Microeconomics II.

Advanced Microeconomics II
Game Theory of Pricing

Major Text
Hal R. Varian. -- 3rd edition
Nicholson & Snyder 9th edition
09/05/22 Andualem Begashaw 1
Contents
 Introduction to Game Theory

 Nash Equilibrium in Games
 Pricing in Static Games
 Entry, Exit and Strategy
 Limit Pricing
 Games of Incomplete Information

Introduction to Game Theory
Game theory involves the study of strategic
situations
Game theory models attempt to portray complex

strategic situations in a highly simplified and
stylized setting
 abstract from personal and institutional details
in order to arrive at a representation of the

situation that is mathematically tractable

Some Applications of Game Theory
The study of oligopolies (industries containing

only a few firms)
The study of cartels; e.g. OPEC
The study of externalities; e.g. using a common

resource such as a fishery.
The study of military strategies.

A game consists of
 a set of players
 a set of strategies for each player
 the payoffs to each player for every
possible list of strategy choices by the
players.

Players
Each decision-maker in a game is called a player
 can be an individual, a firm, an entire nation
Each player has the ability to choose among a

set of possible actions
The specific identity of the players is irrelevant

 no “good guys” or “bad guys”

Strategies
Each course of action open to a player is called a
strategy
Strategies can be very simple or very complex

 each is assumed to be well-defined
In non cooperative games, players are uncertain

about the strategies used by other players

Payoffs
The final returns to the players at the
end of the game are called payoffs
Payoffs are usually measured in terms
of utility
 monetary payoffs are also used
It is assumed that players can rank the
payoffs associated with a game

Two-Player Games
A game with just two players is a two-player

game.
We will study only games in which there are

two players, each of whom can choose
between only two strategies.

E.g. of a Two-Player Game
The players are called A and B.
Player A has two strategies, called “Up” and

“Down”.
Player B has two strategies, called “Left” and

“Right”.
The table showing the payoffs to both players for

each of the four possible strategy combinations is
the game’s payoff matrix.
Player B
L R
(3,9) (1,8) This is the
U game’s
Player A
D (0,0) (2,1) payoff matrix.
Player A’s payoff is shown first.

Player B’s payoff is shown second.
Player B
L R
(3,9) (1,8) This is the
U game’s
Player A
E.g. if A plays Up and B plays Right

then A’s payoff is 1 and B’s payoff is 8.
Player B
L R
(3,9) (1,8) This is the
U game’s
Player A
And if A plays Down and B plays Right

then A’s payoff is 2 and B’s payoff is 1.
Player B
L R
U (3,9) (1,8)
Player A
D (0,0) (2,1)
A play of the game is a pair such as (U,R) where

the 1st element is the strategy chosen by Player
A and the 2nd is the strategy chosen by Player B.
Player B
L R
U (3,9) (1,8)
Player A
D (0,0) (2,1)
What plays are we likely to see for this

game?

Player B
L R
(3,9) (1,8) Is (U,R) a
U likely play?
Player A
D (0,0) (2,1)

Player B
L R
(3,9) (1,8) Is (U,R) a
U likely play?
Player A
D (0,0) (2,1)
If B plays Right then A’s best reply is Down

since this improves A’s payoff from 1 to 2.
So (U,R) is not a likely play.
Player B
L R
(3,9) (1,8) Is (D,R) a
U likely play?
Player A
D (0,0) (2,1)

Player B
L R
Is (D,R) a
U (3,9) (1,8)
likely play?
Player A
D (0,0) (2,1)
If B plays Right then A’s best reply is Down.

Player B
L R
(3,9) (1,8) Is (D,R) a
U likely play?
Player A
D (0,0) (2,1)
If B plays Right then A’s best reply is Down.

If A plays Down then B’s best reply is Right.
So (D,R) is a likely play.
Player B
L R
Is (D,L) a
U (3,9) (1,8) likely play?
Player A
(0,0) (2,1)
D

Player B
L R
(3,9) (1,8) Is (D,L) a
U likely play?
Player A
(0,0) (2,1)
D
If A plays Down then B’s best reply is Right,

so (D,L) is not a likely play.
Player B
L R
(3,9) (1,8) Is (U,L) a
U likely play?
Player A
D (0,0) (2,1)

Player B
L R
(3,9) (1,8) Is (U,L) a
U likely play?
Player A
D (0,0) (2,1)
If A plays Up then B’s best reply is Left.

