Microeconomics II Notes on Game Theory Compiled by: Mesfin A.

CHAPTER FIVE

INTRODUCTION TO GAME THEORY

1. Introduction

In the oligopoly market we noted that competition is intense. That is, firms must consider the likely

responses of competitors when they make strategic decisions about price, advertising, and other

variables. In other words, the actions and reactions of a firm depend on the move and countermove

of the other firm just like a game. Thus the development and application of game theory is one of the

most exciting areas in microeconomics. This unit explains some of this theory and show how firms

can make strategic moves that give them an advantage over their competitors.

2. Definition of a game
Games are played in business, politics, diplomacy and wars. The word game may convey an

impression that the subject is not important in the larger schemes of things –that it deals with trivial

pursuits such as gambling and sports when the world is full of more weighty matters such as war,

business, education, career and relationships. Actually all these weighty matters are games.

Game theory is a branch of applied mathematics. Game theory is the science of rational behavior

in interactive situation. Game is the science of strategic decision making. Any situation in which

individuals must make strategic choices and in which the final outcome will depend on what each

person chooses to do can be viewed as a game. Game is an action where there are two or more

mutually aware players and the outcome for each depends on the action of all.

The reason for spending time on game theory is that it is a tool designed for investigating the

behavior of rational agents in setting for which each agent‟s best action depends upon what other

agents are expected to do. As a result game theory will prove to be very useful in investigating firm

behavior in oligopolies and more generally, in providing insight concerning the strategic behavior of

firms. The game theory can help an oligopoly firm to choose the course of action. For example, the

best price to charge, the optimum degree of product differentiation, or the best level of advertising)

that maximizes its benefit or profit after considering all possible reactions of its competitors.

Page 1 of 16
Microeconomics II Notes on Game Theory Compiled by: Mesfin A.

3. The basic elements of a game

The strategic form (normal form) of a game describes an economic setting by three elements:

1. Players: Each decision maker in a game is called a player. These players can be individuals

(poker game), firms (as in the Oligopolistic markets), or entire nation (as in the military

conflict).

2. Strategies: Each course of action open to a player during a game is called a strategy.

Strategy is a decision rule of players. A strategy tells a player how to behave in the settings

being modeled or is a decision rule that instructs a player how to behave over the course of

the game.

3. Payoffs: The final return to the players of a game at its conclusion is called “payoffs”.

Example the Payoffs for the firms can be profit. A player‟s payoff function describes how it

evaluates different strategies. That is, given the strategies chosen by all players, a player‟s

payoff function tells him his state of wellbeing (or welfare or utility) from players having

played those strategies. It is the objective, usually numerical, that a player in a game aims to

maximize.

4. Fundamental Assumptions of game

Game theoretic analysis is built on two fundamental assumptions: These are

1. Rationality: game theory assumes that players are interested in maximizing their

payoffs.

2. Common Knowledge: all players know the structure of the game and that their

opponents are rational.

5. Types of Games
The economic games that firms play can be either cooperative or non-cooperative. A game is

cooperative if the players can negotiate binding contracts that allow them to plan joint strategies. A

game is non-cooperative if negotiation and enforcement of a binding contract are not possible.

An example of a cooperative game is the bargaining between a buyer and a seller over price of a

commodity. If the commodity costs Birr 100 to produce and the buyer values the commodity at Birr
Page 2 of 16
Microeconomics II Notes on Game Theory Compiled by: Mesfin A.

200, a cooperative solution to the game is possible, because an agreement to sell the commodity at

any price between 101 and 199 will maximize the sum of the buyer‟s consumer surplus and the

seller‟s profit, while making both parties better off.

Another cooperative game can be the negotiation of two firms in an industry for a joint investment to

develop a new technology. If the firms can sign a binding contract to divide the profits from their

joint investment, a cooperative outcome that makes both parties better off is possible. An example of

a non-cooperative game is a situation in which two competing firms take each other‟s likely

behavior into account and independently determine a pricing or advertising strategy to win market

share.

6. Dominant strategies
In any game each player has his own strategy that enables him to win the game. That means the

game‟s likely outcome depends on the strategy the player follows. Thus knowing the strategy helps

us determine how the rational behavior of each player will lead to an equilibrium solution.

