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# Game Theory

Game Theory is a method we can use to analyze the decision-making process for these strategic firms Each game has (a) players, (b) strategies, and (c) payoffs Players these will be the firms Strategies the choices the players have (what price should I charge, should I enter the market) Payoffs what the player receives for playing the game (profits)

## Example: Prisoners Dilemma

Two thieves, Dave and Wes, are arrested as suspects in a murder The police believes they are guilty, but cant prove it without a confession The two suspects are interrogated in separate rooms and given the same speech:
If you confess and testify against your buddy, well let you go free If your buddy turns you in, well ask for the maximum sentence

If neither confess, then there wont be enough evidence to convict them and theyll only go to jail for a minor offense (drug possession, underage drinking, etc.) If both confess, theyll both go to jail for the crime but they wont do the maximum

## The Payoff Matrix

We will represent this game in a matrix form (like a table) In the matrix, we have all of the following information:
Each player (Dave and Wes) Each strategy available (Confess, Remain Silent) The payoff for each possible combination (the amount of time in jail)

We will use game theory to try and anticipate/predict the optimal choices for both players

Payoff Matrix
DAVE
Confess Confess Silent

FOR EXAMPLE:

5 5

0 10

W E S
Silent

If Dave confesses and Wes stays silent, then the payoffs are Dave goes free (no jail time) and Wes serves 10 years in prison

10
0

1
1

How do we read this matrix/table? Daves strategies and payoffs are represented in BLUE Wes strategies and payoffs are represented in GREEN

Equilibrium
Now that we understand each players choices (strategies), we need to figure out what is the optimal choice for each player to make

To help us determine the optimal strategies, we will look for the NASH EQUILIBRIUM

Nash Equilibrium
Nash Equilibrium The strategies or actions in which each firm does the best it can given its competitors actions The key is that the Nash Equilibrium gives us the best strategy given what the others are doing This implies that you have no incentive to change your behavior because you are doing the best thing you can, given what everyone else is doing The explanation in the movie is wrong

DAVE
Confess Confess Silent

If Dave confesses, what is Wes best response? Wes goes to jail for 10 years if he stays silent, but he only goes to jail for 5 years if he confesses, too So, confess is Wes best response What is Dave stays silent? What is Wes best response now?

5 5 10

0 10 1

W E S
Silent

Wes goes to jail for a year if he stays silent, but he goes free if he confesses So, confess is Wes best response

## For either of Daves choices, Wes best response is to CONFESS

Using the same logic for Daves best responses, we can find the Nash Equilibrium

DAVE
Confess
Confess

Silent

5 5 10 0

0 10 1 1

W E S Silent

The Nash Equilibrium occurs where both peoples best responses overlap The Nash Equilibrium is that both players should Confess and receive 5 years in prison

But Adam, couldnt they BOTH be BETTER OFF if they both stayed SILENT? Yes, they could BUT both players would have an incentive to change their strategy. If I knew you were going to stay Silent, Id be better off Confessing (and vice versa). So, the NASH EQUILIBRIUM point is the only stable (sustainable) outcome

## Price-Setting Game: Coke vs. Pepsi

Lets examine a potential situation where Coke and Pepsi simultaneously choose what price to charge To make this simple, suppose each firm can choose whether to charge a high price or a low price If they charge the same price, they split sales in the market and earn equal profit If one firm charges a lower price (undercutting), that lower price firm earns more profit than the high priced firm

## Price-Setting Payoff Matrix

Pepsi
Low Price High Price

## \$500 Low Price \$500

\$1000

\$200

Coke
\$200 High Price \$1000 \$700 \$700

Pepsis perspective: If Coke charges the low price, Pepsi earns \$500 charging the low price but only \$200 by charging the high price better off by charging the low price. If Coke charges the high price, Pepsi earns \$1,000 by charging the low price and \$700 charging the high price earn more by charging the low price. Coke faces the same incentives Each seller will charge the low price, regardless of what the other does each earns \$500 a day

Just like the Prisoners dilemma, both firms would be BETTER OFF if they both charged the HIGH PRICE, but that strategy is not sustainable

## Extending the Game

Weve looked at just two choices up until this point (Confess/Stay Silent OR High Price/Low Price) The same technique for finding the Nash Equilibrium applies to situations where there are more than two moves Consider the following example about Coke and Pepsi choosing how much to spend on advertising

Low Middle High

High

\$300, \$100

\$100, \$100

\$300, \$200

Middle

\$200, \$500

\$300, \$100

\$100, \$300

Low

\$400, \$0

\$400, \$200

\$0, \$400

## Multi-period (Sequential) Games

In multi-period games, there is a timing element
One firm chooses their price, then the other firms set their price Your firm is trying to decide which pricing strategy to adopt to keep out future (potential) rivals The Stackelberg model was an example of a sequential game

In the simultaneous-move game (static), we used the normal form representation For sequential games, we will use an extensive form representation (tree diagram)

Player 1

Player 2

Player 2

(10, 15)

(5, 5)

(0, 0)

(6, 20)

Solution Technique
To solve for the Nash equilibrium strategies in sequential games, we use backward induction
We solve the game from the end to the beginning

How? Start at the final stage of the game and figure out what the firm would do if the game was at the point After considering all the final choices, move up to the preceding stage of the game and figure what that firm would do knowing how the other firm would behave in the final stage of the game

Player 1

Player 2

Player 2

(10, 15)

(5, 5)

(0, 0)

(6, 20)

Nash Equilibrium
The Nash equilibrium in this game is for Player 1 to choose UP and then Player 2 to choose UP Playing these strategies gives Player 1 a pay-off of \$10 and Player 2 a pay-off of \$20 Now try one on your own Firm A is a pharmaceutical company thinking about developing a new cancer drug Firm B is a generic drug manufacturer that may (or may not) clone Firm 1s drug

Firm A

Firm B

(0, 0)

(100, 0)

(-5, 20)