Game Theory

Basic Ideas of Game Theory

 Game theory is the general theory of
strategic behavior.
 Generally depicted in mathematical form.
 Plays an important role in modern
economics.
Rules, Strategies, Payoffs, and
Equilibrium
 Economic situations are treated as games.
 The rules of the game state who can do
what, and when they can do it.
 A player's strategy is a plan for actions in
each possible situation in the game.
Rules, Strategies, Payoffs, and
Equilibrium
 Economic situations are treated as games.
 A player's payoff is the amount that the
player wins or loses in a particular
situation in a game.
 A players has a dominant strategy if that
player's best strategy does not depend on
what other players do.
Nash Equilibrium
 Occurs when each player's strategy is
optimal, given the strategies of the other
players.
 A player's best response (or best strategy)
is the strategy that maximizes that player's
payoff, given the strategies of other
players.
 A Nash equilibrium is a situation in which
each player makes his or her best
response.
Prisoner's Dilemma
 Famous example of game theory.
 Strategies must be undertaken without the
full knowledge of what other players will
do.
 Players adopt dominant strategies, but
they don't necessarily lead to the best
outcome.
Prisoner's Dilemma
Bonnie’s Decision Tree
Economic Applications of Game
Theory
 Cheating on a cartel
 Trade wars between countries
 Advertising
 Games without dominant strategies
Cheating on a Cartel
 Cartel members' possible strategies range
from abiding by their agreement to
cheating.
 Cartel members can charge the monopoly
price or a lower price.
 Cheating firms can increase profits.
 The best strategy is charging the low price.
Cheating on a Cartel
Decision Tree for the Coca Cola
Company
Trade Wars Between Countries
 Free trade benefits both trading countries.
 Tariffs can benefit one trading country.
 Imposing tariffs can be a dominant
strategy and establish a Nash equilibrium
even though it may be inefficient.
Effects of a Tariff on Japanese
Televisions
Trade War Payoffs
Decision Tree for the United States
Advertising
 The prisoner's dilemma applies to
advertising.
 All firms advertising tends to equalize the
effects.
 Everyone would gain if no one advertised.
Advertising Payoffs
Games Without Dominant Strategies
 In many games the players have no
dominant strategy.
 Often a player's strategy depends on the
strategies of others.
 If a player's best strategy depends on
another player's strategy, he has no
dominant strategy.
A Game With No Dominant Strategy
Ma’s Decision Tree
Multiple Equilibria
 Some games have more than one Nash
equilibrium.
Multiple Equilibria
 Multiple Nash equilibria means game
theorists require extra information to
predict what will happen when playing the
game.
Payoffs in a Game with Multiple
Equilibria
Sequential Games and Credibility
 Some games are sequential.
Sequential Games and Credibility
 A sequential game is a game in which players
make at least some of their decisions at
different times.
Sequential Games and Credibility
 When the players are a monopoly and a new
firm, the new firm faces a number of
decisions beginning with whether to enter the
industry.
Sequential Games and Credibility
 Entry decision determines which side of
the decision tree is applicable.
 In the second half of the game, the
monopoly has the dominant strategy.
Sequential Games and Credibility
 A subgame perfect Nash equilibrium is a
Nash equilibrium in which every player's
strategy is credible.
 No player makes incredible threats.
A Sequential Game
Payoffs in a Sequential Game of Entry
Commitments
 Commitments are valuable.
The Benefit of Commitments
 People can benefit from being able to limit
their future actions so that they cannot do
what they would want to do in the future.
The Benefit of Commitments
 A person commits to a future action if they do
something now to limit future options or
change future incentives so that they will
have an incentive to take that action in the
future.
The Benefit of Commitments
 Commitments can provide valuable benefits
by restricting future choices in a way that
changes other people's actions to one's own
benefit.
Commitment Mechanisms
 Committing to future action is often
difficult.
 The law, social pressures, etiquette,
promises and honor all contribute to
helping people commit.
Excess Capacity as Commitment
 A monopoly firm’s excess capacity may
deter the entry of a new firm.
Game With Monopoly Investing in
Additional Capacity
Commitment in Other Games
 Factors such as the capacity to produce
help firms honor commitments.
 Firms can commit to future actions by
convincing government to regulate them.
Repeated Games
 A repeated game is a game that the same
players play more than once.
Repeated Games
 Repeated games differ form one-shot
games because people's current actions
can depend on the past behavior of other
players.
 Cooperation is encouraged.
Analysis Of Repeated Games
 In the tit-for-tat strategy, players
cooperate unless one of them fails to
cooperate in some round of the game.
 The others do in the next round what the
uncooperative player did to them in the
last round.
Experimental Evidence On Tit-For-Tat
 Evidence indicates tit-for-tat is a winning
strategy.
 The success of tit-for-tat strategy may lie
behind customs and etiquette.
Game Theory

 End of Chapter 17