Before we go to look how a certain game is played we define the concept of a „dominant strategy‟.

A dominant strategy is that strategy that is optimal for a player no matter what an opponent does.

The following example illustrates this in a duopoly setting. Suppose firms A and B sell competing

products and are deciding whether to undertake advertising campaigns. Each firm, however, will be

affected by its competitor‟s decision. The possible outcomes of the game are illustrated by the payoff

matrix in the table below.

Firm B Table 5.1:

Advertise Don’t Advertise
Dominant Strategy
Advertise 10,5 15,0
Firm A Don’t Advertise 6,8 10,2

The payoff matrix summarizes the possible outcomes of the game; the first number in each cell is the

payoff to firm A and the second is the payoff to firm B. We can observe from this payoff matrix that

if both firms decide to advertise, firm A will make profits of 10, and firm B will make profits of 5. If

firm A advertises and firm B doesn‟t, firm A will earn 15, and firm B will earn zero.

Page 3 of 16
Microeconomics II Notes on Game Theory Compiled by: Mesfin A.

Now let us look the dominant strategy of each firm.

When firm B chooses to advertise: When firm A chooses to advertise:
 Firm A will get a profit of 10 if it advertises  Firm B will get a profit of 5 if it advertises
 Firm A will get a profit if 6 if it does not advertise Firm B will get a profit if 0 if it does not advertise.
Similarly, if firm B chooses not to advertise: Similarly, if firm A chooses not to advertise:
 Firm A will get a profit of 15 if it advertises  Firm B will get a profit of 8 if it advertises
 Firm A will get a profit of 10 if it do not advertises Firm B will get a profit of 2 if it do not advertises

First, consider firm A.

Firm A should clearly advertise because no matter what firm B does, firm A does best by advertising

(if firm B advertises, A earns a profit of 10 if it advertises, but only 6 if it doesn‟t). And if B dose not

advertise A earns 15 if it advertises, but only 10 if it doesn‟t).

Thus, advertising is a dominant strategy for firm A.

For firm B

The same is true for firm B; no matter what firm A does, firm B does best by advertising. Therefore,

assuming that both firms are rational, we know that the outcome for this game is that both firms will

advertise. Therefore, the equilibrium strategy mix of the above game is (advertise, Advertise) and

the equilibrium profit payoff is (10, 5). This outcome is easy to determine because both firms have

dominant strategies.

7. The Nash Equilibrium Concept

Equilibrium Concept: An equilibrium concept is a solution to a game. The equilibrium concept

identifies, out of the set of all possible strategies, the strategies that players are actually likely to

play. Solving equilibrium is similar to making a prediction about how the game will be played.

The Nash Equilibrium

It should be noted that by identifying the dominant strategies it is possible to arrive the outcome of

the game because dominant strategies are stable. However, dominant strategy equilibriums do not

happen all the time. One or more of the players might not have a dominant strategy. Sometimes the

optimal choice of one player depends on what it thinks the other player does will do. We therefore

need a more general solution concept, which is the Nash equilibrium.

Page 4 of 16
Microeconomics II Notes on Game Theory Compiled by: Mesfin A.

Nash Equilibrium (named after John Forbes Nash) is a set of strategies, one for each player, such

that each player‟s strategy is a best response to others‟ strategy. Assuming that players are rational, a

player chooses the strategy that gives him his highest payoff. In deciding which strategy is best, a

player must take in to account the strategies that he expects that other players to choose. Since each

player has no incentive to deviate from its Nash strategy, the strategies are stable.

The best strategy is that strategy which optimizes a player‟s payoff given others‟ strategies. There is

no incentive to change a strategy by a player as every player is playing a best strategy.

Strategies of A is a Nash equilibrium if A‟s choice is optimal, given B‟s choice; and B‟s choice is

optimal given A‟s choice.

 Under Nash‟s procedure, a pair of strategies, say, (a*, b*), is defined to be an equilibrium if

a* represents player A‟s best strategy when B plays b*, and b* represent B‟s best strategy

when A plays a*.

Note that dominant strategy equilibrium is a special case of Nash equilibrium.

