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Howard Davies

and Pun-Lee Lam

Published by FT Prentice Hall

1

Chapter 13:

in Managerial Economics

2

Objectives

■ On completion of this chapter you should:

– understand the place of game theory in Economics

– be able to represent and solve simple games

– apply game theory to the issue of collusion

– model Cournot, Bertrand and von Stackelberg

competition

– be able to take a game-theoretic approach to entry

deterrence

– appreciate the limits of game theory

3

A ‘Paradigm Shift’ Bringing Industrial

Economics and Managerial Economics

Together

■ The ‘old’ Industrial Economics used the

Structure-Conduct-Performance paradigm

■ dependent variable is the performance/

profitability of a sector

– performance determined by structure; with high entry barriers, high

concentration and high product differentiation profits will be high

– cross- sector multiple regressions the dominant empirical technique

■ behaviour of individual firms (conduct) largely

implicit

4

A ‘Paradigm Shift’ Bringing Industrial

Economics and Managerial Economics

Together

■ Industrial Organization now dominated by

game theory

– focus is on what happens within an oligopolistic

industry, not on differences across industries

– decisions taken by individual firms have become

the centrepiece of analysis

– case studies of firms’ conduct have become the

dominant empirical method

5

Basic Concepts in Game Theory

■ Warning! Game theory is difficult and can involve highly complex chains of

reasoning

■ A game is any situation involving interdependence amongst ‘players’

■ Many different types of game:

– co-operative versus non-co-operative (which is the main focus)

– zero-sum, non-zero-sum

– simultaneous or sequential

– one-off versus repeated

• repeated a known number of times, infinite number of times or an unknown but

finite number of times

– continuous versus discrete pay-offs

– complete versus asymmetric information

– Prisoners’ Dilemma, assurance games, chicken games, evolutionary games

6

Representing and Solving Games

A Simultaneous Game in Strategic Form:

The Payoff Matrix

High Price Low Price

Company B’s High Price 100A,100B 120A, -20B

Actions Low Price -20A,120B 50A,50B

7

Representing and Solving Games

■ The same game in sequential form

High Price

100A, 100B

Company A

High Price

120A, -20B

Low Price

Company B

High Price

-20A, 120B

Low Price

Company A

50A, 50B

Low Price

8

Representing and Solving Games

■ Use rollback or backward induction to solve sequential games

– if Company B has set a high price then A chooses a low price: the

‘B high/A high’ branch can be pruned

– if B set a low price then A will choose a low price: the ‘B low/ A

high’ branch can be pruned

– B is therefore choosing between a high price (-20) and a low price

(50): it chooses low price

– A will also choose a low price

■ For simultaneous games search for dominant strategies (ones

which will be preferred whatever the rival does)

– A prefers a low price if B sets a high price and a low price if B sets

a low price: low price is a dominant strategy

– low price is also dominant for B

9

This Simple Example Illustrates a

Number of Key Ideas

■ Nash Equilibrium - ‘a set of strategies such that each

is best for each player, given that the others are

playing their own equilibrium strategies’

■ Rollback and Dominant strategies

■ The Prisoners’ Dilemma

– an important class of game where players can choose

between co-operating or cheating/defecting

– the best outcome for both is co-operation but the ‘natural’

result is cheating

– collusion is a key example

10

How to Find Nash Equilibria?

■ 1.Note a distinction between pure strategies - the players choose

one or other ‘move’ with certainty - and mixed strategies - the

players choose ‘high price with a 60% probability and low price

with a 40% probability’. Mixed strategies are too complex to deal

with here: see Dixit and Sneath (1999) for a non-technical

introduction

■ For pure strategies

– look for dominant strategies

– if dominant strategies are not to be found, look for dominated

strategies and delete them

– for zero sum games use the minimax criterion: pick the strategy for

each player for which the worst outcome is the least worst

– cell-by-cell inspection: examine every cell and for each one ask

(does either player wish to move from this cell, given what the other

has done?)

11

For example

C o m pany A ’s A ctio ns

H ig h P rice M ed iu m P rice L o w P rice

C o m pa ny B ’s H ig h P rice 100A,100B 120A, 65B 60A, 65B

A ctio ns M ed iu m P rice 65 A ,120B 80A,80B 60A, 55B

L o w P rice 65A,60B 55A , 60B 50A,50B

12

How Many Nash Equilibria?

■ There may be no Nash equilibria in

pure strategies

■ There may be more than one Nash

equilibrium

13

Collusion

■ The Prisoner’s Dilemma game, leading to low

price/low price illustrates a problem for firms trying to

collude. But managers will recognise the problem and

try to find ways round it. How can the dilemma be

escaped?

– Repetition

– Punishments and rewards

– Leadership

14

Repetition and the Prisoners’ Dilemma

■ If the game is repeated an infinite number of times there are

very clearly advantages in co-operating and players can

observe each others’ behaviour, hence co-operation may be

established. THE DILEMMA HAS BEEN ESCAPED

■ BUT the logic of this depends on the number of rounds of the

game being infinite. If the number of rounds is finite, in the last

round there is no longer any incentive to co-operate. Hence

cheating will take place in the last round and therefore in the

round before….and so on. THE DILEMMA RE-APPEARS

■ COMMONSENSE suggests that solutions are found to this

problem, and a good deal of evidence supports that view,but the

basic insight remains.

