The basics of Game

Theory

Understanding strategic
behaviour

The basics of Game Theory

As we saw last week, oligopolies are a

problem for classical theory
The

best strategy for a firm depends on what

the other firm decides to do
Unless some assumption is made, the solution
cant be found...

Game theory is the study of the strategic

behaviour of agents
Not

just useful in economics, but also in

international relations, games of money, etc.

The basics of Game Theory

The prisoners dilemma

Nash equilibrium and welfare
Mixed strategy equilibria
Retaliation

The prisoners dilemma

The prisoners dilemma is the historical game that

founded game theory as a specific area of study:

This is because the solution to this game is suboptimal from the point of view of the players. This
means that there is a solution that makes both
players better off, but the rationality of the agents
does not lead to it.

The prisoners dilemma shows quite elegantly

how difficult it is to get agents to cooperate,
even when this cooperation is beneficial to all
agents.

The prisoners dilemma

A typical prisoners dilemma:

Two

suspected criminals are caught by the

police, but the police lacks the hard evidence
to charge them.
They can only sentence them to 1 year for
minor misdemeanours.
The police needs to get them to confess their
crimes in order to be able to charge them both
to 20 years.

How do the police get the suspects to

confess ?

The prisoners dilemma

They offer the criminals a deal...

If

one of them spills the beans on his

colleague, he gets a reduced sentence (6
months), and the other guys gets a extended
one (25 years)
st

Payoff Matrix

1 criminal

Confess

Deny

Confess

20
20

25
0.5

Deny

0.5
25

1
1

2nd criminal

The prisoners dilemma

The prisoners dilemma applied to a duopoly

Two firms competing on a market can:

Compete

(This leads, for example, to the Cournot

solution)
Collude and share monopoly profits (cartel).

Profit in a cartel > profit in a duopoly.

If collusion is not illegal, then it is clearly the

optimal situation from the point of view of these
two firms. But is it the equilibrium the market ends
up in ?

The prisoners dilemma

2 players :
2

firms (A and B) producing the same good

(Airbus/Boeing fits well!!)

2 strategies :
Produce

at the duopoly level

Produce at the cartel level (which is lower)

Given 2 players and 2 strategies, there are

4 possible market configurations
These

are listed in the payoff matrix

The prisoners dilemma

Lets put some numbers on the different possible profits:

For the Cartel case:

c = 10
For the duopoly competition case :

Each firm earns a share of the monopoly profits:

Each firm earns duopoly profits, which are lower:

d = 2

For the cheating case:

The firm producing at duopoly level captures the market

share of the other firm, and makes very high profits :
t = 15
The other firm is penalised and earns minimum profits :
m = 0

The prisoners dilemma

Firm B

Payoff
Matrix

Qd

Qc

Qd

2
2

0
15

Qc

15
0

10
10

Firm A

What is the best strategy

for each firm?
For firm A:
Qd if firm B chooses Qd
Qd if firm B chooses Qc
For firm B:
Qd if firm A chooses Qd
Qd if firm A chooses Qc

Note: the game is symmetric, so the dominant

strategy is to produce the duopoly quantity.

The basics of Game Theory

The prisoners dilemma

Nash equilibrium and welfare
Mixed strategy equilibria
Retaliation

Nash equilibrium and welfare

Definition of a Nash equilibrium:

A situation where no player can improve his outcome by

unilaterally changing his strategy

Central properties:
The Nash equilibrium is generally stable
Every game has at least one Nash equilibrium:
Either in pure strategies : Players only play a single
strategy in equilibrium
Or in mixed strategies : Players play a combination of
several strategies with a fixed probability
The proof of this result is the main contribution of John
Nash (and the reason why it is called a Nash equilibrium)

Nash equilibrium and welfare

Lets go back to the Duopoly example:

Firm B

Payoff
Matrix

Qd

Qc

Qd

2
2

0
15

Qc

15
0

10
10

Firm A

Is the Qd-Qd equilibrium

a Nash equilibrium ?
Can firm A or B improve
their outcome by shifting
alone to the cartel quantity
Qc ?
Qd-Qd is indeed a Nash
equilibrium

Nash equilibrium and welfare

Firm B

Payoff
Matrix

Qd

Qc

Qd

2
2

0
15

Qc

15
0

10
10

Firm A

So the dominant strategy

is to produce Qd
But the Qd-Qd
equilibrium is not socially
optimal
With a small number of
agents, individual
rationality does not
necessary lead to a social
optimum

The basics of Game Theory

The prisoners dilemma

Nash equilibrium and welfare
Mixed strategy equilibria
Retaliation

Mixed strategy equilibria

A pure-strategy Nash equilibrium does not exist
for all games

Example of a penalty shoot-out:

2

players: a goal-keeper and a striker

2 strategies : shoot / dive to the left or the right
We assume that the players are talented: The
striker never misses and the goalkeeper always
intercepts if they choose the correct side.
This is not required for the game, but it simplifies
things a bit!

What is the payoff matrix?

Mixed strategy equilibria

Payoff
Matrix

Goalkeeper
L

1
0

0
1

0
1

1
0

Striker

For the striker:

R if the keeper goes L
L if the keeper goes R
For the goalkeeper:
L if the striker shoots L
R if the striker shoots R
Whatever the outcome,
one of the players can
increase his sucess by
changing strategy

No pure-strategy Nash equilibrium !

Mixed strategy equilibria

Payoff
Matrix

Goalkeeper
L

1
0

0
1

0
1

1
0

Striker

There is, however, a mixed

strategy equilibrium
Strategy for both players:
Go L and R 50% of the time (1
out of two, randomly)
That way :
o
Each outcome has a
probability of 0.25
o
The striker scores
one out of two, the other is
stopped by the
goalkeeper

Mixed strategy equilibria

Lets check that this is actually a Nash equilibrium:

The goalkeeper plays L and R 50% of the time. Can the

striker increase his score by changing his strategy?
The striker decides to play 60% left and 40% right. His
new success rate is:
(0.6 0.5) + (0.4 0.5) = 0.5
(0.3) +
(0.2) = 0.5

By choosing 60-40, the striker scores more on the left

hand side, but less on the right. His success rate is the
same, his situation has not improved. This corresponds to
a Nash equilibrium !

The basics of Game Theory

The prisoners dilemma

Nash equilibrium and welfare
Mixed strategy equilibria
Retaliation

Retaliation

Finally, the stability of the equilibrium also

depends on whether the game is repeated
or not.
The

very concept of a mixed strategy

equilibrium depends on the repetition of the
game through time.

Even

for a pure strategy equilibrium, the ability

to replay the game can influence the outcome
Players can retaliate, and thus influence the
decisions of other players

Retaliation

Back to the duopoly case:

The

2 firms agree to form a cartel, and

maximise joint profits.
There is, however, the temptation to cheat on
this agreement

Imagine now that the game is played

several times
If

one firm cheats, it captures all the profits for

that period
What do you think happens in the next period?

Retaliation

Actually, this depends on whether the game

is repeated a fixed number of times or
indefinitely (open-ended)...

Lets say that our 2 firms decide to play the

game 5 times (5 years)
What

is the best strategy on year 5 ?

What about year 4, given what we know about
year 5 ?
This process shows that the equilibrium cannot be
stable

Retaliation

Lets imagine now that our 2 firms have an

open-ended agreement.

The threat of retaliation can bring the social optimum

The optimal retaliation strategy is also the

simplest one: tit for tat
Robert

Axelrod: just choose what your opponent

did last period: cooperate if he cooperated, cheat
if he cheated.

But the threat needs to be credible i.e. the

opponent needs to believe that it will
effectively be carried out.