It should be noted that by identifying the dominant strategies it is possible to arrive the outcome of

the game because dominant strategies are stable. However, not every game has a dominant strategy

for each player. In many games one or more players do not have a dominant strategy. We therefore

need a more general solution concept the Nash equilibrium. For example if we change the payoff

(10, 2) in the bottom right- hand corner of table 5.1 into (20, 2) as shown in table 5.2, firm A will not

have a dominant strategy but B does have. A's optimal decision depends on what firm B does. If B

advertises, then A does best by advertising; but if B does not advertise, A does best by not

advertising. Since firm B has a dominant strategy- advertises, A concludes that B will advertise then

a will advertise. The equilibrium is again that both firms will advertise. It is the logical outcome of

the game because firm A is doing the best it can , given firm B's decision; and firm B is doing the

best it can , given firm A's decision, this is called Nash equilibrium.

Firm B
Advertise Don’t Advertise Table 5.2: Nash
Advertise 10,5 15,0 Equilibrium
Firm A Don’t Advertise 6,8 20,2

Page 5 of 16
Microeconomics II Notes on Game Theory Compiled by: Mesfin A.

Firm A If firm B Adv. IIB = 5 Firm A If firm B Adv. IIB = 8

Adver. If firm B Not Adv. IIB = 0 Not Adv. If firm B Not Adv. IIB = 2

Dominant Strategy of firm B is to Advertise

Firm B If firm A Adv. IIA = 10 Firm B If firm A Adv. IIA = 15

Adv. If firm B Not Adv. IIA = 6 Not Adv. If firm A Not Adv. IIA = 20

Firm A has no Dominant Strategy to maximize its payoffs.

If you remember in Cournot‟s equilibrium, each firm sets output or price while taking the output or

price of its competitors as fixed. Once the firms have reached Cournot‟s equilibrium, no firm has an

incentive to change its output or price unilaterally because each firm is doing the best it can given

the decisions of its competitors. Therefore, Cournot‟s equilibrium is also Nash equilibrium. Note that

dominant strategy equilibrium is a special case of Nash equilibrium.

A game may have:

• No Nash equilibrium or

• One Nash equilibrium, or it can have

• Multiple Nash equilibria

a. Game with No Nash Equilibrium

Let us assume that there are two firms; Firm A and Firm B, in the market producing and selling
the same product. The strategy adopted by either firm will have an impact on the demand, hence
on the profits of the other form. Firm A has two strategic choices: Fight and Accommodate, and
Firm B has two strategies: Advertise and don‟t advertise. The payoff for each firm from the pair
of strategies by each firm is given in the following table.
Firm B
Advertise Don’t Advertise Table 5.3: No Nash
Equilibrium
Fight 5, 4 4, 1
Firm A Accommodate 7, 3 3, 4

If Firm A plays „fight‟, Firm B is better off by playing „advertise‟, but if Firm B is playing
„advertise‟, Firm A is better off by playing „accommodate‟. Hence, {advertise, accommodate} is
not a Nash equilibrium. If Firm B is playing „do not advertise‟, the best strategy for Firm A is to
play „fight‟, but „do not advertise‟ is not the best response for Firm b if Firm A plays „fight‟.
Hence, {fight, do not advertise} is not a Nash equilibrium. A similar calculation of all the other

Page 6 of 16
Microeconomics II Notes on Game Theory Compiled by: Mesfin A.

payoffs of a pair of strategies reveals no Nash equilibrium. Generally in this game there is no
Nash equilibrium, in the sense that there is no set of strategies by each firm which imply one
firm is better off given what the other is doing and vice versa.

b. Game with One Nash Equilibrium

If we assume two firms: A and B, A with the strategies „advertise‟ and „don‟t advertise‟ and B
with the strategies „expand production‟ and „cut production‟. The payoffs for each player are
given in the following table.
Firm B
Expand Production Cut Production Table 5.4: One
Nash Equilibrium
Advertise 2, 1 0, 0
Firm A Do not Advertise 0, 0 -1, 2

