You are on page 1of 50

Managerial Economics in a Global Economy, 5th Edition by Dominick Salvatore

Chapter 10 Game Theory and Strategic Behavior

Prepared by Robert F. Brooker, Ph.D.

Copyright ©2004 by South-Western, a division of Thomson Learning. All rights reserved.

Slide 1

Strategic Behavior
• Decisions that take into account the predicted reactions of rival firms
– Interdependence of outcomes

• Game Theory
– Players – Strategies – Payoff matrix

Prepared by Robert F. Brooker, Ph.D.

Copyright ©2004 by South-Western, a division of Thomson Learning. All rights reserved.

Slide 2

Strategic Behavior
• Types of Games
– Zero-sum games – Nonzero-sum games

• Nash Equilibrium
– Each player chooses a strategy that is optimal given the strategy of the other player – A strategy is dominant if it is optimal regardless of what the other player does
Prepared by Robert F. Brooker, Ph.D. Copyright ©2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 3

Advertising Example 1

Firm A

Advertise Don't Advertise

Firm B Advertise Don't Advertise (4, 3) (5, 1) (2, 5) (3, 2)

Prepared by Robert F. Brooker, Ph.D.

Copyright ©2004 by South-Western, a division of Thomson Learning. All rights reserved.

Slide 4

Advertising Example 1
What is the optimal strategy for Firm A if Firm B chooses to advertise?

Firm A

Advertise Don't Advertise

Firm B Advertise Don't Advertise (4, 3) (5, 1) (2, 5) (3, 2)

Prepared by Robert F. Brooker, Ph.D.

Copyright ©2004 by South-Western, a division of Thomson Learning. All rights reserved.

Slide 5

the payoff is 2. the payoff is 4. 5) (3. Copyright ©2004 by South-Western. Brooker. Otherwise. Ph.Advertising Example 1 What is the optimal strategy for Firm A if Firm B chooses to advertise? If Firm A chooses to advertise. Firm A Advertise Don't Advertise Firm B Advertise Don't Advertise (4. 3) (5. All rights reserved. 1) (2. a division of Thomson Learning.D. Slide 6 . The optimal strategy is to advertise. 2) Prepared by Robert F.

Copyright ©2004 by South-Western. Ph. 1) (2. Slide 7 . 3) (5. 2) Prepared by Robert F. Brooker.D. 5) (3. a division of Thomson Learning. All rights reserved.Advertising Example 1 What is the optimal strategy for Firm A if Firm B chooses not to advertise? Firm A Advertise Don't Advertise Firm B Advertise Don't Advertise (4.

2) Prepared by Robert F. Slide 8 . 3) (5.Advertising Example 1 What is the optimal strategy for Firm A if Firm B chooses not to advertise? If Firm A chooses to advertise. Copyright ©2004 by South-Western. 5) (3. Ph. Firm A Advertise Don't Advertise Firm B Advertise Don't Advertise (4. the optimal strategy is to advertise. the payoff is 3.D. a division of Thomson Learning. All rights reserved. the payoff is 5. Otherwise. 1) (2. Brooker. Again.

a division of Thomson Learning. Firm A Advertise Don't Advertise Firm B Advertise Don't Advertise (4.D. 1) (2. Slide 9 . the optimal strategy for Firm A is to advertise. The dominant strategy for Firm A is to advertise. 5) (3. Ph. 3) (5. 2) Prepared by Robert F.Advertising Example 1 Regardless of what Firm B decides to do. Copyright ©2004 by South-Western. All rights reserved. Brooker.

Ph. 5) (3. Brooker. 2) Prepared by Robert F. 3) (5. a division of Thomson Learning. 1) (2. All rights reserved. Copyright ©2004 by South-Western.D. Slide 10 .Advertising Example 1 What is the optimal strategy for Firm B if Firm A chooses to advertise? Firm A Advertise Don't Advertise Firm B Advertise Don't Advertise (4.

