GAME

GAME THEORY
THEORY AND
AND
EXTERNALITIES
EXTERNALITIES
 GAME THEORY

Game Theory is a framework for hypothetical

social situations among competing players. In
some respects, game theory is the science of
strategy, or at least the optimal decision-making
of independent and competing actors in a
strategic setting. The key pioneers of game theory
were mathematicians John von Neumann and
John Nash, as well as economist Oskar
Morgenstern.
The focus of game theory is the game, which serves as a model of
an interactive situation among rational players. The key to game
theory is that one player’s payoff is contingent on the strategy
implemented by the other player. The game identifies then
player’s identities, preferences, and available strategies and how
these strategies affect the outcome. Depending on the model,
various other requirements or assumptions may be necessary.
Game Theory has a wide range of applications, including
psychology, evolutionary biology, war, politics, economics, and
business. Despite its many advances, game theory is still a young
and developing science.
Game Theory- is a branch of economics that assumes that
economic outcomes are conditioned by uncertainty and risk. In
this world, interactions of economic players (such as sellers in
competition) can be analyzed in a way that certain profits or
losses (or rewards and punishments) are earned through the
moves that participants make in a game of interaction.
In the last few decades, game theory has evolved into a powerful
tool for the study of economic behavior. The problems in oligopoly
lend themselves to a useful application of game theory as an
analytical tool. It is therefore a useful way of understanding the
economic behavior of sellers in competition.
 Impact on Economics and Business

Game theory brought about a revolution in economics

by addressing crucial problems in prior mathematical
economic models. For instance, neoclassical
economics struggled to understand entrepreneurial
anticipation and could not handle imperfect
competition. Game theory turned attention away from
steady-state equilibrium toward the market process.
In business, game theory is beneficial for modeling
competing behaviors between economic agents.
Businesses often have several strategic choices that affect
their ability to realize economic gain. For example,
businesses may face dilemmas such as whether to retire
existing products or develop new ones, lower prices relative
to the competition, or employ new marketing strategies.
Economists often use game theory to understand oligopoly
firm behavior. It helps to predict likely outcomes when firms
engage in certain behaviors, such as price-fixing and
collusion.
 Price fixing

 One type of competition is through price-cutting. The issue is what

competitors would do the face of the possibility of their main
competitor either maintaining current prices or reducing them.
 Variants of these game would include the following examples.
Coke and Pepsi are recognizable international brands of well-
known American companies. They are often faced with the
problem of whether the price of their main drinks should be the
same or different. A lower or higher price has consequences for the
revenues--- and therefore--- profits of the firm. But what one
company does in response to a move by one of the players would
affect the total profit.
 Another variance is the competition between Jollibee and
MacDonald’s, the dominant players in the burger market in the
Philippines. Should each one retain the price of their products, knowing
that any price decision will be matched by a decision of the other? A
given set of actions would lead to a particular outcome on their net
profits, depending on the move made by the other party.
 Collusion- is acting together in accordance with agreed strategies.
Collusive members of an industry are often called a cartel. Most
governments prohibit collusion among the sellers. Collusion means
there is agreement, not competitive behavior. It is possible, however,
for quite collusion to become the outcome of a particular competitive
behavior when all members of the industry just follow a particular
strategy that follows their self-interest.
 Types of Game Theory
Cooperative game theory deals with how coalitions, or
cooperative groups, interact when only the payoffs are
known. It is a game between coalitions of players rather than
between individuals, and it questions how groups form and
how they allocate the payoff among players.
Non-cooperative game theory deals with how rational
economic agents deal with each other to achieve their own
goals. The most common non-cooperative game is the
strategic game, in which only the available strategies and
the outcomes that result from a combination of choices are
listed. A simplistic example of a real-world non-cooperative
game is Rock-Paper-Scissors.
Classic Game Theory Example

Prisoner’s Dilemma is the most well-known example of

game theory. Consider the example of two criminals
arrested for a crime. Prosecutors have no hard evidence
to convict them. However, to gain a confession, officials
remove the prisoners from their solitary cells and question
each one in separate chambers. Neither prisoner has the
means to communicate with each other.
 Officials present 4 deals:

If both confess, they will each receive a 5-year prison sentence.
If prisoner 1 confesses but prisoner 2 does not, prisoner 1 will get 3
years and prisoner 2 will get 9 years.
If prisoner 2 confesses but prisoner 1 does not, prisoner 1 will get
10 years and prisoner 2 will get 2 years.
If neither confesses, each will serve 2 years in prison.
The most favorable strategy is to not confess. However, neither is
aware of the other’s strategy and without certainty that one will not
confess, both will likely confess and receive a 5-year prison
sentence.
 Externalities