In the above table, the strategy (Advertise, expand production) is a Nash equilibrium. If A
chooses to advertise, then the best thing for B to do is expand production, since the payoff to B
from choosing Expand production is 1 and from choosing to cut production is 0; and if B
chooses to expand production then the optimal choice for A is to choose to advertise since then
A will get a payoff of 2 rather than 0.
Thus if A chooses to advertise, the optimal choice for B is to expand production; and if B
chooses to expand production, then the optimal choice for A is to advertise. So we have a Nash
equilibrium, each firm is making the optimal choice given the other firm‟s choice.
c. A Game With Multiple Nash equilibria
Assume there are two cola companies, Pepsi and Coke, that each owns a vending machine. Each
must decide how stock its machine. They can fill the machine with diet soda or regular soda. The
payoffs are presented in the following table.
Coke
Advertise Don’t Advertise Table 5.5: Multiple
Nash Equilibrium
Fight 25, 25 50, 30
Pepsi Accommodate 30, 50 15, 15

There is no dominant strategy for either Pepsi or Coke. In this game you can use „best response‟
to find that there are two Nash equilibria. Playing „regular‟ is the best response for Pepsi when
Coke plays „diet‟, and the best response for Coke is to play „diet‟ if Pepsi plays „regular‟. Hence,
the set of strategies {diet, regular}, where Pepsi plays „diet‟ and Coke plays „regular‟ is the Nash

Page 7 of 16
Microeconomics II Notes on Game Theory Compiled by: Mesfin A.

equilibrium. In similar way we can also find that the set of strategies {regular, diet} where Pepsi
plays „regular‟ and Coke plays „diet‟ is another Nash equilibrium for the same game.
In a nut shell, there are two Nash equilibria in the above game. There are two features of the two
Nash equilibria
 The total payoff is no greater for any other strategy pairs.
 The total payoff is the same for both equilibria.

8. The Prisoners’ Dilemma

A classic example in game theory, called the prisoners‟ dilemma, illustrates the problem

oligopolistic firms‟ face. It goes as follows: two prisoners have been accused of collaborating in a

crime. They were in separate jail cells and cannot communicate with each other. Each has been

asked to confess to the crime. The payoff matrix in table below summarizes the possible outcomes.

Prisoner B Table 5.6: Prisoners‟

Confess Don‟t confess Dilemma
Prisoner A Confess -5, -5 -1, -10
Don't Confess -10, -1 -2, -2

The payoffs are negatives because they show the number of years one will spend in prison.

Obviously, in numeric example -1 is greater than -10 (i.e,-1> -10) implies spending one year in

prison is preferred to spending 10 years in prison.

Pri. A If Prisoner B Confess, -5 Pri. A If Prisoner B Confess, -1

Conf. If Prisoner B Don‟t Confess, -10 Don‟t Conf If Prisoner B Don‟t Confess, -2

Dominant Strategy of Prisoner B is to Confess

Pri. B If Prisoner A Confess, -5 Pri. A If Prisoner B Confess, -1

Conf. If Prisoner A Don‟t Confess, -10 Don‟t Conf If Prisoner B Don‟t Confess, -2

Dominant Strategy of Prisoner A is to Confess

Now let us look the game.
If both prisoners confess, each will receive a term of five years. On the other hand, if one prisoner

confesses and the other does not, the one who confesses will receive a term of only one year, while

Page 8 of 16
Microeconomics II Notes on Game Theory Compiled by: Mesfin A.

the other will go to prison for ten years. If you were one of these prisoners, what would you do-

confess or not confess? It is very difficult to determine.

As the table shows these prisoners face a dilemma. If they could only both agree not to confess, then

each would go to jail for only two years. But they can't talk to each other, and even if they could, can

they trust each other?

If prisoner A does not confess, s/he risks being taken advantage of by his/her former accomplice.

After all, no matter what prisoner A does, prisoner B comes out ahead by confessing. Similarly,

prisoner A always comes out ahead by confessing, so prisoner B must worry that by not confessing,

s/he will be taken advantage of. Therefore, both prisoners will probably confess, and go to jail for

five years.

Thus the unique Nash equilibrium for this game is for both players to confess (It is also dominant

strategy equilibrium). The strategy (deny, deny) is efficient for there is no other strategy choice that

makes both players better off, while the strategy (confess, confess) – the Nash equilibrium – is

inefficient. The problem is that there is no way for the two prisoners to co-ordinate their actions.

Oligopolistic firms often find themselves in a prisoner's dilemma. They must decide whether to

compete aggressively, attempting to capture a larger share of the market at the competitors' expense,

or to "cooperate" and compete more passively, i.e. they can set high prices and limiting output, they

will make higher profits than if they compete aggressively. Let us look the following game that is

played by firm 1 and firm 2.

