73 82 88 90 89 86 80 73 50 0
400
240 220 200 188 172 156 140 124 107 93 80 68 40 0
0 26 47 57 68 76 80 81 79 75 68 60 35 0
430
245 224 202 189 172 155 138 120 102 87 73 60 30 0
0 23 40 48 56 61 63 61 56 49 40 30 0 0
500
250 225 200 185 165 145 125 105 84 67 50 35 0 0
0 18 30 35 39 40 38 32 22 12 0 0 0 0
600
© WU IMS 240 210 180 162 138 114 90 66 40 20 0 0 0 500
 2nd
payoff Second mover’s best responses
1st payoff
Experiment 5
0 50 100 130 170 210 250 290 333 367 400 430 500 600
0 48 90 113 141 166 188 206 222 232 240 245 250 240
0
Choose 0
0
0
45
0
85
0
107
0
133
0
155
0
175
0
191
0
205
0
214
0
220
0
224
0
225
0
210
50
500 48 45 43 41 39 37 35 33 31 29 28 26 23 18
0 43 80 100 124 145 163 177 189 196 200 202 200 180
– 0.5Q2 100
90 85 80 77 73 69 65 61 57 53 50 47 40 30
0 41 77 96 119 139 155 168 179 185 188 189 185 162
130
First mover’s best response

113 107 100 96 91 86 81 75 70 65 61 57 48 35

0 39 73 91 112 130 145 157 166 170 172 172 165 138
170
141 133 124 119 112 105 99 92 84 79 73 68 56 39
0 37 69 86 105 122 135 145 152 155 156 155 145 114
210
166 155 145 139 130 122 113 105 96 89 82 76 61 40
0 35 65 81 99 113 125 133 139 141 140 138 125 90
250
188 175 163 155 145 135 125 115 104 96 88 80 63 38
0 33 61 75 92 105 115 122 126 126 124 120 105 66
290
206 191 177 168 157 145 133 122 109 99 90 81 61 32
0 31 57 70 84 96 104 109 111 110 107 102 84 40.2
333
222 205 189 179 166 152 139 126 111 100 89 79 56 22
0 29 53 65 79 89 96 99 100 98 93 87 67 19.8
367
232 214 196 185 170 155 141 126 110 98 86 75 49 12
0 28 50 61 73 82 88 90 89 86 80 73 50 0
400
240 220 200 188 172 156 140 124 107 93 80 68 40 0
0 26 47 57 68 76 80 81 79 75 68 60 35 0
430
245 224 202 189 172 155 138 120 102 87 73 60 30 0
0 23 40 48 56 61 63 61 56 49 40 30 0 0
500
250 225 200 185 165 145 125 105 84 67 50 35 0 0
0 18 30 35 39 40 38 32 22 12 0 0 0 0
600
© WU IMS 240 210 180 162 138 114 90 66 40 20 0 0 0 510
 Experiment 6
 So the (only) Nash Equilibrium which we found is:
• Producer 1: Choose 333.
• Producer 2: Choose 333.

© WU IMS 52
 Experiment 6
 Because the first mover can change her decision, she
cannot credibly commit to a choice of 500 bottles.
 She loses her first mover advantage, her quantity
announcement in the first stage becomes cheap talk.
 The only price at which none of both producers wants to
deviate is the Cournot competition price, the intersection
of the two best reply functions.

  1st mover:
• Sometimes it is better not to have another option.
  2nd mover:
• Sometimes it is better not to know the other’s choice.

© WU IMS 53
 Experiment 6
 In math:
 2nd mover behaves as before:
• 2 = P * Q2 = (1-0.001(Q1+Q2)) Q2
• max 2  0 = 1 - 0.001 Q1 - 0.002 Q2*
•  Q2* = 500 – 0.5 Q1 (best reply function)
 1st mover now wants to play best reply to second mover’s
actually chosen quantity (just because he can, he should!)
• 1 = P * Q1 = (1-0.001(Q1+Q2)) Q1
• max 1  0 = 1 - 0.001 Q2- 0.002 Q1*
•  Q1* = 500 – 0.5 Q2 (best reply function)
 2nd mover will anticipate this behavior. And 1st mover, too.
 Thus, 1st mover should choose Q1*=500–0.5 (500–0.5 Q1*)
•  Q1*= 333  Q2* = 500 – 0.5 Q1 = 333
© WU IMS 54
 Experiment 6
 Data
e) Analyze the data set of experiment 6 to see if people
change their behavior or not compared to experiment
5. Does the behavior match your predictions?

© WU IMS 55
 Experiment 6

© WU IMS 56
 Experiment 6
 Many 1st movers switched between announcement and
quantity choice, and so tried to “cheat” the second mover
 But not always in the right direction?

  Limited depth of reasoning?

• 1st movers should know that 2nd movers don’t trust
their announcement
• 2nd movers should not react on the cheap talk
announcement

© WU IMS 57
 Experiment 7
 Price matching policies
a) Review our analysis of experiment 2 from last lecture
(simultaneous price competition). Assume that only
company 1 announces a “price matching” policy. How
does this change the payoff matrix? Does it change
the Nash equilibrium?
b) Assume that all companies announce the “price
matching” policy, and then choose their prices. How
does this change the payoff matrix? Does it change
the Nash equilibrium?

© WU IMS 58
 Experiment 7
 Experiment 7 had the exactly same setup as experiment 2
 Only that in experiment 7, firms could announce a “price
matching” policy (PMP) before making decisions
 Does this change optimal strategies?
•  Yes: collusion becomes an equilibrium!

