Chapter Three

Game Theory
 Game Theory

 Game theory models strategic

behavior by agents who understand
that their actions affect the actions of
other agents.
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.
 What is a Game?

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.
 Essential Elements of a Game

 Players:
Each decision maker in a
game is called a player.
These players may be
. individuals,
. firms,
.or entire nations
 Essential Elements of a Game
 Strategies: Each course of action
open to a player during the game is
called a strategy.
 Payoffs: The final returns to the
players at the conclusion of a game
are called payoffs.
 Players are assumed to prefer higher
payoffs than lower payoffs.
 4.2 Payoff Matrix of the Game
 The payoff matrix of the game is a
table that summarizes the different
possible outcomes of the game.
Example: Firm B
Adv. Don’t Adv.
 Adv.
Firm A

(10, 5) (15, 0)
Don’t
Adv. (6, 8) (10, 2)
 4.2 Payoff Matrix of the Game

 Firm A has two strategies he can

choose either advertise or don’t
advertise.
 similarly firm B can choose either
advertise or don’t advertise.
 The first and second entries in each
cell represent the benefits of firm A
and firm B respectively.
 4.2 Payoff Matrix of the Game
 For instance when both firm A and
firm B advertise:
. the benefit of A is 10 and
.the benefit of B is 5
 The payoff matrix of a game simply
depicts the payoffs to each player for
each combination of strategies that
are chosen.
 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.
An Example 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.
An Example of a Two-Player Game
Player B
L R

U (3,9) (1,8) This is the

Player A game’s
D (0,0) (2,1) payoff matrix.

Player A’s payoff is shown first.

Player B’s payoff is shown second.
An Example of a Two-Player Game
Player B
L R

U (3,9) (1,8) This is the

Player A game’s
D (0,0) (2,1) payoff matrix.

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

A’s payoff is 1 and B’s payoff is 8.
An Example of a Two-Player Game
Player B
L R

U (3,9) (1,8) This is the

Player A game’s
D (0,0) (2,1) payoff matrix.

And if A plays Down and B plays Right

then A’s payoff is 2 and B’s payoff is 1.
An Example of a Two-Player Game
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.
An Example of a Two-Player Game
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?
An Example of a Two-Player Game
Player B
L R
Is (U,R) a
U (3,9) (1,8)
likely play?
Player A
D (0,0) (2,1)
An Example of a Two-Player Game
Player B
L R
Is (U,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

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

An Example of a Two-Player Game
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.

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

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

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

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

An Example of a Two-Player Game
Player B
L R
Is (U,L) a
U (3,9) (1,8)
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.
3.3 Dominant Strategy Equilibrium
 A dominant strategy is a strategy in
a game that is best for a player no
matter what an opponent does.
 Example:

Firm B
Adv. Don’t Adv.
Firm Adv. (10, 5) (15, 0)
A Don’t Adv. (6, 8) (10, 2)
3.3 Dominant Strategy Equilibrium
 Itcan be easily seen that firm A
should advertise no matter what B
does.
 Firm A does the best by advertising.
 Thus advertising is the dominant
strategy for firm A and the same is
true for firm B.
3.3 Dominant Strategy Equilibrium

 The outcome of the game will be that

both firms advertise.
 If there is a dominant strategy for
each player in a game it would be the
equilibrium outcome of the game.
3.3 Dominant Strategy Equilibrium
 Equilibrium of the game will be

Firm B

Adv. Don’t
Adv.
Adv. (10, 5) (15, 0)
Firm
A Don’t (6, 8) (10, 2)
Adv.
 3.4 Nash Equilibrium

 Dominant strategy equilibrium is

stable.
 But one or more players may not
have dominant strategy.
 Example: see Advertisement game
below.
 3.4 Nash Equilibrium
 Advertisement game:
Firm B
Don’t
Adv. Adv.
(12, 10) (0, 0)
Firm A Adv.
(0, 0) (10, 12)
Don’t Adv.
 3.4 Nash Equilibrium
 IfA advertises the optimal choice for
B is to advertise
 But if A chooses not to advertise the
optimal choice for B is not to
advertise.
 Thus, firm A has no dominant
strategy.
 Similarly, B has no dominant strategy.
 3.4 Nash Equilibrium