Firm 2 Table 5.7:

Charge Birr 4 Charge Birr 6 Ologopolists‟
Charge Birr 4 12, 12 20, 4 Dilemma
Firm 1 Charge Birr 6 4, 20 16, 16

Now let us assume that both firms have reached the agreement to cooperate by charging birr 6 for a

product they sell and each one will receive birr16 Profits. However, if one firm cheats the other by

charging 4 (the other charged as before 6) it would increase its profit while the profit of the other

will fall down. That is, if firm 1 charge 4 and firm 2 keeps its promise (charging 6) firm 1 will

increase its profit from 16 to 20.

Page 9 of 16
Microeconomics II Notes on Game Theory Compiled by: Mesfin A.

On the other round, if firm 2 cheats firm 1 by charging 4 it increases its profit from 16 to 20
while the profit of firm 1 falls down from 16 to 4. Since both have the strong incentive to cheat
the other, the final outcome will be to charge 4 and both will have a profit of 12 which is less
than the cooperative profits, 16. Have you noted that the result of this game is similar to the
prisoners‟ dilemma?
The prisoner‟s dilemma applies to a wide range of economic and political phenomena. The
problem of cheating in a cartel agreement for market sharing is taken as an example of prisoners‟
game in economic phenomenon. If you think the other firm is going to stick to its share, it will
pay you to produce more than your own share. And if you think that the other firm will over
produce, then you might as well too!
The prisoner‟s dilemma has provoked a lot of controversy as to what is the „correct‟ way to play
the game – or more precisely, what is a reasonable way to play the game. The answer seems to
depend on whether you are playing a one-shot game or whether the game is to be repeated an
indefinite number of times. If the game is going to be played just one time, the strategy of
defeating – in the above example confessing - seems to be a reasonable one. After all, whatever
the other fellow does you are better off, and you have no way of influencing the other prisoner‟s
behavior. What if the game is repeated?
9. Repeated Games
In the above section the players met only once and played the prisoner‟s dilemma game a single
time. However, the situation is different if the game is to be played repeatedly by the same
player. In this case there are new strategic possibilities open to each player. If the other player
chooses to defeat on one round, then you can choose to defeat on the next round. Thus, your
opponent can be „punished‟ for „bad‟ behavior. In a repeated game, each player has the
opportunity to establish a reputation for cooperation and thereby encourage the other player to
do the same. Whether this kind of strategy will be possibility depends on whether the game is
going to be played a fixed number of times or an indefinite number of times.

If a game has a known, fixed number of rounds (say 10) then each player will defeat on every
round because if there is no way to enforce cooperation on the last round (10th round), there will
be no way to enforce cooperation on the next to the last round (9th round), and so on. Players
cooperate because they hope that cooperation will induce further cooperation in the future. But

Page 10 of 16
Microeconomics II Notes on Game Theory Compiled by: Mesfin A.

this requires that there will always be the possibility of future play. In a repeated game with fixed
number of rounds, since there is no possibility of future play in the last round, no one will
cooperate then. But then why should anyone cooperate on the next to the last round, or the one
before that? And so it goes – the cooperative solution „unravels‟ (collapse) from the end in a
prisoner‟s dilemma with a known, fixed number of rounds.
On the other hand, if a game is going to be repeated an indefinite number of times, a player has a
way of influencing other player‟s behavior. If the opponent refuses to cooperate this time, you
can refuse to cooperate next time. As long as both players care enough about future payoffs, the
threat of non-cooperation in the future may be sufficient to convince players to choose the
optimal strategy. Therefore, the winning strategy – the one with the highest overall payoffs – is
the „tit for tat‟, that is do whatever the other player did in the last round. This strategy does very
well because it offers an immediate punishment for defection. It is also a forgiving strategy, for it
punishes the other player only once for each defection- that is, if the opponent falls into line and
starts to cooperate, then the strategy will reward the other player with cooperation.
10. Dominant Versus Dominated Strategies
The opposite of a dominant strategy is a dominated strategy. A strategy is dominated when the
player has another strategy that gives it a higher payoff no matter what the other player does. In
games with just two strategies for each player, if one strategy is dominant then the other must be
dominated. However, with more than two strategies available to each player, a player might have
dominated strategies but no dominant strategy. Identifying dominated strategies can sometimes
help us deduce the Nash equilibrium in a game where neither player has a dominant strategy.
The following example illustrates the application of finding dominated strategies.
Assume that Honda and Toyota are in a strategic game of competition where each firm have
three strategies; Do not build, build a small plant, or build a large plant.
Toyota
Build Large Build Small Do not Build Table 5.8: Capacity
Build Large 0, 0 12, 8 18, 9 expansion 3 X 3
Honda Build Small 8, 12 16, 16 20, 15 payoff matrix
Do not Build 9, 18 15, 20 18, 18

