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Game Theory and Strategic

Behavior

BESANKO AND BRAEUTIGAM, CHAPTER 14


Nash Equilibrium

A situation in which every player chooses a strategy that


gives it the highest pay-off given the strategies chosen by the
other players in the game.

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Dominant Strategy

Dominant Strategy (DS): A strategy that is better than any


other a player might choose, no matter what strategy the
other player follows.
- There are games where there are no DS.
- When a player has a DS, that strategy will be the player’s
NE strategy.

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Dominated Strategy

Dominated Strategy: A strategy such that the player has


another strategy that gives a higher payoff no matter what the
other player does.
Example:
- Consider the competition between Honda and Toyota,
- Each firm faces the decision of whether to build a new auto
assembly plant.

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Dominated Strategy
Toyota
Build Large Build Small Do not build
Build Large 0, 0 12, 8 18, 9

Honda Build Small 8, 12 16, 16 20, 15


Do not build 9, 18 15, 20 18, 18

- Neither player has a DS.


- ‘Build large’ is a dominated strategy for both.

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Dominated Strategy

- New payoff matrix after eliminating dominated strategies:


Toyota

Build Small Do not build


Build Small 16, 16 20, 15
Honda
Do not build 15, 20 18, 18

- In this game, each player has now a DS: Build small


- The NE is (Build small, Build small)

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Finding a NE by Identifying DS and Eliminating Dominated Strategies

Whenever both players have a DS, those strategies will


constitute the NE in the game.
- If just 1 player has a DS, that strategy will be the player’s
NE strategy. We can find the other player’s NE strategy by
identifying that player’s best response to the 1st player’s
DS.
- If neither player has a DS, but both have dominated
strategies, we can often deduce the NE by eliminating the
dominated strategies and thereby simplifying the analysis
of the game.

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ACTIVE LEARNING 1
Finding the NE: Coke versus Pepsi

Here are Coke’s and Pepsi’s profits for various combinations


of prices that each firm might charge.
Coke

$10.50 $11.50 $12.50 $13.50

$6.25 66, 190 68, 199 70, 198 73, 191


Pepsi
$7.25 79, 201 82, 211 85, 214 89, 208

$8.25 82, 212 86, 224 90, 229 95, 225

$9.25 75, 223 80, 237 85, 244 91, 245

Find the NE in this game.

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ACTIVE LEARNING 1
Answers

- A price of $8.25 is a DS for Pepsi (no matter which price


Coke chooses, Pepsi’s payoff is always higher in row 3 than
in any other row).
- The other 3 prices ($6.25, $7.25 and $9.25) are dominated
strategies for Pepsi.
- These dominated strategies will be eliminated.

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ACTIVE LEARNING 1
Answers

Coke
$10.50 $11.50 $12.50 $13.50

$6.25 66, 190 68, 199 70, 198 73, 191

$7.25 79, 201 82, 211 85, 214 89, 208


Pepsi
$8.25 82, 212 86, 224 90, 229 95, 225

$9.25 75, 223 80, 237 85, 244 91, 245

- Coke’s best response to Pepsi’s DS (price of $8.25) is to set


a price of $12.50.
- Then, NE in this game is a price of $8.25 for Pepsi and a
price of $12.50 for Coke.

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Games with More Than One NE
- So far, we only studied games that have a unique NE, but
some games have more than one NE.
- 2 famous examples:
 Battle of the sexes.
 Game of Chicken.

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Games with more than one NE
1. Battle of the sexes
- Two players: husband and wife.
- Strategies: go to a football game / go to the theater.
- Each player prefers to be with the other.
- What are the NE in this game?
Wife

Football Theater

Husband Football 3, 1 0, 0

Theater 0, 0 1, 3

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Games with More Than One NE
2. The game of Chicken
- Two players: 2 teenagers. They want to prove their manhood
to their friends. They drive toward each other at vertiginous
speed. The one that didn’t swerve becomes a hero, while the
other loses face (he is a ‘Chicken’). If both swerve, nothing
gets proven: no gain. If neither swerves, they crach into each
other.
- Strategies: go straight / swerve.