A play of the game where each

strategy is a best reply to the other is
a Nash equilibrium.
 3.4 Nash Equilibrium

 Nash equilibrium is a set of actions

or strategies such that each player
believes that it is doing the best it
can, given the action of its
opponents.
 3.4 Nash Equilibrium

 Ifthere are two players in a game

(say A and B), Nash equilibrium
implies that A is doing the best it can
given B’s choice and B is doing the
best it can, given what A is doing.
 3.4 Nash Equilibrium
Example: 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.
 3.4 Nash Equilibrium
Player B
Example
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?
 3.4 Nash Equilibrium
 Limitations of Nash equilibrium
concept.
1. A game may have more than one
Nash Equilibrium.
2. Some games may not have Nash
Equilibrium.
3. It may not be pareto-efficient
 3.4 Nash Equilibrium
 Example of one Nash Equilibrium game
Firm B

Don’t
Adv. Adv.
Adv. (10, 5) (15, 0)
Firm A
Don’t (5, 8) (20, 2)
Adv.
 3.4 Nash Equilibrium
 Example of two Nash Equilibrium game
Firm B

Don’t
Adv. Adv.
Firm A
Adv. (12, 10) (0, 0)
Don’t (0, 0) (10, 12)
Adv.
 3.4 Nash Equilibrium
 Example of no Nash Equilibrium game
Matching Pennies
Player B
Head Tail

Player A Head (2, -2) (-2, 2)

Tail (-2, 2) (2, -2)

 3.4 Nash Equilibrium
 Example of no Nash Equilibrium game
 Two people choose simultaneously
whether to show the head or a tail of a
coin.
 If they show the same side player B
pays player A 2 dollars.
 If they show different sides player A
pays player B 2 dollars.
 This game is zero-sum-game.
 3.4 Nash Equilibrium
 Example of no Nash Equilibrium game

Firm B

Don’t
Adv.
Adv.
Firm A Adv. (0, 0) (0, -1)
Don’t (1, 0) (-1, 3)
Adv.
 3.5 The Prisoner’s Dilemma

 Tosee if Pareto-preferred outcomes

must be what we see in the play of a
game, consider a famous example of
a two-player game called the
Prisoner’s Dilemma.
 3.5 The Prisoner’s Dilemma
Clyde
S C
S (-1,-1) (-15, 0)
Bonnie
C (0, -15) (-8, -8)

What plays are we likely to see for this

game?
 3.5 The Prisoner’s Dilemma
Clyde
S C
S (-1,-1) (-15,0)
Bonnie
C (0,-15) (-8,-8)

If Bonnie plays Silence then Clyde’s best

reply is Confess.
 3.5 The Prisoner’s Dilemma
Clyde
S C
S (-1, -1) (-15, 0)
Bonnie
C (0, -15) (-8, -8)

If Bonnie plays Silence then Clyde’s best

reply is Confess.
If Bonnie plays Confess then Clyde’s
best reply is Confess.
 3.5 The Prisoner’s Dilemma
Clyde
S C
S (-1, -1) (-15, 0)
Bonnie
C (0, -15) (-8, -8)

So no matter what Bonnie plays, Clyde’s

best reply is always Confess.
Confess is a dominant strategy for Clyde.
 3.5 The Prisoner’s Dilemma
Clyde
S C
S (-1, -1) (-15, 0)
Bonnie
C (0, -15) (-8, -8)

Similarly, no matter what Clyde plays,

Bonnie’s best reply is always Confess.
Confess is a dominant strategy for
Bonnie also.
 3.5 The Prisoner’s Dilemma
Clyde
S C
S (-1, -1) (-15, 0)
Bonnie
C (0, -15) (-8, -8)

So the only Nash equilibrium for this

game is (C,C), even though (S,S) gives
both Bonnie and Clyde better payoffs.
The only Nash equilibrium is inefficient.
 3.6 Pure Strategies
Player B
L R

U (3,9) (1,8)
Player A
D (0,0) (2,1)

This is our previous example once more.