Player B
L R
(3,9) (1,8) Is (U,L) a
U likely play?
Player A
D (0,0) (2,1)
If A plays Up then B’s best reply is Left.

If B plays Left then A’s best reply is Up.
So (U,L) is a likely play.
Nash Equilibrium in Games
At market equilibrium, no participant has an

incentive to change his behavior
In games, a pair of strategies (a*,b*) is defined

to be a Nash equilibrium if a* is player A’s best
strategy when player B plays b*, and b* is
player B’s best strategy when player A plays a*

Nash Equilibrium
A play of the game where each strategy

is a best reply to the other is a Nash
equilibrium.
Our example has two Nash equilibria;

(U,L) and (D,R).

Player B
L R
U (3,9) (1,8)
Player A
D (0,0) (2,1)
(U,L) and (D,R) are both Nash equilibria for

the game.
Player B
L R
U (3,9) (1,8)
Player A
D (0,0) (2,1)
(U,L) and (D,R) are both Nash equilibria for the

game. But which will we see? Notice that (U,L) is
preferred to (D,R) by both players. Must we then
see (U,L) only?
The Prisoner’s Dilemma
To see if Pareto-preferred outcomes must

be what we see in the play of a game,
consider a famous second example of a
two-player game called the Prisoner’s
Dilemma.

The most famous game theory model, in

which self-interest on the part of each
player leads to a result in which all
players are worse off than they could be
if different choices were made

Gaga
S C
S (-5,-5) (-30,-1)
Dada
C (-1,-30) (-10,-10)
What plays are we likely to see for this

game?
Gaga
S C
S (-5,-5) (-30,-1)
Dada
C (-1,-30) (-10,-10)
If Dada plays Silence then Gaga’s best

reply is Confess.
Gaga
S C
S (-5,-5) (-30,-1)
Dada (-1,-30)
C (-10,-10)
If Dada plays Silence then Gaga’s best reply is

Confess.
If Dada plays Confess then Gaga’s best reply
is Confess.
Gaga
S C
S (-5,-5) (-30,-1)
Dada
C (-1,-30) (-10,-10)
So no matter what Dada plays, Gaga’s

best reply is always Confess.
Confess is a dominant strategy for Gaga.
Gaga
S C
S (-5,-5) (-30,-1)
Dada
C (-1,-30) (-10,-10)
Similarly, no matter what Gaga plays,

Dada’s best reply is always Confess.
Confess is a dominant strategy for Dada also.
Gaga
S C
S (-5,-5) (-30,-1)
Dada
C (-1,-30) (-10,-10)
So the only Nash equilibrium for this game is

(C,C), even though (S,S) gives both Dada and
Gaga better payoffs. The only Nash equilibrium
is inefficient.
Who Plays When?
In both examples the players chose
their strategies simultaneously.
Such games are simultaneous play
games.

Who Plays When?
But there are games in which one
player plays before another player.
Such games are sequential play games.
The player who plays first is the leader.
The player who plays second is the
follower.

A Sequential Game Example
Sometimes a game has more than one
Nash equilibrium and it is hard to say
which is more likely to occur.
When such a game is sequential it is
sometimes possible to argue that one of
the Nash equilibria is more likely to
occur than the other.

Player B
L R
(3,9) (1,8)
U
Player A (0,0) (2,1)
D
(U,L) and (D,R) are both Nash equilibria when

this game is played simultaneously and we have
no way of deciding which equilibrium is more
likely to occur.
Player B
L R
(3,9) (1,8)
U
Player A (0,0) (2,1)
D
Suppose instead that the game is played
sequentially, with A leading and B following. We
can rewrite the game in its extensive form.
A
U D A plays first.
B B B plays second.
L R L R
(3,9) (1,8) (0,0) (2,1)

A
U D A plays first.
B B B plays second.
L R L R
(3,9) (1,8) (0,0) (2,1)
(U,L) is a Nash equilibrium.

A
U D A plays first.
B B B plays second.
L R L R
(3,9) (1,8) (0,0) (2,1)
(U,L) is a Nash equilibrium.

(D,R) is a Nash equilibrium.
Which is more likely to occur?
A
U D A plays first.
B B B plays second.
L R L R
(3,9) (1,8) (0,0) (2,1)
If A plays U then B plays L; A gets 3.