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Games with More Than One NE
What are the NE in the game of Chicken?
Teenager 2

Go straight Swerve
Go straight - ∞, - ∞ 10, -10
Teenager 1
Swerve -10, 10 0, 0

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Games with More Than One NE

- In the ‘Battle of the Sexes’, there are 2 Nash equilibria:


(Football, Football) and (Theater, Theater).

- In the game of ‘Chicken’, there are 2 Nash equilibria: (Go


straight, Swerve) and (Swerve, Go straight).

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Finding All of the Nash Equilibria in a Game

Step 1: Identify DS or dominated strategies and try to simplify


the game.
Step 2: Find player 1’s best response to each of the possible
strategies of player 2.
Step 3: Find player 2’s best response to each of the possible
strategies of player 1.
Step 4: NE occurs in cells with both players 1 and 2 best
responses.

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Finding All of the Nash Equilibria in a Game

What are the NE in the following game?


Player 2

Strategy D Strategy E Strategy F


Strategy A 4, 2 13, 6 1, 3

Strategy B 3, 10 0, 0 15, 2
Player 1
Strategy C 12, 14 4, 11 5, 4

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Finding all of the Nash Equilibria in a game

Step 1: None in this game.


Step 2: Find player 1’s best response to each of the possible
strategies of player 2.
Step 3: Find player 2’s best response to each of the possible
strategies of player 1.
Step 4: 2 NE in this game: (Strategy A, Strategy E) and
(Strategy C, strategy D)

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Mixed Strategies
1. Pure strategy: A specific choice of strategy from the player’s
possible strategies in a game.
2. Mixed strategy: A choice among 2 or more pure strategies
according to pre-specified probabilities.
Example
In the game of ‘battle of the sexes’,
- Go to a football game and go to the theater are pure strategies.
- Go to a football game with probability ½ and go to the theater with
a probability ½ is an example of mixed strategies.

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Mixed Strategies
- Consider the following game: a tennis match between Roger Federer and Rafael
Nadal:

Nadal

q 1-q
l r

p L 50, 50 80, 20
Federer
1-p R 90, 10 20, 80

- There is no NE in pure strategies.


- What is the NE in mixed strategies?
- Hint: To find Nadal’s NE mix (q, 1 – q), look at Federer’s payoffs.

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Mixed Strategies

- If Federer plays L, his payoff will be 50 q + 80 (1-q)


- If Federer plays R, his payoff will be 90 q + 20 (1-q)
- If Federer is mixing in NE, he must be indifferent between L and R
(i.e. the payoffs must be equal) 50 q + 80 (1-q) = 90 q + 20 (1-q),
q = 0.6.
- If Nadal plays l, his payoff will be 50 p + 10 (1-p)
- If Nadal plays r, his payoff will be 20 p + 80 (1-p)
- If Nadal is mixing in NE, he must be indifferent between l and r (i.e.
the payoffs must be equal) 50 p + 10 (1-p) = 20 p + 80 (1-p),p =
0.7
- Nash Equilibrium = [ (0.7, 0.3); (0.6, 0.4)]

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ACTIVE LEARNING 2
Mixed Strategies

Suppose that instead of (50, 50), the payoffs are(30, 70). Find
the new NE in mixed strategies.
Nadal

q 1- q
l R
Federer
p L 30, 70 80, 20

1- p R 90, 10 20, 80

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ACTIVE LEARNING 2
Answers
- If Federer plays L, his payoff will be 30 q + 80 (1-q)
- If Federer plays R, his payoff will be 90 q + 20 (1-q)
- If Federer is mixing in NE, he must be indifferent between L and R (i.e. the
payoffs must be equal): 30 q + 80 (1-q) = 90 q + 20 (1-q), q = 0.5
- If Nadal plays l, his payoff will be 70 p + 10 (1-p)
- If Nadal plays r, his payoff will be 20 p + 80 (1-p)
- If Nadal is mixing in NE, he must be indifferent between l and r (i.e. the
payoffs must be equal): 70 p + 10 (1-p) = 20 p + 80 (1-p), p = 7/12
- Nash Equilibrium = [(7/12, 5/12); (0.5, 0.5)]