5) (3. 1) (2. All rights reserved. Otherwise. Firm A Advertise Don't Advertise Firm B Advertise Don't Advertise (4. a division of Thomson Learning. Slide 11 . The optimal strategy is to advertise. Ph. Copyright ©2004 by South-Western.Advertising Example 1 What is the optimal strategy for Firm B if Firm A chooses to advertise? If Firm B chooses to advertise. Brooker. 2) Prepared by Robert F. the payoff is 3.D. 3) (5. the payoff is 1.

3) (5.Advertising Example 1 What is the optimal strategy for Firm B if Firm A chooses not to advertise? Firm A Advertise Don't Advertise Firm B Advertise Don't Advertise (4.D. 5) (3. Slide 12 . Copyright ©2004 by South-Western. 2) Prepared by Robert F. Brooker. a division of Thomson Learning. Ph. All rights reserved. 1) (2.

D. 1) (2. Brooker. All rights reserved. Ph. 2) Prepared by Robert F. the optimal strategy is to advertise. 5) (3.Advertising Example 1 What is the optimal strategy for Firm B if Firm A chooses not to advertise? If Firm B chooses to advertise. Firm A Advertise Don't Advertise Firm B Advertise Don't Advertise (4. Again. 3) (5. the payoff is 2. a division of Thomson Learning. Slide 13 . Otherwise. Copyright ©2004 by South-Western. the payoff is 5.

Firm A Advertise Don't Advertise Firm B Advertise Don't Advertise (4. Copyright ©2004 by South-Western.D. Slide 14 . 1) (2. 3) (5.Advertising Example 1 Regardless of what Firm A decides to do. a division of Thomson Learning. All rights reserved. the optimal strategy for Firm B is to advertise. 5) (3. The dominant strategy for Firm B is to advertise. Ph. 2) Prepared by Robert F. Brooker.

5) (3. a division of Thomson Learning.Advertising Example 1 The dominant strategy for Firm A is to advertise and the dominant strategy for Firm B is to advertise. Copyright ©2004 by South-Western. Firm A Advertise Don't Advertise Firm B Advertise Don't Advertise (4. The Nash equilibrium is for both firms to advertise. Ph. All rights reserved.D. Slide 15 . 3) (5. 2) Prepared by Robert F. Brooker. 1) (2.

3) (5. Brooker.D. Slide 16 . Copyright ©2004 by South-Western. All rights reserved. Ph. 5) (6. a division of Thomson Learning. 2) Prepared by Robert F.Advertising Example 2 Firm A Advertise Don't Advertise Firm B Advertise Don't Advertise (4. 1) (2.

Brooker. 3) (5. Ph.Advertising Example 2 What is the optimal strategy for Firm A if Firm B chooses to advertise? Firm A Advertise Don't Advertise Firm B Advertise Don't Advertise (4. Slide 17 . 2) Prepared by Robert F. 5) (6. All rights reserved. 1) (2.D. Copyright ©2004 by South-Western. a division of Thomson Learning.

Slide 18 . All rights reserved. 2) Prepared by Robert F. a division of Thomson Learning. Brooker. the payoff is 4.Advertising Example 2 What is the optimal strategy for Firm A if Firm B chooses to advertise? If Firm A chooses to advertise.D. Otherwise. Firm A Advertise Don't Advertise Firm B Advertise Don't Advertise (4. the payoff is 2. Ph. 3) (5. 1) (2. 5) (6. Copyright ©2004 by South-Western. The optimal strategy is to advertise.

Slide 19 . All rights reserved. 2) Prepared by Robert F. Ph.Advertising Example 2 What is the optimal strategy for Firm A if Firm B chooses not to advertise? Firm A Advertise Don't Advertise Firm B Advertise Don't Advertise (4. 3) (5. Copyright ©2004 by South-Western. 1) (2. a division of Thomson Learning. Brooker. 5) (6.D.

Brooker. Otherwise. In this case. Ph. 5) (6. Copyright ©2004 by South-Western. All rights reserved. the payoff is 5. 2) Prepared by Robert F. Firm A Advertise Don't Advertise Firm B Advertise Don't Advertise (4. Slide 20 .Advertising Example 2 What is the optimal strategy for Firm A if Firm B chooses not to advertise? If Firm A chooses to advertise. 1) (2. the payoff is 6. the optimal strategy is not to advertise. 3) (5.D. a division of Thomson Learning.