Suppose again that play is simultaneous.
We discovered that the game has two Nash
equilibria; (U,L) and (D,R).
 3.6 Pure Strategies
Player B
L R

U (3,9) (1,8)
Player A
D (0,0) (2,1)

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.
 3.6 Pure Strategies
Player B
L R

U (3,9) (1,8)
Player A
D (0,0) (2,1)

Similarly, L and R are Player B’s pure

strategies.
 3.6 Pure Strategies
Player B
L R

U (3,9) (1,8)
Player A
D (0,0) (2,1)

Consequently, (U,L) and (D,R) are pure

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

Here is a new game. Are there any pure

strategy Nash equilibria?
 3.6 Pure Strategies
Player B
L R
U (1,2) (0,4)
Player A
D (0,5) (3,2)

Is (U,L) a Nash equilibrium?

 3.6 Pure Strategies
Player B
L R
U (1,2) (0,4)
Player A
D (0,5) (3,2)

Is (U,L) a Nash equilibrium? No.

Is (U,R) a Nash equilibrium?
 3.6 Pure Strategies
Player B
L R
U (1,2) (0,4)
Player A
D (0,5) (3,2)

Is (U,L) a Nash equilibrium? No.

Is (U,R) a Nash equilibrium? No.
Is (D,L) a Nash equilibrium?
 3.6 Pure Strategies
Player B
L R
U (1,2) (0,4)
Player A
D (0,5) (3,2)

Is (U,L) a Nash equilibrium? No.

Is (U,R) a Nash equilibrium? No.
Is (D,L) a Nash equilibrium? No.
Is (D,R) a Nash equilibrium?
 3.6 Pure Strategies
Player B
L R
U (1,2) (0,4)
Player A
D (0,5) (3,2)

Is (U,L) a Nash equilibrium? No.

Is (U,R) a Nash equilibrium? No.
Is (D,L) a Nash equilibrium? No.
Is (D,R) a Nash equilibrium? No.
 3.6 Pure Strategies
Player B
L R
U (1,2) (0,4)
Player A
D (0,5) (3,2)

So the game has no Nash equilibria in pure

strategies. Though, the game does have a
Nash equilibrium, but in mixed strategies.
 3.7 Mixed Strategies
 Instead of playing purely Up or Down,
Player A selects a probability
distribution (pU,1-pU), meaning that with
probability pU Player A will play Up and
with probability 1-pU will play Down.
 Player A is mixing over the pure
strategies Up and Down.
 The probability distribution (pU,1-pU) is a
mixed strategy for Player A.
 3.7 Mixed Strategies
 Similarly, Player B selects a probability
distribution (pL,1-pL), meaning that with
probability pL Player B will play Left and
with probability 1-pL will play Right.
 Player B is mixing over the pure
strategies Left and Right.
 The probability distribution (pL,1-pL) is a
mixed strategy for Player B.
 3.7 Mixed Strategies
Player B
L R
U (1,2) (0,4)
Player A
D (0,5) (3,2)

This game has no pure strategy Nash

equilibria but it does have a Nash
equilibrium in mixed strategies. How is it
computed?
 3.7 Mixed Strategies
Player B
L,pL R,1-pL

U,pU (1,2) (0,4)

Player A
D,1-pU (0,5) (3,2)
 3.7 Mixed Strategies
Player B
L,pL R,1-pL

U,pU (1,2) (0,4)

Player A
D,1-pU (0,5) (3,2)

If B plays Left her expected payoff is

2pU  5(1  pU )
 3.7 Mixed Strategies
Player B
L,pL R,1-pL

U,pU (1,2) (0,4)

Player A
D,1-pU (0,5) (3,2)

