FINC304

MANAGERIAL ECONOMICS

Session 11– Game Theory

Lecturer: Dr. Agyapomaa Gyeke-Dako, UGBS

Contact Information: agyeke-dako@ug.edu.gh

College of Education
School of Continuing and Distance Education
2014/2015 – 2016/2017
 Session Overview
• We have seen from session 10 that when firms are few, their
actions affect and can be affected by the actions of other
firms. For instance, the output and pricing decisions of one
firm in an oligopoly market will have consequences for the
profit of another firm in oligopoly. In this session, we continue
our analysis on strategic behaviour. We delve deeply into
managerial decisions when firms are interdependent.
Specifically, we use a tool called game theory to analyse
interdependence amongst firm. This tool will help firms in
oligopolistic markets to make managerial decisions including
how much output to produce, what price to charge, how
much advertising to do etc.

Agyapomaa Gyeke-Dako(PhD) 4/27/2018 Slide 2

 Session Outline
The key topics to be covered in the session are as follows:
At the end of the session, the student will
1. Understand what we mean by strategic behavior/firm
interdependence
2. Select the price and output that will maximize profit in all four
models

Agyapomaa Gyeke-Dako(PhD) 4/27/2018 Slide 3

 Reading List
• Baye Michael and Price Jeffery: Managerial
Economics and Business Strategy, 8th Edition

Agyapomaa Gyeke-Dako(PhD) 4/27/2018 Slide 4

 Introduction
Game theory is the main tool for studying strategic
interactions

It has a wide range of applications in economics and

other disciplines
eg Political Science, Biology etc

In economics it is used extensively to study strategic

interactions among firms

Agyapomaa Gyeke-Dako(PhD) 4/27/2018 Slide 5

 In competitive markets, there is absence of rivalry; each
firm make decisions without regard to what other firms
are doing
in monopoly markets, there is only firm so strategic behavior of this kind does
not exist

In oligopoly markets where there are few firms, what

one firm does affects the rivals
rivals react to what others do

Agyapomaa Gyeke-Dako(PhD) 4/27/2018 Slide 6

 Basic Concepts
Game:
A game is a abstract representation of a strategic
situation. The basic elements of a game are players,
strategies and payoffs
A game may be a sequential or a
simultaneous-move game
In a sequential game, players make their move in turns
In a simultaneous-move game, players make their
moves at the same time

Agyapomaa Gyeke-Dako(PhD) 4/27/2018 Slide 7

 Basic Concepts
Players:
players are the decision-makers in a game
players may be individuals, households, firms, communities or even
countries
the number of players are typically the same throughout the game
Strategies
Strategies refers to the various actions/moves available to the players
during a game

Payoffs
payoffs refers to the various returns available to the players of the game
at the conclusion of the game

Agyapomaa Gyeke-Dako(PhD) 4/27/2018 Slide 8

 Pure versus Mixed
Pure strategies are those that are played with
probability 1
In this case the strategies are played with certainty

Strategies that the played with probabilities less than

one are mixed strategies
eg a player plays heads with probability 0.5 and tails with probability 0.5, this
is a mixed strategy

Note that pure strategies are a special case of mixed

strategies

Agyapomaa Gyeke-Dako(PhD) 4/27/2018 Slide 9

 Normal Form
Games can be presented in two main forms:
strategic/normal form and extensive form
Extensive form is an extended description of the game
This usually takes the form of a tree diagram

The strategic/normal form of a game summarizes the

players, strategies and payoffs in the form of a table
the strategic form is also called the normal form

Agyapomaa Gyeke-Dako(PhD) 4/27/2018 Slide 10

 Tullow

Narrow Wide

Energy Narrow (15 15) (0 17)

Wide (17 0) (0 0)

Agyapomaa Gyeke-Dako(PhD) 4/27/2018 Slide 11

 A Market –Share Game
• Two managers want to maximize market share
• Strategies are pricing decisions
• Simultaneous moves One-shot game

Agyapomaa Gyeke-Dako(PhD) 4/27/2018 Slide 12

 Manager 1

P=$15 P=$5

Manager 2 P=$15 0.3, 0.7

0.1, 0.1

P=$5 0.6, 0.4 0.1, 0.1

Agyapomaa Gyeke-Dako(PhD) 4/27/2018 Slide 13

 Prisoner’s Dilemma
• A.W. Tucker’s Prisoner’s Dilemma is one of the most
famous games in game theory
• It is a game that summarizes the strategic choices
facing two criminals who face time in prison
• The prisoner’s are interviewed differently and they
face different payoffs based on their strategy and the
strategy of the other prisoner

Agyapomaa Gyeke-Dako(PhD) 4/27/2018 Slide 14

 Player 2
Strategy Confess Don’t Confess
Player 1 Confess (6,6) (0,8)
Don’t Confess (8,0) (3,3)

Agyapomaa Gyeke-Dako(PhD) 4/27/2018 Slide 15

 Dominant Strategy
A strategy for a player is a dominant strategy for a
player if it gives that player its highest payoff
irrespective of the strategy of the other player
Consider the following advertising game played
between NESTLE and UNILEVER:
each play can choose the level of advertising: high (H), moderate (M) or low
(L)
the normal form of the game is depicted on the next slides

Agyapomaa Gyeke-Dako(PhD) 4/27/2018 Slide 16

 Unilever
Nestle High Moderate Low
High (12,11) (11,12) (14,13)
Moderate (11,10) (10,11) (12,12)
Low (10,15) (10,13) (13,14)

Agyapomaa Gyeke-Dako(PhD) 4/27/2018 Slide 17

 In the above example, Nestle has a dominant strategy to
choose high (H) advertising
To see this, compare his payoff from choosing high with
moderate or low
If Unilever chooses High, Nestle gets 12 for H compared with 11 for M
and 10 for L
If Unilever chooses moderate, Nestle gets 11 with H compare with 10
with H or L
If Unilever chooses low, Nestle gets 12 with H compared with 12 with M
and 13 with L
A player with a dominant strategy always plays that strategy

Agyapomaa Gyeke-Dako(PhD) 4/27/2018 Slide 18

 Equilibrium
In economics, we define equilibrium as state where
both sides of the market are content with the existing
market outcome
Equilibrium for a product market is the point where quantity demanded and
quantity supplied are such that both sellers and buyers do not desire to
alter their quantities
This general concept of equilibrium is also used with
Nash equilibrium

Agyapomaa Gyeke-Dako(PhD) 4/27/2018 Slide 19

 Nash Equilibrium
A Nash equilibrium strategy for each player is his/her
best strategy given other player’s strategy

A Nash equilibrium occurs when the current strategies

are such that each player has no incentive to change
strategies given the strategy of the other player(s)

It is a pair of strategies such that each agent’s choice

maximizes his/her utility given the strategy of the other
player

Agyapomaa Gyeke-Dako(PhD) 4/27/2018 Slide 20

 Unilever does not have a dominant strategy

But it will reason that since Nestle has a dominant

strategy in H, it will choose H

Given that Nestle will play this strategy, Unilever plays L

The Nash Equilirium set of strategies is H for Nestle and

L for Unilever.

Agyapomaa Gyeke-Dako(PhD) 4/27/2018 Slide 21

 Nash Equilibrium: Prisoner’s Dilemma
The Nash equilibrium for Prisoner’s Dilemma presented
above is (Confess, Confess)

Each player has no incentive to deviate from this

strategy given the strategy of the other player

This is not a socially desirable equilibrium

Agyapomaa Gyeke-Dako(PhD) 4/27/2018 Slide 22