Neither player in this game has a dominant strategy, and with three strategies rather than two, the
task of finding a Nash equilibrium seems rather time taking. But notice that for each player
“build large” is a dominated strategy: that is

Page 11 of 16
Microeconomics II Notes on Game Theory Compiled by: Mesfin A.

 No matter what Toyota does, Honda is always better off by choosing “build small” rather
than “build large.”
 Similarly, no matter what Honda does, Toyota is always better off choosing “build small”
rather than “build large.”
If each player thinks about the payoffs of the other, each should conclude that its rival will not
choose “build large.” If each player assumes that the other will not choose “build large” (and
rules out choosing “build large” itself), then the 3 × 3 game in the first table reduces to the 2 × 2
game in the following table.
Toyota Table 5.9: Reduced
Build Small Do not Build capacity expansion
Build Small 16, 16 20, 15 2X 2 payoff matrix
Honda
Do not Build 15, 20 18, 18

In this reduced game, each player now has a dominant strategy: “build small.” By eliminating a
dominated strategy, we were able to find a dominant strategy for each player that, in turn,
enabled us to find the Nash equilibrium in the full game; which is for each firm to build a small
plant.

11. Sequential Games

So far, we have studied games in which players make decisions simultaneously. In many
interesting games, however, one player can move before other players do. These are called
sequential-move games. In a 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 Stackelberg‟s model of oligopoly
was an example of sequential move game.
In sequential move games, we analyze strategic moves using a Game Tree and not a payoff
matrix table.
Consider the example of the Toyota-Honda capacity expansion game shown in table 5.8. Both
have three strategic moves to choose. Assuming a simultaneous move game, the equilibrium of
the game can be found by eliminating the dominated strategy as in the previous example shown
in table 5.9. The Nash equilibrium is: (Build small, Build Small).

Page 12 of 16
Microeconomics II Notes on Game Theory Compiled by: Mesfin A.

But now suppose that Honda can make its capacity decision before Toyota decides what to do
(perhaps because it has accelerated its decision-making process). We now have a sequential-
move game in which Honda is the first mover and Toyota is the second mover. To analyze this
sequential-move game, we use a game tree, which shows the different strategies that each player
can follow in the game and the order in which those strategies get chosen. The following figure
shows the game tree for our Toyota-Honda capacity expansion game.

In any game tree, the order of moves flows from left to right. Because Honda moves first, it is in
the leftmost position. For each of Honda‟s possible actions, the tree then shows the possible
decisions for Toyota.
To analyze the game tree, it is convenient to use a thought process called backward induction.
When you solve a sequential-move game using backward induction, you start at the end of the
game tree, and for each decision point, you find the optimal decision for the player at that point.
You continue to do this until you reach the beginning of the game. The thought process of
backward induction has the attractive property that it allows us to break a potentially complicated
game into manageable pieces.
To apply backward induction in this example, we must find Toyota‟s optimal decision for each
of the three choices Honda might make:
 If Honda chooses “do not build,” Toyota‟s optimal choice is “build small.”
 If Honda chooses “build small,” Toyota‟s optimal choice is “build small.”
 If Honda chooses “build large,” Toyota‟s optimal choice is “do not build.”
As we work backward in the tree, we assume that Honda anticipates that Toyota will choose its
best response to each of the three actions Honda might take. We can then determine which of

Page 13 of 16
Microeconomics II Notes on Game Theory Compiled by: Mesfin A.