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Mixed Strategies
Consider the final match of the Women’s World Cup in 1999 between
the U.S. and China.
U.S. kicker
Aim Right Aim Left

Dive to kicker’s Right 0, 0 -10, 10


Chinese Goalie Dive to kicker’s Left -10, 10 0, 0

- The pure strategies are ‘aim right’ and ‘aim left’.


- This game doesn’t have a NE in pure strategies but it has a NE in a mixed
strategy.
- Even though some games might have no NE in pure strategies, every game
has at least 1 NE in mixed strategies.

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Mixed Strategies
- The U.S. kicker should ‘aim right’ with proba ½ and ‘aim left’
with probability ½.
- The Chinese goalie should ‘dive right’ with proba ½ and ‘dive
left’ with probability ½.
- If the U.S. kicker believes that the Chinese goalie will dive
right or left with probability ½, the U.S. kicker can do no better
than to choose to aim left or right with probability ½.
- The same thing for the Chinese goalie …
- Hence, when the players choose these mixed strategies, each is
doing the best it can given the actions of the other.

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ACTIVE LEARNING 3
Mixed Strategies
Consider the following mixed strategies in the World Cup
game:
- The U.S. kicker aims right with probability ¾ and left with
probability ¼.
- The Chinese goalie dives right with probability ¾ and left
with probability ¼.
Is this a NE in mixed strategies?

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ACTIVE LEARNING 3
Answers
- If the kicker aims right with probability ¾ and left with
probability ¼, the goalie’s best response is to dive to kicker’s
right with probability ¾ and to kicker’s left with probability ¼ .
- If the goalie dives to the kicker’s right with probability ¾ and
left with probability ¼, the kicker’s best response is to aim left
with probability ¾ (not ¼) and right with probability ¼ (not
¾).
- Thus, this is not a NE in mixed strategies.

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How to Find all the NE in a Simultaneous-Move Game with 2
Players
1. Look for DS. If both players have a dominant strategy, these constitute their NE
strategies.
2. If one player has a DS, this is the player’s NE strategy. To identify the other
player’s NE strategy, look for his best response.
3. If neither player has a DS, search for dominated strategies. Then, successively
eliminate each player’s dominated strategies to simplify the game and look for NE
strategies.
4. If neither player has dominated strategies, identify Player 1’s best response to
each of Player 2’s strategies and then identify Player 2’s best response to each of
Player 1’s strategies. NE occurs in cells with both players 1 and 2 best responses.
5. If the approach in the previous step does’nt bring out any pure strategy NE, i.e.
if the game doesn’t have a NE in pure strategies, look for an equilibrium in mixed
strategies.

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The Repeated Prisoner’s Dilemma

- The prisoners’ dilemma: the individual pursuit of profit maximization


doesn’t necessarly result in the maximization of the collective profit of a
group of players.
- However, the prisoners’ dilemma is a one-shot game. What would be the
result if the game was played over and over again by the same players?
Player 2

Cheat Cooperate

Player 1 Cheat 5, 5 14, 1


Cooperate 1, 14 10, 10

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The Repeated Prisoner’s Dilemma

- Suppose that the 2 players will be playing the game again and again. In
this case, it is possible that they might achieve an equilibrium in which
they cooperate.

- Suppose that Player 1 believes that Player 2 will apply the following
strategy: Start off choosing cooperate and continue to do so as long as
Player 1 cooperates. If Player 1 cheats, Player 2 will cheat forever after
(Grim trigger strategy).