15

Contingent Strategies in Repeated Games

■ Contingent strategies are strategies whereby the actions taken in

repeated games depend upon actions taken by rivals in the last

round

– grim strategy: co-operate until the rival defects and then defect forever; this is

‘too unforgiving’ - one mistake and the prospect of collusion is gone forever

– tit-for-tat: co-operate when the rival co-operated in the last round, defect if they

defected; this strategy makes permanent cheating unprofitable and out-

performs most others in simulations and experiments

• in terms of the original game, defecting in every round under tit-for-tat leads to profit

of 120,50,50,50,50, whereas not defecting leads to 100,100,100,100. Choice of

defect is only rational at a very high discount rate

16

Contingent Strategies in Repeated Games

■ If the game is not repeated an infinite number of

times, but there is a probability ‘p’ of another round

the analysis can follow the same logic but adjust the

discount rate so that $1 accruing two periods in the

future is discounted by p/(1+r)2 instead of 1/(1+r)2 .

■ If ‘p’ is relatively low, cheating becomes relatively

more profitable, because the future gains from co-

operation become less.

17

Penalties and Rewards to Support

Collusion

■ Introducing penalties and rewards changes the pay-

off structure

■ Firms may ‘punish’ themselves in order to set up

structures which assist collusion

– e.g.’I will match any lower price set by my competitor’ or

looks like a highly competitive move, but it produces a pay-

off structure in which collusion is the outcome

■ Penalties and rewards might come from other sources

- consumers or the law might punish collusion - trade

associations might punish those who defect from the

collusion

18

Leadership to Support Collusion

L e a d e r s h ip a s a S o lu t io n

C o m p a n y A ’s A c t io n s

H ig h P r ic e L o w P r ic e

C o m p a n y B ’s H ig h P r ic e 1 0 0A,3 0 B0 1 2 0A, 1 2B0

A c t io n s L o w P r ic e - 2 0A,2 8 B0 5 0A,5 0B

19

Leadership to Support Collusion

■ If one firm has much larger pay-offs than the other it

may suit it to charge the higher price even if the rival

charges a lower price - see the example

■ Furthermore, the large firm may increase overall

profits by making side-payments to rivals

■ Saudi Arabia in the oil market?

20

Cournot and Bertrand Competition

■ Cournot competition

– two firms, identical products, firms choose output levels

– each firm’s profit-maximising output depends on the other

firm’s output; hence each firm has a reaction function

– as each firm will operate on its reaction function the point

where they cross is the Cournot Nash equilibrium

■ Bertrand competition

– two firms, identical products, firms choose price levels

– price is forced down to marginal cost

21

Von Stackelberg equilibrium

■ A ‘Leader’ and a ‘Follower’

■ The Leader chooses a price and the Follower then

chooses the price that suits it best, given what the

Leader has done

■ A sequential game and the solution is found by

working backwards. The Leader maximises his profit

(which depends on what the Follower does in

response to what the Leader does) by taking into

account what the Follower will do

22

Entry Deterrence

■ A major area of application for game

theory

■ “Firms may deter entry by threatening

retaliation”

– in particular firms may build excess

capacity in order to deter entry by

indicating that they will cut price and

increase output if entry takes place

23

Entry Deterrence

■ But is the threat credible?

■ If it is more profitable for the incumbent to allow entry

and share the market the threat is not credible

■ However, if the incumbent can make commitments

which effectively force him to fight the entrant. For

instance, if the incumbent installs excess capacity so

that his cost per unit rises if market share is given up

to an entrant, he is forced to fight: see Figure 13.7

24

Airbus and Boeing: No

Government Intervention

B oeing and A irbus Produce a Super-Jum bo:

N o G overnm ent Intervention

A irbus

D evelo p Super- Stay O ut

Ju m bo

B o eing D evelo p Super- -100A,-100B 0A, 500B

Ju m bo

Stay O ut 500A,0B 0A,0B

25

Airbus and Boeing: No

Government Intervention

B oeing and A irbus Produce a Super-Jum bo:

B oeing isSubsidized by the U S G overnm ent

A irbus

D evelop Super- Stay O ut

Jumbo

Boeing D evelop Super- -100A, 10B 0A, 610B

Jum bo

Stay O ut 500A,0B 0A,0B

26

How Useful Is Game Theory?

■ A powerful tool, BUT

– outcomes are very sensitive to the protocols

– there may be many equilibria

– when using it to model real life cases there may be many different

options - “ a model may be devised to fit almost any fact” Saloner

1991

– analysis works backwards - instead of theory to hypotheses to

empirical data - empirical data to theory

– sometimes players’ commonsense tells them what to do despite

multiple equilibria

– the requirement that firms do as expected (in rollback, for instance)

– where do the protocols come from, how do they change? GE and

Westinghouse found new protocols which helped them to collude -

why then and not before?

27

How Useful Is Game Theory?

■ An overall judgment?

■ Some very useful insights

– Nash equilibrium concept

– collusion; the price matching result

– entry deterrence; the importance of credibility

– Cournot and Bertrand provide determinate solutions for

oligopoly

■ The degree of complexity involved may limit its

usefulness as a predictive tool

■ The degree of rationality which has to be assumed on

the part of players is uncomfortable

28

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