A
U D A plays first.
B B B plays second.
L R L R
(3,9) (1,8) (0,0) (2,1)

If A plays D then B plays R; A gets 2.
A
U D A plays first.
B B B plays second.
L R L R
(3,9) (1,8) (0,0) (2,1)

If A plays D then B plays R; A gets 2.
So (U,L) is the Andualem
09/05/22
likelyBegashaw
Nash equilibrium. 48
Pure Strategies
Player B
L R
(3,9) (1,8)
U
Player A (0,0) (2,1)
D
This is our original example once more. Suppose
again that play is simultaneous.
We discovered that the game has two Nash
equilibria; (U,L) and (D,R).
Pure Strategies
Player B
L R
(3,9) (1,8)
U
Player A (0,0) (2,1)
D
Player A’s has been thought of as choosing
to play either U or D, but no combination of
both; that is, as playing purely U or D.
U and D are Player A’s pure strategies.
Pure Strategies
Player B
L R
(3,9) (1,8)
U
Player A
D (0,0) (2,1)
Similarly, L and R are Player B’s pure strategies.

Pure Strategies
Player B
L R
(3,9) (1,8)
U
Player A (0,0) (2,1)
D
Consequently, (U,L) and (D,R) are pure strategy

Nash equilibria. Must every game have at least
one pure strategy Nash equilibrium?
Pure Strategies
Player B
L R
(1,2) (0,4)
U
Player A (0,5) (3,2)
D
Here is a new game. Are there any pure

strategy Nash equilibria?

Pure Strategies
Player B
L R
(1,2) (0,4)
U
Player A (0,5) (3,2)
D
Is (U,L) a Nash equilibrium?
Is (U,R) a Nash equilibrium?
Is (D,L) a Nash equilibrium?
Is (D,R) a Nash equilibrium?
Pure Strategies
Player B
L R
(1,2) (0,4)
U
Player A (0,5) (3,2)
D
So the game has no Nash equilibria in pure
strategies. Even so, the game does have a
Nash equilibrium, but in mixed strategies.

Mixed Strategies
Instead of playing purely Up or Down, Player A

selects a probability distribution (U,1-U), meaning
that with probability U Player A will play Up and with
probability 1-U will play Down.
Player A is mixing over the pure strategies Up and

Down.
The probability distribution (U,1-U) is a mixed

strategy for Player A.
Mixed Strategies
Similarly, Player B selects a probability distribution

(L,1-L), meaning that with probability L Player B
will play Left and with probability 1-L will play Right.
Player B is mixing over the pure strategies Left and

Right.
The probability distribution (L,1-L) is a mixed

strategy for Player B.
Mixed Strategies
Player B
L R
(1,2) (0,4)
U
Player A (0,5) (3,2)
D
This game has no pure strategy Nash equilibria but
it does have a Nash equilibrium in mixed strategies.
How is it computed?
Mixed Strategies
Player B
L,L R,1-L
U,U (1,2) (0,4)

Player A
(0,5) (3,2)
D,1-U

Mixed Strategies
Player B
L,L R,1-L
U,U (1,2) (0,4)

Player A
D,1-U (0,5) (3,2)
If B plays Left her expected payoff is

2  U  5 ( 1   U ).
If B plays Right her expected payoff is
09/05/22 4  U  2( 1   U ). Andualem Begashaw 60
Mixed Strategies
Player B
L,L R,1-L
U,U (1,2) (0,4)

Player A
D,1-U (0,5) (3,2)
If 2  U  5 ( 1   U )  4  U  2( 1   U ) then
B would play only Left. But there are no

Nash equilibria in which B plays only Left.
Mixed Strategies
Player B
L,L R,1-L
U,U (1,2) (0,4)

Player A
D,1-U (0,5) (3,2)
If 2  U  5 ( 1   U )  4  U  2( 1   U ) then
B would play only Right. But there are no
Nash equilibria in which B plays only Right.
Mixed Strategies
Player B
L,L R,1-L
3
U (1,2) (0,4)
5
Player A 2
D (0,5) (3,2)
5
So for there to exist a Nash equilibrium, B must
be indifferent between playing Left or Right; i.e.
2  U  5 ( 1   U )  4  U  2( 1   U )
  U  3 / 5.
Mixed Strategies
Player B
L,L R,1-L
3
U, (1,2) (0,4)
5
Player A 2
D, (0,5) (3,2)
5
If A plays Up his expected payoff is
1   L  0  (1   L )   L .
If A plays Down his expected payoff is
0   L  3  (1   L )  3(1   L ).
Mixed Strategies
Player B
L,L R,1-L
3
U, (1,2) (0,4)
5
Player A 2
D, (0,5) (3,2)
5
If  L  3( 1   L ) then A would play only Up.
But there are no Nash equilibria in which A plays

only Up.
Mixed Strategies
Player B
L,L R,1-L
3
U, (1,2) (0,4)
5
Player A 2
D, (0,5) (3,2)
5
If  L  3( 1   L ) then A would play only
Down. But there are no Nash equilibria in which
A plays only Down.