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The Repeated Prisoner’s Dilemma

- If Player 1 cooperates today and in all subsequent periods, he will receive a stream of
payoffs equal to 10 per period.
- If Player 1 cheats today, he has a payoff of 14 now but a payoff of 5 in all subsequent
periods.
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The Repeated Prisoner’s Dilemma

- Should players cooperate or not?


- To answer this question, we need additional information about
time preference: how Player 1 evaluates current versus future
payoffs?
- If Player 1 cares more about future payoffs than about current
payoffs, he will prefer continued cooperation to cheating (the same
applies to Player 2).
- There are factors affecting the likelihood that players will
cooperate in a repeated prisoners’ dilemma….

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The Repeated Prisoner’s Dilemma

The likelihood of a cooperative outcome increases under these conditions:


- The players are patient: they value payoffs in future periods almost as
much as payoffs in the current period.
- Interactions between the players are frequent: this implies that the
length of a ‘period’ is short and that the one-shot benefit to cheating
accumulates over a short period of time.
- Cheating is easy to detect: this has the same effect as shortening the
length of the period, a firm cannot get away with cheating for very long.
- The one-time gain from cheating is relatively small.

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The Repeated Prisoner’s Dilemma

What lesson can be drawn from the repeated prisoners’ dilemma?


- In competitive framework, anticipating the reactions of the competitors is essential.
- Example: a business firms that cuts price in order to increase its market share must
anticipate whether its price cut will be detected, whether its competitor will respond
by matching the price, and if so, how long the competitor will take to match.
- By ignoring the possibility of competitive responses, the firm runs the risks of:
1. Overestimating the potential benefits from non-cooperative behavior.
2. Set off a costly price war.
e.g. of the cigarette price war in 1993 between Philip Morris and B.A.T.

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Sequential-Move Games and Strategic Moves

- Sequential-move Game: one player (the first mover) takes an action


before another player (the second mover). The second mover observes
the action taken by the first mover before it decides what action it
should take.

- The ability to move first in a sequential-move game can sometimes


have significant strategic value.

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Analyzing Sequential-Move Games
- Recall the simultaneous-move capacity expansion game between Toyota and

Honda for which the NE was (build small, build small).


Toyota
Build Large Build Small Do not build
Build Large 0, 0 12, 8 18, 9
Honda Build Small 8, 12 16, 16 20, 15
Do not build 9, 18 15, 20 18, 18
- Now suppose that Honda can make its capacity decision before Toyota decides
what to do (perhaps because it has accelerated its decision-making process).
- This is a sequential-move game in which Honda is the first mover and Toyota is
the second mover. To analyze this game, we use a game tree.

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Analyzing Sequential-Move Games

Game tree: a diagram that shows the different strategies that each player can follow
in a game and the order in which those strategies get chosen.

The game tree for the the sequential-move capacity expansion game between Toyota
and Honda is as follows:

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Analyzing Sequential-Move Games

To analyze the game tree, we will use the backward induction process.
Backward induction: a procedure for solving a sequential-move game by starting
at the end of the game tree and finding the optimal decision for the player at each
decision point.
In this example, we must find Toyota’s optimal decision for each of the 3 choices
Honda may make:
- If Honda chooses ‘build large’, Toyota’s best response is ‘do not build’.
- If Honda chooses ‘build small’, Toyota’s best response is ‘build small’.
- If Honda chooses ‘do not build’, Toyota’s optimal choice is ‘build small’.

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Analyzing Sequential-Move Games

- Which strategy will Honda choose?


- Honda will choose the strategy that gives it the highest profit given Toyota’s
optimal response:
1. If Honda chooses ‘build large’, given that Toyota’s best reponse is ‘do not
build’, Honda’s profit will be $18 million.
2. If Honda chooses ‘build small’, given that Toyota’s best reponse is to ‘build
small’, Honda’s profit will be $16 million.
3. If Honda chooses ‘do not build’, given that Toyota’s best reponse is to ‘build
small’, Honda’s profit will be $15 million.
- So Honda will choose to ‘build large’ (because it is the strategy that gives it the
highest profit).
- The NE in this game is ‘build large’ (for Honda) and ‘do not build’ (for Toyota).