Honda‟s three strategies gives it the highest profit, by identifying the profit that Honda gets from
each option it might choose, given that Toyota responds optimally:
• If Honda chooses “do not build,” then given Toyota‟s optimal reaction, Honda‟s profit
will be $15 million.
• If Honda chooses “build small,” then given Toyota‟s optimal reaction, Honda‟s profit
will be $16 million.
• If Honda chooses “build large,” then given Toyota‟s optimal reaction, Honda‟s profit will
be $18 million.
Thus, Honda attains the highest profit when it chooses “build large.”
The Nash equilibrium in this game is for Honda to choose “build large” and for Toyota to choose
“do not build.” At this equilibrium, Honda‟s profit is $18 million and Toyota‟s profit is $9
million.
Note that:
 The equilibrium of the sequential game (build large, do not build) is different from the
equilibrium of the simultaneous game (build small, build small).
 The profit for Honda in the sequential game (which is 18) is greater than Hondas profit in
the simultaneous game (which was 16). This suggests that in a sequential game, moving
first gives the first mover an advantage to better maximize its payoff than the second
mover.
12. Chapter End Exercises (it is important that you solve exercises for yourself and by
yourself)
Exercise 1:
Identify the Nash equilibrium for the following game.

Exercise 2:
Suppose you own a firm that is considering entry into the digital camera business, where you
will compete head to head with Kodak (which, let‟s say, currently has a monopoly). Kodak can

Page 14 of 16
Microeconomics II Notes on Game Theory Compiled by: Mesfin A.

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 scale or a small scale. The following table shows the payoffs you and Kodak
are likely to get under the various scenarios that could unfold.
Kodak
Accommodate Price War
Small 16, 16 20, 15
You
Large 15, 20 18, 18

I. Should you enter this business on a large scale or a small scale if the game is
simultaneous?
II. Should you enter this business on a large scale or a small scale if the game is
sequential?
III. Which game is more profitable for you? Sequential or simultaneous?
Exercise 3:
Does either player in the following game have a dominant strategy? If so, identify it. Does either
player have a dominated strategy? If so, identify it. What is the Nash equilibrium in this game?
Player 2
Left Middle Right
Up 15, 12 14, 8 8, 10
Player 1
Down 13, 11 12, 9 5, 14

Exercise 4:
Two firms are competing in a certain market. Both firms are to decide whether to cut or expand
production. The annual profits associated with each strategy are summarized in the following
table.
Firm 2
Cut Production Expand Production
Cut Production 200, 160 340, 80
Firm 1
Expand Production 160, 280 240, 200

a. Does either player have a dominant strategy? Explain.

b. Is there a Nash equilibrium in this game? If so what is it?
c. Is this game an example of the prisoners‟ dilemma? Explain.
Exercise 5:

Page 15 of 16
Microeconomics II Notes on Game Theory Compiled by: Mesfin A.

The following table summarizes the profit payoff for two firms competing through price war in
an oligopoly market. The strategies of the two firms consists of charging different prices: 630,
660, 690 and 720. Using the information given in the table below, answer questions a to e.
Firm B
630 660 690 720
630 180, 180 184, 178 185, 175 186, 173
660 178, 184 183, 183 192, 182 194, 180
Firm A
690 175, 185 182, 192 191, 191 198, 190
720 173, 186 180, 194 190, 198 196, 196

a. Does each firm have a dominant strategy?

b. Both firms have a dominated strategy: Find and identify it.
c. Assume that firm A and Firm B will not play the dominated strategy you identified in
part (b) (i.e., cross out the dominated strategy for each firm in the table). Having
eliminated the dominated strategy, show that Firm A and Firm B now have another
dominated strategy.
d. Assume that both Firm and Firm B will not play the dominated strategy you identified in
part (c). Having eliminated this dominated strategy, determine whether firm A and firm B
now have a dominant strategy.
e. What is the Nash equilibrium in this game?
Exercise: 6
Identify the Nash equilibrium for the following price game between Coke and Pepsi.

Questions:
 Can a game have a Nash equilibrium even though neither player has a dominant strategy?
Can a game have a Nash equilibrium even though neither player has a dominated strategy?
 How can cooperation emerge in the infinitely repeated prisoners‟ dilemma game even though
in a single shot prisoners‟ dilemma, noncooperation is a dominant strategy?

Page 16 of 16