 An externality is a positive or negative consequence of an

economic activity experienced by unrelated third parties.
Pollution emitted by a factory that spoils the surrounding
environment and affects the health of nearby residents is an
example of a negative externality. The effect of a well-
educated labor force on the productivity of a company is an
example of a positive externality. Externalities occur in an
economy when the production or consumption of a specific
good impacts a third party that is not directly related to the
production or consumption. Externalities, such as pollution, are
one of the main reasons why governments step in with
increased regulations.
 Most externalities are negative. Pollution, for example, is well-known
negative externality. A corporation may decide to cut costs and
increase profits by implementing new operations that are almost all
externalities are considered to be technical externalities. These types
of externalities have an impact on the consumption and production
opportunities of unrelated third parties, but the price of consumption
does not include the externalities. This makes it so there is a difference
between the gain or loss of private individuals and the aggregate gain
or loss of the society as a whole. Oftentimes, the action of an individual
or organization results in positive private gains but detracts from the
overall economy. Many economists consider technical externalities to
be market deficiencies. This is why people advocate for government
intervention to curb negative externalities through taxation and
regulation.
 Positive and Negative Externality

A positive externality benefits society and therefore it

tends to reduce private costs. A positive externality brings
social benefits. In the presence of a positive externality,
private costs are lower than social costs. This means that
a given economic activity reduces the costs of other
bystanders. Take the example of the beekeeper. This is a
classic example in economics, and it is the first among
the examples cited below.
The private costs of the beekeeper are internal to the honey
grower. The presence of bees in the neighborhood makes it
easy for flowers to get pollinated. Flowering and fruiting of
gardens and orchards become more prolific. The benefits are
felt by all neighbors and passersby (who have nothing to do
with beekeeping, i.e., external to them). Of course, one could
argue that bees could sting some people in the neighborhood
so that the presence of bees could become a nuisance (that
is, a negative externality) to other people.
 A negative externality increases costs to society. Therefore, a
negative externality gives rise to social costs. There are quite a
number of examples of negative externalities enumerated in the
list below and it would be useful to devote some careful attention
to them.
 The presence of externalities is often used to justify an active role
for governments in the economy. The government can reduce
the social costs of an externality by taxing or by raising the
explicit costs formally faced by the private industry that is the
cause of the negative externality. In the case of an activity with a
positive externality, the government could enhance its presence
by encouraging its provision and even by including it in its array
of public goods.
 Examples of Externalities
 Many types of externality can be illustrated. Below, general and
specific examples are given. An effort at comprehensiveness is made
in order to illustrate the interlinking of various elements that may
complicate the workings of the market.
 In examining the examples it could be well to pause and explore the
source of externality (whether production or consumption), to identify
the effect on the uninvolved other economic agent, and then to
analyzed the possible outcome (whether it is a social cost or a
benefit). After going through this examples and their various
implications, one realizes the thicket of issues and concerns that have
to be cleared in the formulation of social and economic policies that
often are at the heart of nation-building.
 1. A beekeeper in an area improves the beauty of the nearby flower
gardens and the output of fruits orchards.
 2. The increased number of water pumps in a community affects the
water table and makes water more costly to extract for all. People
have to dig deeper pumps just to get the same amount of water as
before.
 3. The increased number of motor vehicles increases the amount of
carbon monoxide and other gas emissions in the atmosphere and
therefore leads to smog in the city and to pollution.
 4. Large traffic jams slowdown everybody’s trip to the office on a daily
basis and therefore jack up the costs of going to work.
 5. The large emissions of smoke from factories raise the level of smog in
the city and increase the incidence of respiratory diseases.
 How to Overcome Externalities: Possible Solutions
 Several possible solutions exist to overcome the problems that arise
from externalities. These can include those from both the public and
private sectors.
 Taxes are one type of solution to overcome externalities. To help
reduce the negative effects of certain externalities (like pollution),
governments can impose a tax on the goods affecting them. The tax,
called a Pigovian tax (named after economist Arthur C. Pigou), is
considered to be equal to the value of the negative externality. This tax
is meant to discourage activities that impose a net cost to an unrelated
third party. That means that by imposing this type of tax, it will reduce
the market outcome of the externality to an amount that is considered
efficient.
Subsidies can also be put into place, which helps increase
consumption of positive externality. One example would be to
subsidize orchards that plant fruit trees in order to correct the
positive externalities they offer to beekeepers.
Governments can also implement regulation to offset the effects of
externalities, and is considered to be the most common kind of
solution. As mentioned above, people often turn to governments
to pass and enact legislation and regulation to curb the negative
side of externalities. Several examples include environmental
regulations or health-related legislation.
THANK YOU! 