Mixed Strategies
Player B
3 1
L, 4 R, 4
3
U, (1,2) (0,4)
5
Player A 2
D, (0,5) (3,2)
5
So for there to exist a Nash equilibrium, A
must be indifferent between playing Up or
Down; i.e.
 L  3( 1   L )   L  3 / 4 .
Mixed Strategies
Player B
3 1
L, 4 R, 4
3
U, (1,2) (0,4)
5
Player A 2
D, (0,5) (3,2)
5
So the game’s only Nash equilibrium has A

playing the mixed strategy (3/5, 2/5) and has B
playing the mixed strategy (3/4, 1/4).
Mixed Strategies
Player B
3 1
L, 4 R, 4
3 (1,2)
U, (0,4)
5 9/20
Player A 2
D, (0,5) (3,2)
5
The payoffs will be (1,2) with probability

3 3 9
 
5 4 20

Mixed Strategies
Player B
3 1
L,4 R,4
3 (1,2) (0,4)
U, 9/20 3/20
5
Player A 2
D, (0,5) (3,2)
5

3 1 3
 
5 4 20
Mixed Strategies
Player B
3 1
L, 4 R, 4
3 (1,2) (0,4)
U, 9/20 3/20
5
Player A 2 (0,5)
D, (3,2)
5 6/20

2 3 6
 
5 4 20

Mixed Strategies
Player B
3 1
L, 4 R, 4
3 (1,2) (0,4)
U, 9/20 3/20
5
Player A 2 (0,5) (3,2)
D,
5 6/20 2/20

2 1 2
 
5 4 20

Mixed Strategies
Player B
3 1
L, 4 R, 4
3 (1,2) (0,4)
U,
5 9/20 3/20
Player A 2 (0,5) (3,2)
D,
5 6/20 2/20
A’s expected Nash equilibrium payoff is
9 3 6 2 3
1  0  0  3  .
20 20 20 20 4
B’s expected Nash equilibrium payoff is
9 3 6 2 16
2  4  5  2  .
20
09/05/22 20 20 20 5 73
Andualem Begashaw
How Many Nash Equilibria?
A game with a finite number of players,

each with a finite number of pure
strategies, has at least one Nash
equilibrium.
So if the game has no pure strategy
Nash equilibrium then it must have at
least one mixed strategy Nash
equilibrium.
Pricing in Static Games
Suppose there are only two firms (A and
B) producing the same good at a constant
marginal cost (c)
 the strategies for each firm consist of
choosing prices (PA and PB) subject only to the
condition that the firm’s price must exceed c
Payoffs in the game will be determined by
demand conditions

Because output is homogeneous and
marginal costs are constant, the firm
with the lower price will gain the entire
market
If PA = PB, we will assume that the firms
will share the market equally

In this model, the only Nash equilibrium
is PA = PB = c
 if firm A chooses a price greater than c, the
profit-maximizing response for firm B is to
choose a price slightly lower than PA and
corner the entire market
 but B’s price (if it exceeds c) cannot be a
Nash equilibrium because it provides firm A
with incentive for further price cutting
Therefore, only by choosing PA = PB = c
will the two firms have achieved a Nash
equilibrium
 we end up with a competitive solution even
though there are only two firms
This pricing strategy is sometimes
referred to as a Bertrand equilibrium

The Bertrand result depends crucially
on the assumptions underlying the
model
 if firms do not have equal costs or if the
goods produced by the two firms are not
perfect substitutes, the competitive result
no longer holds

Entry, Exit, and Strategy
In previous models, we have assumed
that entry and exit are driven by the
relationship between the prevailing
market price and a firm’s average cost
The entry and exit issue can become
considerably more complex

Entry, Exit, and Strategy
A firm wishing to enter or exit a market
must make some conjecture about how
its actions will affect the future market
price
 this requires the firm to consider what its
rivals will do
 this may involve a number of strategic ploys
 especially when a firm’s information about its
rivals is imperfect
Reading Assignment
Stackelberg Games