© WU IMS 59
 Experiment 2 Simplified normal form
Players 2 - 5

0.30 0.40 0.60 0.80 1.00

5* 0 0 0 0
0.30
5* 24* 24 24 24
6 13* 0 0 0
0.40
Player 1

0 13 67* 67 67
6 16 24.5* 0 0
0.60
0 0 24.5 122* 122
6 16 30* 26 0
0.80
0 0 0 26 134*
6 16 30 33* 17
1.00
0 0 0 0 17
© WU IMS 60
 Experiment 7: All players set PMP
Players 2 - 5

0.30 0.40 0.60 0.80 1.00

5* 5* 5* 5* 5*
0.30
5* 5 5 5 5
5 13* 13* 13* 13*
0.40
Player 1

5* 13* 13 13 13
5 13 24.5* 24.5* 24.5*
0.60
5* 13* 24.5* 24.5 24.5
5 13 24.5 26* 26*
0.80
5* 13* 24.5* 26* 26*
5 13 24.5 26* 17
1.00
5* 13* 24.5* 26* 17
© WU IMS 61
 Experiment 7
 In the game after all players have set a price-matching
policy, we now have many Nash equilibria:
• Eq1: All players choose price 0.30.
• Eq2: All players choose price 0.40.
• Eq3: All players choose price 0.60.
• Eq4: All players choose price 0.80.
• Eq 5... : At least one player chooses price 0.80,
other players choose 1.00.

© WU IMS 62
 Experiment 7
 If one player chooses a PMP, it does not hurt her. The
others don’t want to undercut her anymore, but she still
wants to undercut the prices of others.
 If all (many) players do it, undercutting others’ prices does
not pay anymore, as they will match the price anyway.

 When all players have a PMP, it is a best reply for each

player to just announce the same price as all others
(except if higher than monopoly price).
 Thus, each price lower or equal the monopoly price
becomes an equilibrium price.
  Firms are able to coordinate on high prices without
explicit collusion.
 Price matching policies are a signal to competitors, not to
consumers!
© WU IMS 63
 Experiment 7
 Data
c) Review the data set of experiment 7. Describe the
behavior of participants, and compare to the behavior
we observed in experiment 2.

© WU IMS 64
 Experiment 7

© WU IMS 65
 Experiment 7

 Other data? Plenty!

 I asked Google about how to play that game. Here are

Google’s answers.

© WU IMS 66
 Experiment 7

© WU IMS 67
 Experiment 7

© WU IMS 68
 Experiment 7

© WU IMS 69
 Experiment 7

© WU IMS 70
© WU IMS 71
© WU IMS 72
 Price Undercutting Policies
 Most popular are price matching policies.
• Restricted to same product. (Prevention of fierce price
competition only necessary for homogenous goods.)
 However, some companies have price undercutting
policies rather than price matching policies.

© WU IMS 73
 Experiment 7

© WU IMS 74
 Experiment 7

© WU IMS 75
 Price Undercutting Policies
 Most popular are price matching policies.
• Restricted to same product. (Prevention of fierce price
competition only necessary for homogenous goods.)
 However, some companies have price undercutting
policies rather than price matching policies. But:
• Undercutting only if there is a difference. No undercutting if
prices are equal! (“Refund of 110% of price difference.”)
• Refund often not in cash, but in other, less valuable form of
payment (E.g., Expedia offers coupons.)
• Many have clauses trying to prevent a loop. (Only beat
“advertised price”.)
• Even if cash/loops: collusive equilibria persist, but are “less
stable” with respect to discoordination/mistakes.
© WU IMS 76
 Price Undercutting Policies
Players 2 - 5

0.30 0.40 0.60 0.80 1.00

5* 5* 5* 5* 5*
0.30
5* 5 5 5 5
5 13* 5 5 5
0.40
Player 1

5* 13* 5 5 5
5 5 24.5* 5 5
0.60
5* 5 24.5* 5 5
5 5 5 26* 5
0.80
5* 5 5 26* 5
5 5 5 5 17*
1.00
5* 5 5 5 17*
© WU IMS 77
 Strategic moves
 Strategic moves are actions which change the game
• Payoff matrix
• Available strategies
 Commitment is one of such moves (building a new factory
to produce a large quantity, publicly announcing price
matching, building a bomb which triggers automatically if
you are attacked, and cannot be switched off)
 Must be credible to have an effect
• clear to understand
• public
• Irreversible
© WU IMS 78
 Not credible threat - Example
( 30 , 30 )
Boe accommodate
enter ing
Air ( -10 , 20 )
bus price war
stay out
 There are two Nash equilibria: ( 0 , 100 )
 1. Enter; Accommodate if Enter
 2. Stay Out; Price war if Enter
 We found that the second NE is not subgame-perfect. It
involved a not credible threat (Price war). Even if Boeing threats
a price war, it will reverse this decision once Airbus entered.
 So the only way to make Airbus staying out is to make the
threat credible by making it irreversible, such that
“accommodate” is not an option for Boeing anymore.
© WU IMS 79
 Strategic moves
 Strategic moves are actions which change the game
• Payoff matrix
• Available strategies
 Commitment is one of such moves (building a new factory
to produce a large quantity, publicly announcing price
matching, building a bomb which triggers automatically if
you are attacked, and cannot be switched off)
 Must be credible to have an effect
• clear to understand
• public
• irreversible
 Doomsday machine
© WU IMS 80