If B plays Left her expected payoff is

2pU  5(1  pU ).
If B plays Right her expected payoff is
4pU  2(1  pU ).
 3.7 Mixed Strategies
Player B
L,pL R,1-pL

U,pU (1,2) (0,4)

Player A
D,1-pU (0,5) (3,2)

If 2p U  5(1  p U )  4p U  2(1  p U ) then

B would play only Left. But there are no
Nash equilibria in which B plays only Left.
 3.7 Mixed Strategies
Player B
L,pL R,1-pL

U,pU (1,2) (0,4)

Player A
D,1-pU (0,5) (3,2)

If 2p U  5(1  p U )  4p U  2(1  p U ) then

B would play only Right. But there are no
Nash equilibria in which B plays only Right.
 3.7 Mixed Strategies
Player B
L,pL R,1-pL

U,pU (1,2) (0,4)

Player A
D,1-pU (0,5) (3,2)

So for there to exist a Nash equilibrium, B

must be indifferent between playing Left or
Right; i.e. 2p U  5(1  p U )  4p U  2(1  p U )
 3.7 Mixed Strategies
Player B
L,pL R,1-pL

U,pU (1,2) (0,4)

Player A
D,1-pU (0,5) (3,2)

So for there to exist a Nash equilibrium, B

must be indifferent between playing Left or
Right; i.e. 2p U  5(1  p U )  4 p U  2(1  p U )
 p U  3 / 5.
 3.7 Mixed Strategies
Player B
L,pL R,1-pL
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. 2p U  5(1  p U )  4 p U  2(1  p U )
 p U  3 / 5.
 3.7 Mixed Strategies
Player B
L,pL R,1-pL
3
U, (1,2) (0,4)
5
Player A 2
D, (0,5) (3,2)
5
 3.7 Mixed Strategies
Player B
L,pL R,1-pL
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  pL  0  (1  pL )  pL .
 3.7 Mixed Strategies
Player B
L,pL R,1-pL
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  pL  0  (1  pL )  pL .
If A plays Down his expected payoff is
0  pL  3  (1  pL )  3(1  pL ).
 3.7 Mixed Strategies
Player B
L,pL R,1-pL
3
U, (1,2) (0,4)
5
Player A 2
D, (0,5) (3,2)
5
If p L  3(1  p L ) then A would play only Up.
But there are no Nash equilibria in which A
plays only Up.
 3.7 Mixed Strategies
Player B
L,pL R,1-pL
3
U, (1,2) (0,4)
5
Player A 2
D, (0,5) (3,2)
5
If p L  3(1  p L ) then A would play only
Down. But there are no Nash equilibria in
which A plays only Down.
 3.7 Mixed Strategies
Player B
L,pL R,1-pL
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. p L  3(1  p L )
 3.7 Mixed Strategies
Player B
L,pL R,1-pL
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.
 3.7 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. pL  3(1  pL )  pL  3 / 4.
 3.7 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).
 3.7 Mixed Strategies
Player B
3 1
L, 4 R, 4
3 (1,2) (0,4)
U,
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
 3.7 Mixed Strategies
Player B
3 1
L, 4 R, 4
3 (1,2) (0,4)
U,
5 9/20 3/20
Player A 2
D, (0,5) (3,2)
5

The payoffs will be (0,4) with probability

3 1 3
 
5 4 20
 3.7 Mixed Strategies
Player B
3 1
L, 4 R, 4
3 (1,2) (0,4)
U,
5 9/20 3/20
Player A 2
D, (0,5) (3,2)
5 6/20
The payoffs will be (0,5) with probability
2 3 6
 
5 4 20
 3.7 Mixed Strategies
Player B
3 1
L, 4 R, 4
3 (1,2) (0,4)
U,
5 9/20 3/20
Player A 2
D, (0,5) (3,2)
5 6/20 2/20
The payoffs will be (3,2) with probability
2 1 2
 
