Chapter 16 “Game theory is the study of how people

behave in strategic situations. By ‘strategic’

Oligopoly we mean a situation in which each person,
when deciding what actions to take, must
and consider how others might respond to that
action.”

Game Theory

Oligopoly Oligopoly
• “Oligopoly is a market structure in which only a few • “Figuring out the environment” when there are
sellers offer similar or identical products.” rival firms in your market, means guessing (or
• As we saw last time, oligopoly differs from the two ‘ideal’ inferring) what the rivals are doing and then
cases, perfect competition and monopoly. choosing a “best response”
• In the ‘ideal’ cases, the firm just has to figure out the
environment (prices for the perfectly competitive firm, • This means that firms in oligopoly markets are
demand curve for the monopolist) and select output to playing a ‘game’ against each other.
maximize profits • To understand how they might act, we need to
• An oligopolist, on the other hand, also has to figure out the understand how players play games.
environment before computing the best output.
• This is the role of Game Theory.
 Some Concepts We Will Use Strategies
• Strategies • Strategies are the choices that a player is allowed
• Payoffs to make.
• Sequential Games • Examples:
• Simultaneous Games – In game trees (sequential games), the players choose
paths or branches from roots or nodes.
• Best Responses – In matrix games players choose rows or columns
• Equilibrium – In market games, players choose prices, or quantities,
• Dominated strategies or R and D levels.
– In Blackjack, players choose whether to stay or draw.
• Dominant Strategies.

Sequential Games A Sequential Game

A
• A sequential game is a game that is played
B A
in strict order.
• One person makes a move, then another
B A
sees the move and then she moves. A
• Examples: A
– Chess and checkers, A
– Nim B
– Entry games by firms. A
 Simultaneous Games A Matrix Game
• Simultaneous games occur when players have to \ Player Left Right
make their strategy choices without seeing what Player \ Two
their rivals have done.
• Note: These do not literally have to be One \
simultaneous. Up
• Examples:
– Rock, paper scissors, Snap
– Pricing games by rivalrous firms Down
– R and D games by firms

Payoffs Payoffs
• Payoffs describe what a player gets when she • More often, though, payoffs can vary a lot.
plays the game.
• To fully describe a game, we need to
• In some cases, we do not have to be very precise. explain the consequences of every move by
• For example, some games are “zero-sum”, when every player.
one person wins, another loses.
• Then it doesn’t really matter what number we
• Examples:
assign. – Profits for firms
• A winner could get 1 and a loser, -1. Or a winner – Prizes (first, second third) in competitions
could get, say, 15 and the loser -15. – Inventions in R and D games.
 A Sequential Game with Payoffs Sequential Game
Price
High (5,24) • In the above game, the first number refers to
r Low
Price the (dollar) payoff for the first mover, the
E nte (-10, 20) second is the payoff for the second mover.
B Pr ice
h
Hig (0, 27)
No
t En L ow (0, 23)
ter Price
A

Consider a Pricing Game Between

Two Firms B
• Firms price simultaneously. LOW(P = 1) HIGH(P = 2)
• They may price High or Low
LOW( P = 1) 4, 4 6, 3
• Both Pricing High yields the highest profits.
• But each wants to cheat. A HIGH(P = 2) 3, 6 5, 5
 Simultaneous Game Payoffs Equilibrium
• In the above game, the first number refers to • Once we have described strategies and
the Row player’s payoffs (the number of payoffs, we can go ahead and try to predict
years in prison) how a player will play a game.
• The second number refers to the Column • But where do we start?
player’s payoffs (the number of years in • “Equilibrium” is the term game theorists use
prison). to describe how the game will (likely?) be
played.

Equilibrium
• We will focus on two types of equilibrium: “A dominated strategy is any strategy such
• Elimination of Dominated Strategies that there is some other strategy that always
• Nash Equilibrium does better for a player in a game regardless
of the strategies chosen by other players.”
Elimination of Dominated Strategies
B
• If Strategy A always gives a player a lower payoff LOW(P = 1) HIGH(P = 2)
than Strategy B, no matter what the rivals do, then
it seems foolish ever to use A. LOW( P = 1) 4, 4 6, 3
• One way to simplify a game, and see if we can
predict what a player will do, is eliminate all A HIGH(P = 2) 3, 6 5, 5
dominated strategies and see what we have left.
• Pricing High is a dominated by pricing Low for
Firm A.

B
LOW(P = 1) HIGH(P = 2)

Pricing High is also dominated by LOW( P = 1) 4, 4 6, 3

pricing Low for Firm B.
A HIGH(P = 2) 3, 6 5, 5
 B
LOW(P = 1) HIGH(P = 2)

The only equilibrium outcome is LOW( P = 1) 4, 4 6, 3

both Firms pricing Low.
A HIGH(P = 2) 3, 6 5, 5

Big Games B
LEFT MIDDLE RIGHT
• Eliminating dominated strategies can make
solving big games a lot easier: TOP 6, 2 10,2 7,3

CENTER 5, 3 9,1 6, 1
A
BOTTOM 4, 2 8, 1 3,7
 Equilibrium B
LEFT MIDDLE RIGHT
• When the elimination of dominated
strategies leads to a single pair of strategies, TOP 6, 2 9, 3 5, 1
then we call this an equilibrium of a game.
• Some games, however, do not have CENTER 5, 3 10, 2 6, 1
dominated strategies, or after elimination, A
do not lead to a single pair of strategies.
BOTTOM 4, 2 8, 1 7, 3
• For example, the next game has no
dominated strategies.