3) (5. Copyright ©2004 by South-Western. 5) (6. Firm A Advertise Don't Advertise Firm B Advertise Don't Advertise (4.D. Slide 21 . All rights reserved. Ph. Brooker. 1) (2. 2) Prepared by Robert F. a division of Thomson Learning.Advertising Example 2 The optimal strategy for Firm A depends on which strategy is chosen by Firms B. Firm A does not have a dominant strategy.

2) Prepared by Robert F. Ph. a division of Thomson Learning. Slide 22 . 1) (2.D. All rights reserved.Advertising Example 2 What is the optimal strategy for Firm B if Firm A chooses to advertise? Firm A Advertise Don't Advertise Firm B Advertise Don't Advertise (4. 5) (6. Copyright ©2004 by South-Western. 3) (5. Brooker.

Brooker. 1) (2. 2) Prepared by Robert F. Copyright ©2004 by South-Western. Ph. The optimal strategy is to advertise. 3) (5. Slide 23 . a division of Thomson Learning. 5) (6. Firm A Advertise Don't Advertise Firm B Advertise Don't Advertise (4. the payoff is 3.D. All rights reserved. Otherwise. the payoff is 1.Advertising Example 2 What is the optimal strategy for Firm B if Firm A chooses to advertise? If Firm B chooses to advertise.

3) (5. Brooker. Slide 24 .Advertising Example 2 What is the optimal strategy for Firm B if Firm A chooses not to advertise? Firm A Advertise Don't Advertise Firm B Advertise Don't Advertise (4. Copyright ©2004 by South-Western. 2) Prepared by Robert F. a division of Thomson Learning.D. All rights reserved. 1) (2. 5) (6. Ph.

5) (6. Again. the optimal strategy is to advertise. Firm A Advertise Don't Advertise Firm B Advertise Don't Advertise (4. the payoff is 2. 2) Prepared by Robert F. 1) (2. Slide 25 . All rights reserved.Advertising Example 2 What is the optimal strategy for Firm B if Firm A chooses not to advertise? If Firm B chooses to advertise. 3) (5. Copyright ©2004 by South-Western. Otherwise. Ph. Brooker. a division of Thomson Learning. the payoff is 5.D.

Slide 26 . Ph. 5) (6. Brooker. The dominant strategy for Firm B is to advertise.D. 1) (2. 3) (5. Copyright ©2004 by South-Western. All rights reserved. Firm A Advertise Don't Advertise Firm B Advertise Don't Advertise (4. the optimal strategy for Firm B is to advertise. 2) Prepared by Robert F. a division of Thomson Learning.Advertising Example 2 Regardless of what Firm A decides to do.

2) Prepared by Robert F. If Firm B chooses to advertise. The Nash equilibrium is for both firms to advertise.D. Brooker. Firm A Advertise Don't Advertise Firm B Advertise Don't Advertise (4. All rights reserved. 5) (3. 3) (5.Advertising Example 2 The dominant strategy for Firm B is to advertise. then the optimal strategy for Firm A is to advertise. Ph. Copyright ©2004 by South-Western. a division of Thomson Learning. Slide 27 . 1) (2.

Prisoners’ Dilemma Two suspects are arrested for armed robbery. Ph. If convicted. you will go free. Prepared by Robert F. If you both confess. Copyright ©2004 by South-Western. All rights reserved. a division of Thomson Learning.D. you will get 10 years in prison. the evidence is not sufficient to convict them of more than the crime of possessing stolen goods. which carries a sentence of only 1 year. The suspects are told the following: If you confess and your accomplice does not. They are immediately separated. Brooker. However. If you do not confess and your accomplice does. you will both get 5 years in prison. Slide 28 . they will get a term of 10 years in prison.

D. 5) (0. Brooker. Slide 29 . Copyright ©2004 by South-Western.Prisoners’ Dilemma Payoff Matrix (negative values) Confess Individual A Don't Confess Individual B Confess Don't Confess (5. Ph. a division of Thomson Learning. 10) (10. 0) (1. All rights reserved. 1) Prepared by Robert F.