5 4 20
 3.7 Mixed Strategies
Player B
3 1
L, 4 R, 4
3 (1,2) (0,4)
U,
5 9/20 3/20
Player A 2
D, (0,5) (3,2)
5 6/20 2/20
 3.7 Mixed Strategies
Player B
3 1
L, 4 R, 4
3 (1,2) (0,4)
U,
5 9/20 3/20
Player A 2
D, (0,5) (3,2)
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
 3.7 Mixed Strategies
Player B
3 1
L, 4 R, 4
3 (1,2) (0,4)
U,
5 9/20 3/20
Player A 2
D, (0,5) (3,2)
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 20 20 20 5
 3.7 Mixed Strategies
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.
3.8 Repeated Games and Enforcing a
Cartel
 Whatif a game is repeated by the
same players
. For fixed number of times?
. For indefinite number of times?
 Consider the prisoner’s dilemma
 The game is to be played repeatedly
by the same players.
Repeated games and Enforcing a cartel
 In this case there are new strategic
possibilities open to each player.
 If the other player chooses to defect on
one round, then you can choose to
defect on the next round.
 Thus your opponent can be "punished"
for "bad" behavior.
Repeated games and Enforcing a cartel

 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
viable depends on whether the game is
going to be played a fixed number of
times or an indefinite number of times.
Repeated games and Enforcing a cartel
 Assume both players know that the
game is going to be played 10 times.
 What will the outcome be?
 Suppose we consider round 10. This is
the last time the game will be played, by
assumption.
 In this case, it seems likely that each
player will choose the dominant
strategy equilibrium, and defect.
Repeated games and Enforcing a cartel
 After all, playing the game for the last time
is just like playing it once, so we should
expect the same outcome.
 Now consider what will happen on round 9.
 We have just concluded that each player
will defect on round 10. So why cooperate
on round 9?
Repeated games and Enforcing a cartel
 If you cooperate, the other player
might as well defect now and exploit
your good nature.
 Each player can reason the same way,
and thus each will defect. It goes like
that in round 8, 7,…
 If the game has a known, fixed number
of rounds, then each player will defect
on every round.
Repeated games and Enforcing a cartel
 Ifthere is no way to enforce
cooperation on the last round, there
will be no way to enforce cooperation
on the next to the last round, and so
on.
 Players cooperate because they hope
that cooperation will induce further
cooperation in the future.
Repeated games and Enforcing a cartel
 But this requires that there will always be
the possibility of future play.
 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?
Repeated games and Enforcing a cartel

 So for games like the prisoner’s

dilemma repeating the game for
known fixed number of times results
similar outcomes with the one-shot
game.
 What about if the game is to be
played for indefinite number of
times?
Repeated games and Enforcing a cartel

 If the game is going to be repeated an

indefinite number of times, then you do
have a way of influencing your
opponent's behavior:
 if he refuses to cooperate this time, you
can refuse to cooperate next time.
Repeated games and Enforcing a cartel

 Aslong as both parties care enough

about future payoffs, the threat of
non- cooperation in the future may be
sufficient to convince people to play
the Pareto efficient strategy.
Repeated games and Enforcing a cartel
 Consider the Bertrand price competition
 It has the same structure as the
prisoner's dilemma.
 If each firm charges a high price, then
they both get large profits(both
cooperating to maintain the monopoly
outcome.)
Repeated games and Enforcing a cartel

 But if one firm is charging a high

price, then it will pay the other firm to
cut its price a little, capture the other
fellow's market, and thereby get even
higher profits.
Repeated games and Enforcing a cartel

 But if both firms cut their prices, they

both end up making lower profits.
 Whatever price the other fellow is
charging, it will always pay you to
shave your price a little bit.
 The Nash equilibrium occurs when
each fellow is charging the lowest
possible price.
Repeated games and Enforcing a cartel

 However, if the game is repeated an

indefinite number of times, there may
be other possible outcomes.
 Suppose that you decide to play tit
for tat. If the other fellow cuts his
price this week, you will cut yours
next week.
Repeated games and Enforcing a cartel

 Ifeach player knows that the other

player is playing tit for tat, then each
player would be fearful of cutting his
price and starting a price war.
 The threat implicit in tit for tat may
allow the firms to maintain high
prices.
 3.9 Sequential Game
 Up until now we have been thinking
about games in which both players act
simultaneously.
 But in many situations one player gets to
move first, and the other player
responds.
 E.g. the Stackelberg model described in
Chapter 2, where one player is a leader
and the other player is a follower.
 Who Plays When?