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Analyzing Sequential-Move Games

- The NE of the sequential-move game differs from that of the


simultaneous-move game (both firms choose ‘build small’).
- Recall that when Honda and Toyota made their capacity choices
simultaneously, ‘build large’ was a dominated strategy.
- Why is Honda’s behavior so different when it can move first?
- Because Toyota can see what Honda has done and Honda counts on a
rational response by Toyota to whatever action it chooses.
- By committing to a large capacity expansion, Honda puts Toyota in a
position where the best it can do is ‘not build’.

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ACTIVE LEARNING 4
An entry game
- Suppose you own a firm that is considering entry into the digital camera business, where
you will compete head to head with Kodak which can react in one of two ways: it can start
a price war or it can be accommodating. You can enter this business on a large or a small
scale.

- The following table shows the different payoffs.


Kodak Accommodate Price War

Small 4, 20 1, 16

Large 8, 10 2, 12
You

1. What is the NE in the simultaneous-move game?


2. Suppose that you can commit to your scale of operation in advance, before Kodak
decides what to do. What is the NE in the sequential –move game?

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ACTIVE LEARNING 4
Answers

1. ‘Large’ is a dominant strategy for you and the best response of Kodak will
be to start a ‘price war’. So the NE in the the simultaneous-move game is
(Large, Price war).

2. To find the NE in the sequential-move game, we have to draw the game


tree.

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ACTIVE LEARNING 4
Answers

If you choose ‘small’, Kodak’s optimal response will be to


‘accommodate’. But if you choose ‘large’, Kodak’s optimal response will
be to launch a ‘price war’. In this case, the strategy that gives you the
highest profit is ‘small’. So the NE in this sequential-move game is for
you to enter on a ‘small’ scale and for Kodak to ‘accommodate’.

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The Strategic Value of Limiting one’s Options
- In the sequential-move capacity expansion game, Honda committed in advance
to a particular course of actions whereas Toyota had the flexibility to respond to
Honda.
- Honda’s equilibrium profits were twice as large as Toyota’s. The firm that tied its
hand in advance fared better than the firm that maintained flexibility.
- Strategic moves that seemingly limit options can actually make a player better off
(Inflexibility can have a value).
- Strategic moves are actions that a player takes in a early stage of a game that
alter the player’s behavior and the other players’ behavior later in the game in a
way that is favorable to the first player.
- Example of strategic move: By committing in advance to the more aggressive
strategy of building a large plant, Honda makes it less attractive for Toyota to
expand its capacity.

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The Strategic Value of Limiting one’s Options

Examples of strategic moves:


1. In Politics:
- Some governments have for many years maintained a policy that they
will not under any circumstances negotiate with terrorists
2. In Business:
- How to position a product in the marketplace (mass market versus high-
end niche)?
- Should a firm make its product compatible with those of its competitors?

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The Strategic Value of Limiting one’s Options
The strategic move must be:
1. Visible
2. Understandable
3. Irreversible (to be credible)
For example, in the capacity expansion game,
- Toyota must observe and understand that Honda has made the commitment to
‘build large’. Otherwise, this move will not affect Toyota’s decision making.
- Toyota must believe that Honda will not back down from its commitment to
build a large plant. Honda’s ideal course of action is to bluff Toyota into
believing that it intends to choose ‘build large’, thereby causing Toyota to
choose ‘do not build’, but then to actually choose ‘build small’ (because it will
have a higher profit $20 million vs $18 million).

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The Strategic Value of Limiting one’s Options

What makes a strategic move hard to reverse?

1. The creation of specialized assets (assets that can’t be easily


redeployed to alternative uses)
2. Contracts
3. Public announcements of intentions to take actions

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