Brooker. Slide 30 . 1) Prepared by Robert F. 0) (1. All rights reserved. Copyright ©2004 by South-Western. Ph. a division of Thomson Learning. 5) (0.D. 10) (10.Prisoners’ Dilemma Dominant Strategy Both Individuals Confess (Nash Equilibrium) Confess Individual A Don't Confess Individual B Confess Don't Confess (5.

5) (3. Brooker.D. 1) (1. 2) (5. Slide 31 . Ph.Prisoners’ Dilemma Application: Price Competition Firm A Low Price High Price Firm B Low Price High Price (2. All rights reserved. 3) Prepared by Robert F. a division of Thomson Learning. Copyright ©2004 by South-Western.

5) (3. 2) (5.D. Ph. a division of Thomson Learning. 1) (1. Copyright ©2004 by South-Western. Slide 32 . All rights reserved. 3) Prepared by Robert F.Prisoners’ Dilemma Application: Price Competition Dominant Strategy: Low Price Firm A Low Price High Price Firm B Low Price High Price (2. Brooker.

D.Prisoners’ Dilemma Application: Nonprice Competition Firm A Advertise Don't Advertise Firm B Advertise Don't Advertise (2. Ph. 1) (1. All rights reserved. Copyright ©2004 by South-Western. a division of Thomson Learning. 5) (3. Slide 33 . 2) (5. Brooker. 3) Prepared by Robert F.

a division of Thomson Learning. 2) (5. Slide 34 . All rights reserved. Brooker.D. 1) (1. 3) Prepared by Robert F. Copyright ©2004 by South-Western.Prisoners’ Dilemma Application: Nonprice Competition Dominant Strategy: Advertise Firm A Advertise Don't Advertise Firm B Advertise Don't Advertise (2. Ph. 5) (3.

All rights reserved. Ph. Copyright ©2004 by South-Western.D. Slide 35 . 1) (1. 5) (3. Brooker. 2) (5. a division of Thomson Learning.Prisoners’ Dilemma Application: Cartel Cheating Firm A Cheat Don't Cheat Firm B Cheat Don't Cheat (2. 3) Prepared by Robert F.

1) (1. Slide 36 . 3) Prepared by Robert F. 2) (5.D. Brooker. 5) (3.Prisoners’ Dilemma Application: Cartel Cheating Dominant Strategy: Cheat Firm A Cheat Don't Cheat Firm B Cheat Don't Cheat (2. All rights reserved. Copyright ©2004 by South-Western. Ph. a division of Thomson Learning.

D. a division of Thomson Learning. All rights reserved. Brooker. Slide 37 .Extensions of Game Theory • Repeated Games – Many consecutive moves and countermoves by each player • Tit-For-Tat Strategy – Do to your opponent what your opponent has just done to you Prepared by Robert F. Ph. Copyright ©2004 by South-Western.

Ph.Extensions of Game Theory • Tit-For-Tat Strategy – Stable set of players – Small number of players – Easy detection of cheating – Stable demand and cost conditions – Game repeated a large and uncertain number of times Prepared by Robert F. All rights reserved. Copyright ©2004 by South-Western.D. a division of Thomson Learning. Slide 38 . Brooker.

Brooker. Ph. All rights reserved. Slide 39 . Copyright ©2004 by South-Western. a division of Thomson Learning.D.Extensions of Game Theory • Threat Strategies – Credibility – Reputation – Commitment – Example: Entry deterrence Prepared by Robert F.

0) Credible Entry Deterrence Firm A Low Price High Price Firm B Enter Do Not Enter (4. Copyright ©2004 by South-Western. 0) (7. -2) (6. Brooker. 0) (3.Entry Deterrence No Credible Entry Deterrence Firm A Low Price High Price Firm B Enter Do Not Enter (4. 0) Slide 40 Prepared by Robert F. 2) (8. . 2) (10. a division of Thomson Learning. All rights reserved. -2) (6.D. Ph.