Nash Equilibrium
• John Nash, the celebrated mathematician (Nobel
Prize, A Beautiful Mind) became famous for
suggesting how to solve this problem.
• A Nash equilibrium is a situation in which
economic actors interacting with one another each
choose their best strategy given the strategies that
all the other actors have chosen
 Nash Equilibrium
• A Best Response to a rival player’s strategy
s, is a strategy choice that, assuming the
rival plays s is the payoff maximizing
choice.
• A Nash equilibrium is a pair of strategies
that are best responses to each other.

Some Games may have many Nash Some Games May Have No Nash
equilibria. Equilibria (in non-random strategies)
B
B
LEFT RIGHT
LEFT RIGHT

A TOP 0, 1 -2, 0 A TOP 0, 0 0, -1

BOTTOM -3, -1 -1, 0
BOTTOM 1, 0 -1, 3
 Sequential Games and Backward
Induction
A sequential game is a game in which players A sequential game is a game in which players
make at least some of their decisions at make at least some of their decisions at
different times. different times.
• Sequential games can almost always be
solved by ‘Backward Induction’
• This is like doing sequential elimination of
dominated strategies starting from the end
of the game going to the beginning.

Nim Version 1
• Start with a pile of matches 2 First
• Take turns. When it is your turn, you can 3
take either 1 or 2 matches from the pile. 4
• If it is your turn and there is just 1 match 5
left in the pile, you lose. 6
7
8
2 First 2 First
3 First 3 First
4 4 Second
5 5
6 6
7 7
8 8

2 First 2 First
3 First 3 First
4 Second 4 Second
5 First 5 First
6 6 First
7 7
8 8
2 First 2 First
3 First 3 First
4 Second 4 Second
5 First 5 First
6 First 6 First
7 Second 7 Second
8 8 First

Nim Version 2 NIM Version 3

• Start with two piles of matches • Pearls Before Swine
• Take turns. When it is your turn, you can • http://www.transience.com.au/pearl.html
take 1 or more matches from either pile.
• You are not allowed to take matches from
both piles.
• If it is your turn and there is just 1 match
left in one pile and no matches left in the
other pile, you lose.
 Addition Game
90 – 99 First
Two players, A and B take turns choosing a number
between 1 and 10 (inclusive). A goes first. The
cumulative total of all the numbers chosen is
calculated as the game progresses. The player
whose choice takes the total to exactly 100 is the
winner.

90 – 99 First 90 – 99 First
89 Second 89 Second
79 – 88 First
90 – 99 First 90 – 99 First
89 Second 89 Second
79 – 88 First 79 – 88 First
78 Second 78 Second
68 – 77 First

90 – 99 First 90 – 99 First
89 Second 89 Second
79 – 88 First 79 – 88 First
78 Second 78 Second
68 – 77 First 68 – 77 First
67 Second 67 Second
……….
1 Second
 i ce (5, 24) uc e (-5, -5)
h Pr Prod
A Hig A
Low e Not
t er Price d uc Prod
En
(-10, 20) Pro uc e (100, 0)
B B
No No
t ice (0, 27) t ce (0, 100)
En h Pr Pro u
ter H ig d uce Prod
A L ow A Not
Price (0, 23) Pro duce (0, 0)
Note: B’s profits are shown first Note: B’s profits are shown first

e (-5, 5)
Prod
uc Bargaining
A
e Not January $120 Firm
d uc Prod
Pro uc e (100, 0)
February $80 Union
B
No March $50 Firm
t Pro ce (0, 110)
u
d uce Prod
April $20 Union
A Not
Produ
Note: B’s profits are shown first
ce (0, 0)
• Solve this problem by going to the end of the • In February, Union must offer Firm at least $30; if
game and working backward. Union offers less, Firm will reject the offer and the
• In April, Union will ask for $20, leaving Firm strike will continue. Therefore in March Union
with $0. will receive $80 - $30 = $50.
• In March, Firm must offer Union at least $20; if • In January, Firm must offer Union at least $50; if
Firm offers less, Union will reject the offer and the Firm offers less, Union will reject the offer and the
strike will continue. Therefore in March Firm will strike will begin. Therefore in January the Firm
receive $50 - $20 = $30. will receive $120 - $50 = $70.

A
A • Backward induction
B

B A • Subgame perfect Nash equilibrium

A
A
A
B
A
 Chapter 16 Oligopoly and Game Theory
• Simultaneous move games • Sequential games
– Rock-scissors-paper – Chess, checkers
• Backwards induction
• Dominant strategy
• Credible threats
– Prisoner’s dilemma
• Examples:
– Oligopoly -- firms choose quantities
– Nim
• Nash equilibrium – Addition Game
– Number of Nash equilibria – Entry
– Government subsidies
– Labor Negotiations

A Simultaneous Game with Payoffs

B (The Prisoner’s Dilemma Game)
Confess Not Confess Confess Not Confess

Confess 8, 8 0, 20 Confess 8, 8 0, 20
A A
Not confess 20, 0 1, 1 Not confess 20, 0 1, 1
 Not Confess is Dominated by Not Confess is Dominated by
Confess for Player A. Confess for Player B.
B B
Confess Not Confess Confess Not Confess

Confess 8, 8 0, 20 Confess 8, 8 0, 20

A Not confess 20, 0 1, 1 A Not confess 20, 0 1, 1

The Only Outcome that Remains is

Confess, Confess.
B
Confess Not Confess

Confess 8, 8 0, 20

A Not confess 20, 01 1, 1

 NIKE

ASICS H M L LL
H 60,60 36,70 36,35 0,20
M 70,36 50,50 30,35 16,19
L 35,36 35,30 25,25 15,18
LL 20,0 19,16 18,15 14,14

Pricing Game

Server
Receiver Left Right
Backhand -1,1 1,-1
Forehand 1,-1 -1,1
Tennis Serve Game