Limit Pricing
Are there situations where a monopoly
might purposely choose a low (“limit”)
price policy to deter entry into its market?
In most simple situations, the limit pricing
strategy does not yield maximum profits
and is not sustainable over time
 choosing PL < PM will only deter entry if PL is
lower than the AC of any potential entrant

Limit Pricing
If the monopoly and the potential entrant
have the same costs, the only limit price
sustainable is PL = AC
 defeats the purpose of being a monopoly
because  = 0
Thus, the basic monopoly model offers
little room for entry deterrence through
pricing behavior
Limit Pricing and Incomplete
Information
Believable models of limit pricing must
depart from traditional assumptions
The most important set of such models
involves incomplete information
 if an incumbent monopolist knows more
about the market situation than a potential
entrant, the monopolist may be able to
deter entry
Information
Suppose that an incumbent monopolist
may have either “high” or “low”
production costs as a result of past
decisions
The profitability of firm B’s entry into
the market depends on A’s costs
We can use a tree diagram to show B’s
dilemma
Limit Pricing and Incomplete Information
1,3
Entry The profitability
High Cost
B
 of entry for
No Entry
4,0
Firm B depends
A
Entry
3,-1 on Firm A’s
Low Cost B costs which are

unknown to B
No Entry
6,0

Information
Firm B could use whatever information it
has to develop a subjective probability of A’s
cost structure
If B assumes that there is a probability of 
that A has high cost and (1-) that it has
low cost, entry will yield positive expected
profits if
E(B) = (3) + (1-)(-1) > 0
>¼
Information
Regardless of its true costs, firm A is
better off if B does not enter
One way to ensure this is for A to
convince B that  < ¼
Firm A may choose a low-price strategy
then to signal firm B that its costs are low
 this provides a possible rationale for limit
pricing

The End

Microeconomics II.

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Microeconomics II.

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Advanced Microeconomics II

Game Theory of Pricing

 Introduction to Game Theory

09/05/22 Andualem Begashaw 2

Game theory models attempt to portray complex

in order to arrive at a representation of the

09/05/22 Andualem Begashaw 3

The study of oligopolies (industries containing

The study of cartels; e.g. OPEC

The study of externalities; e.g. using a common

The study of military strategies.

09/05/22 Andualem Begashaw 4

09/05/22 Andualem Begashaw 5

Each player has the ability to choose among a

The specific identity of the players is irrelevant

09/05/22 Andualem Begashaw 6

Strategies can be very simple or very complex

In non cooperative games, players are uncertain

09/05/22 Andualem Begashaw 7

09/05/22 Andualem Begashaw 8

A game with just two players is a two-player

We will study only games in which there are

09/05/22 Andualem Begashaw 9

Player A has two strategies, called “Up” and

Player B has two strategies, called “Left” and

The table showing the payoffs to both players for

Player A’s payoff is shown first.

E.g. if A plays Up and B plays Right

And if A plays Down and B plays Right

A play of the game is a pair such as (U,R) where

What plays are we likely to see for this

09/05/22 Andualem Begashaw 15

09/05/22 Andualem Begashaw 16

If B plays Right then A’s best reply is Down

09/05/22 Andualem Begashaw 18

If B plays Right then A’s best reply is Down.

09/05/22 Andualem Begashaw 19

If B plays Right then A’s best reply is Down.

09/05/22 Andualem Begashaw 21

If A plays Down then B’s best reply is Right,

09/05/22 Andualem Begashaw 23

If A plays Up then B’s best reply is Left.

09/05/22 Andualem Begashaw 24

If A plays Up then B’s best reply is Left.

At market equilibrium, no participant has an

In games, a pair of strategies (a*,b*) is defined

09/05/22 Andualem Begashaw 26

A play of the game where each strategy

Our example has two Nash equilibria;

09/05/22 Andualem Begashaw 27

(U,L) and (D,R) are both Nash equilibria for

(U,L) and (D,R) are both Nash equilibria for the

To see if Pareto-preferred outcomes must

09/05/22 Andualem Begashaw 30

The most famous game theory model, in

09/05/22 Andualem Begashaw 31

What plays are we likely to see for this

If Dada plays Silence then Gaga’s best

If Dada plays Silence then Gaga’s best reply is

So no matter what Dada plays, Gaga’s

Similarly, no matter what Gaga plays,

So the only Nash equilibrium for this game is

09/05/22 Andualem Begashaw 38

09/05/22 Andualem Begashaw 39

In games, a pair of strategies (a,b) is defined