Brooker. 2) (8. 0) (3. Ph. 0) Slide 41 Prepared by Robert F. -2) (6.D. All rights reserved. a division of Thomson Learning. 0) (7. 2) (10. Copyright ©2004 by South-Western.Entry Deterrence No Credible Entry Deterrence Firm A Low Price High Price Firm B Enter Do Not Enter (4. . -2) (6. 0) Credible Entry Deterrence Firm A Low Price High Price Firm B Enter Do Not Enter (4.

Copyright ©2004 by South-Western.International Competition Boeing Versus Airbus Industries Boeing Produce Don't Produce Airbus Produce Don't Product (-10.D. 0) Prepared by Robert F. Brooker. Slide 42 . 0) (0. 100) (0. Ph. All rights reserved. -10) (100. a division of Thomson Learning.

Ph. Slide 43 . Brooker.D. a division of Thomson Learning.Sequential Games • Sequence of moves by rivals • Payoffs depend on entire sequence • Decision trees – Decision nodes – Branches (alternatives) • Solution by reverse induction – From final decision to first decision Prepared by Robert F. Copyright ©2004 by South-Western. All rights reserved.

All rights reserved. Brooker. a division of Thomson Learning. Copyright ©2004 by South-Western.High-price. Slide 44 .D. Ph. Low-price Strategy Game Firm A ice h Pr Hig igh H c P ri e Firm B $100 $100 B Low P rice e $130 $50 A Lo w Pri ric gh P Hi ce $180 $80 B Low P rice $150 $120 Prepared by Robert F.

D. All rights reserved.High-price. Ph. Slide 45 . Brooker. Low-price Strategy Game Firm A ice h Pr Hig igh H c P ri e Firm B $100 $100 B Low P A Lo w Pri ce ric gh P Hi B X X rice e $130 $50 $180 $80 Low P rice $150 $120 Prepared by Robert F. a division of Thomson Learning. Copyright ©2004 by South-Western.

All rights reserved. Slide 46 .D. Ph.High-price. a division of Thomson Learning. Low P rice $150 $120 Prepared by Robert F. Low-price Strategy Game Firm A ice h Pr Hig H igh Firm B $100 $100 A X Pri ce c P ri e B Low P Lo w ric gh P Hi B X X rice e $130 $50 $180 $80 Solution: Both firms choose low price. Brooker. Copyright ©2004 by South-Western.

Airbus and Boeing Airbus Boeing J B et bo J um c Cr uiser $50 $50 0 38 A A Soni $120 $100 No A3 8 J mbo Ju et $0 $150 0 B Soni c Cr uiser $0 $200 Prepared by Robert F. a division of Thomson Learning.D. Copyright ©2004 by South-Western. Brooker. Ph. Slide 47 . All rights reserved.

All rights reserved.D. Copyright ©2004 by South-Western. Slide 48 . Ph. Brooker.Airbus and Boeing Airbus Boeing J B et bo J um X $50 $50 0 38 A A Soni c Cr uiser $120 $100 No A3 8 J mbo Ju 0 B X et $0 $150 Soni c Cr uiser $0 $200 Prepared by Robert F. a division of Thomson Learning.

Brooker. a division of Thomson Learning.Airbus and Boeing Airbus Boeing J B et bo J um X $50 $50 0 38 A A Soni c Cr uiser $120 $100 No A3 8 X J mbo Ju B 0 X et $0 $150 Soni c Cr uiser $0 $200 Solution: Airbus builds A380 and Boeing builds Sonic Cruiser. All rights reserved.D. Ph. Copyright ©2004 by South-Western. Prepared by Robert F. Slide 49 .

All rights reserved. a division of Thomson Learning.Integrating Case Study gh Hi Firm A se verti Ad c Pri e A Firm B 60 70 Not Adv er erti Adv tise 100 50 B ric e Lo w se 40 60 gh P Pri ce A Not A dver ti Hi 75 se 70 A se verti Ad Hi gh c Pri e A Not A e 70 50 Prepared by Robert F. w Lo ic Pr B Lo w Pri ce dver tise 90 40 tise dver A 80 50 A Not Adv er tise 60 30 Slide 50 Copyright ©2004 by South-Western. Brooker. Ph.D. .