 Inthe previous 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.
 A Sequential Game Example
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

when this game is played simultaneously
and we have no way of deciding which
equilibrium is more likely to occur.
 A Sequential Game Example
Player B
L R

U (3,9) (1,8)
Player A
D (0,0) (2,1)

Suppose instead that the game is played

sequentially, with A leading and B following.
We can rewrite the game in its extensive
form.
 A Sequential Game Example
A
U D A plays first.
B B B plays second.
L R L R

(3,9) (1,8) (0,0) (2,1)

 A Sequential Game Example
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 Sequential Game Example
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 Sequential Game Example
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 Sequential Game Example
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.
If A plays D then B plays R; A gets 2.
 A Sequential Game Example
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.
If A plays D then B plays R; A gets 2.
So (U,L) is the likely Nash equilibrium.
 3.10 Game of Entry Deterrence

 Consider a monopolist who is facing

a threat of entry by another firm.
 The entrant decides whether or not
to come into the market, and then the
incumbent decides whether or not to
cut its price in response.
 3.10 Game of Entry Deterrence

 If the entrant decides to stay out, it

gets a payoff of 1 and the incumbent
gets a payoff of 9.
 If the entrant decides to come in,
then its payoff depends on whether
the incumbent fights-by competing
vigorously-or not.
 3.10 Game of Entry Deterrence

 Ifthe incumbent fights, then we

suppose that both players end up
with 0.
 On the other hand, if the incumbent
decides not to fight, we suppose that
the entrant gets 2 and the incumbent
gets 1.
 3.10 Game of Entry Deterrence
.
Incumbent
chooses
Fight . (1, 9)
(Ent, Inc)

Entrant
chooses Stay out
. Don’t fight

. . (1, 9)
Incumbent
. (0, 0)
Enter
.
chooses
Fight

Don’t fight . (2, 1)

 3.10 Game of Entry Deterrence
 The equilibrium outcome is for the
potential entrant to enter and the
incumbent not to fight.
 The incumbent's problem is that he
cannot precommit himself to fighting if
the other firm enters.
 If the other firm enters, the damage is
done and the rational thing for the
incumbent to do is to live and let live.
 3.10 Game of Entry Deterrence
 But suppose that the incumbent can
purchase some extra production capacity
that will allow him to produce more output
at his current marginal cost.
 If the other firm enters, the incumbent will
now be able to produce so much output
that he may well be able to compete much
more successfully against the new
entrant.
 3.10 Game of Entry Deterrence
 By investing in the extra capacity, he will
lower his costs of fighting if the other
firm tries to enter.
 Let us assume that if he purchases the
extra capacity and if he chooses to fight,
he will make a profit of 2. This changes
the game tree to the form depicted in the
figure below.
 3.10 Game of Entry Deterrence
.
Incumbent
chooses
Fight . (1, 9)
(Ent, Inc)

Entrant
chooses Stay out
. Don’t fight

. . (1, 9)
Incumbent
. (0, 2)
Enter
.
chooses
Fight

Don’t fight . (2, 1)

 3.10 Game of Entry Deterrence
 Now, because of the increased capacity,
the threat of fighting is credible.
 If the potential entrant comes into the
market, the incumbent will get a payoff of
2 if he fights and 1 if he doesn't.
 thus the incumbent will rationally choose
to fight.
 3.10 Game of Entry Deterrence
 The entrant will therefore get a payoff of 0
if he enters, and if he stays out he will get
a payoff of 1.
 The sensible thing for the potential
entrant to do is to stay out.
 By investing in "excess" capacity, the
monopolist has signaled to the potential
entrant that he will be able to successfully
defend his market.