Chapter 10

Game theory and strategic behavior

Game Theory
• Game theory was pioneered by the mathematician John Von Neumann and the economist Oskar Morgensten in 1944. • It is an instrument used to analyze cooperation and conflicts between firms in oligopolistic markets. • In general, game theory is concerned with the choice of the best or optimal strategy in conflict situations.

• Game theory can help a firm determine the conditions under which lowering its price would not trigger a ruinous price war. • Game theory would help us understand why cheating leads to the collapse of a cartel.

The features of a game
• Every game theory model includes: The players Strategies The payoffs

The players
• There are the decision-makers.

The strategies
• These are the actions available to each player

• The payoff is the outcome or consequence of each action

• We distinguish between a zero-sum games and a nonzero-sum games

A Zero-sum games
• It is one in which the gain of one player comes at the expense and is exactly equal to the loss of the other player. • Example: If firm A increases its market share by 10% and firm B loses 10% of its market share.

A nonzero sum game
• It is one in which the gains of one player do not come at the expense of the other player. • Example: If firm A and Firm B increase their profits as a result of one action.

Dominant Strategy
• The dominant strategy is the optimal choice for a player no matter what the other player does.

Payoff matrix for an advertising game
Firm B Advertise Advertise Firm A Don’t advertise (2, 5) (3, 2) (4, 3) Don’t advertise (5, 1)

The Nash equilibrium
• Not all games have a dominant strategy for each player. • It is the situation in where each player chooses his or her optimal strategy, given the strategy chosen by the other player.

Payoff matrix for the advertising game
Firm B advertise (4, 3) advertise Firm A don’t (2, 5) (6, 2) don’t (5, 1)

The prisoner’s Dilemma
Individual B

Confess confess Confess
Individual A


(5, 5) (10, 0)

(0, 10) (1,1)

Don’t confess

Price competition and the prisoner’s dilemma
Firm B

Low price Low price (2, 2)
Firm A

High price (5, 1) (3, 3)

(1, 5) High price

In-class problems
• Problem #5 page 426 • Problem #8 page 426

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