Game Theory

Topics to be Discussed

 Games and Strategic Decisions

 Dominant Strategies
 The Nash Equilibrium
 Pure Strategy and Mixed Strategy
 Subgame Perfect Nash Equilibrium
 Repeated Games
Games and Strategic Decisions

 A game is any situation in which players (the

participants) make strategic decisions.
 Monopoly vs Oligopoly
 Baseball vs Dance

 Strategic decisions result in payoffs to the players:

outcomes that generate rewards or benefits
Games and Strategic Decisions

 Game theory tries to determine optimal strategy for

each player
 Strategy is a rule or plan of action for playing the
game
 Optimal strategy for a player is one that maximizes
the expected payoff
 We consider players who are rational – they think
through their actions
Gaming and Strategic Decisions

 “If I believe that my competitors are rational and act

to maximize their own profits, how should I take their
behavior into account when making my own profit-
maximizing decisions?”

 Equilibrium
 Solution of the game
 Prediction of behavior
 An Example: Prisoners’ Dilemma
Prisoner B
Confess Don’t Confess

Confess -5, -5 -1, -10

Prisoner A

Don’t
Confess -10, -1 -2, -2
Implications

 Always trying to understand human nature through

social interaction!

 Thinking Strategically

 Maximizing each individual’s payoff does not mean

the best to the society. (more sophistication, living
worse).
Gaming and Strategic Decisions

 An Example: How to buy a dollar bill

1. Auction a dollar bill
2. Bids increase in increments of five cents
3. Highest bidder receives the dollar in return for the
amount bid
4. Second highest bidder must pay the amount he or she
bid but gets nothing in return
5. How much would you bid for a dollar?
 Typically bid more for the dollar when faced with
loss as second highest bidder
Analysis

 Players (): 1 and 2

 Strategy (): Confess or Don’t confess
 Payoff: depends on strategy combinations
 Equilibrium: ()
 Outcome: ,

9
 An Example: Prisoners’ Dilemma
Prisoner B
Confess Don’t Confess

Confess -5, -5 -1, -10

Prisoner A

Don’t
Confess -10, -1 -2, -2
 Payoff Matrix for Advertising Game:
Example 2
Firm B Don’t
Advertise Advertise

Advertise 10, 5 15, 0

Firm A

Don’t
Advertise 6, 8 10, 2
Payoff Matrix for Advertising Game

 Observations
 Dominant strategy
for A & B is to
Firm B Don’t
advertise
Advertise Advertise
 Do not worry about
the other player
Advertise 10, 5 15, 0
 Equilibrium in
dominant strategyFirm A
Don’t
Advertise 6, 8 10, 2
Dominant Strategies

 Equilibrium in dominant strategies

 Outcome of a game in which each firm is doing the best it can
regardless of what its competitors are doing
 Optimal strategy is determined without worrying about
actions of other players

 However, not every game has a dominant strategy for

each player
Dominant Strategies

 Game Without Dominant Strategy

 The optimal decision of a player without a dominant strategy
will depend on what the other player does.
 Revising the payoff matrix we can see a situation where no
dominant strategy exists
 Modified Advertising Game
Firm B Don’t
Advertise Advertise

Advertise 10, 5 15, 0

Firm A

Don’t
Advertise 6, 8 20, 2
 Modified Advertising Game
Firm B Don’t
 Observations Advertise Advertise

 A: No dominant
strategy; depends Advertise 10, 5 15, 0
on B’s actions
Firm A
 B: Dominant
Don’t
strategy is to Advertise 6, 8 20, 2
Advertise
 Firm A determines
B’s dominant
strategy and makes
its decision
accordingly
The Nash Equilibrium Revisited

 A dominant strategy is stable, but in many games one

or more party does not have a dominant strategy.

 A more general equilibrium concept is the Nash

Equilibrium (named for John Nash)
 A set of strategies (or actions) such that each player is doing
the best it can given the actions of its opponents
The Nash Equilibrium Revisited

 None of the players have incentive to deviate from its

Nash strategy, therefore it is stable
 In the Cournot model, each firm sets its own price assuming
the other firms outputs are fixed. Cournot equilibrium is a
Nash Equilibrium
The Nash Equilibrium Revisited

 Dominant Strategy
 “I’m doing the best I can no matter what you do. You’re doing
the best you can no matter what I do.”

 Nash Equilibrium
 “I’m doing the best I can given what you are doing. You’re
doing the best you can given what I am doing.”

 Dominant strategy is special case of Nash equilibrium

 Modified Advertising Game
Firm B Don’t
 Observations Advertise Advertise

 A: No dominant
strategy; depends Advertise 10, 5 15, 0
on B’s actions
Firm A
 B: Dominant
Don’t
strategy is to Advertise 6, 8 20, 2
Advertise
 Firm A determines
B’s dominant
strategy and makes
its decision
accordingly
The Nash Equilibrium Apply to Firm
Competition

 Two cereal companies face a market in which two

new types of cereal can be successfully introduced
provided each type is introduced by only one firm
 Product Choice Problem
 Market for one producer of crispy cereal
 Market for one producer of sweet cereal
 Each firm only has the resources to introduce one cereal
 Noncooperative
Product Choice Problem
Firm 2
Crispy Sweet

Crispy -5, -5 10, 10

Firm 1

Sweet 10, 10 -5, -5

 Product Choice Problem
Firm 2
 If firm 1 hears Crispy Sweet
firm 2 is
introducing a new
sweet cereal, its Crispy -5, -5 10, 10
best action is to
make crispy Firm 1

 Bottom left corner

Sweet 10, 10 -5, -5
is Nash
equilibrium
 What is other
Nash Equilibrium?
Non Existence of Pure Strategy Nash
Equilibrium
 Sometime, pure strategy Nash Equilibrium does not
exist

 Randomization is necessary in order to hide your

strategic purpose: that is called mixed strategy

 How to calculate a mixed strategy Nash Equilibrium

Other Examples: Matching Pennies
Player B
Heads Tails

Heads 1, -1 -1, 1
Player A

Tails -1, 1 1, -1
 Matching Pennies

 Pure strategy: No
Player B
Nash equilibrium
Heads Tails
 No combination of
head and tails
leaves both players Heads 1, -1 -1, 1
better off
Player A
 Mixed strategy:
Tails -1, 1 1, -1
Random choice is
a Nash equilibrium
Matching Pennies

 Player A might flip coin playing heads with ½

probability and tails with ½ probability.

 If both players follow this strategy, there is a Nash

equilibrium – both player will be doing the best they
can given what they opponent is doing.

 Although the outcome is random, the expected payoff

is 0 for each player.
 The Battle of the Sexes
Joan
Wrestling Opera

Wrestling 2,1 0,0

Jim

Opera 0,0 1,2

 The Battle of the Sexes

 Pure Strategy Joan

 Both watch Wrestling Opera
wrestling
 Both watch opera Wrestling 2,1 0,0
 Mixed Strategy
Jim
 Jim chooses
wrestling Opera 0,0 1,2
 Joan chooses
wrestling
 Joan
Prob. q: Wrestling Prob. 1-q: Opera

Prob. p: Wrestling 2,1 0,0

Jim

0,0 1,2
Prob. (1-p): Opera

Joan’s expected payoff when she chooses W: p*1+(1-p)*0

Joan’s expected payoff when she chooses O: p*0+(1-p)*2
Then, p=2/3

Jim’s expected payoff when he chooses W: q*2+(1-q)*0

Jim’s expected payoff when he chooses O: q*0+(1-q)*1
Then, q=1/3
Dynamic Games

 Trust game: a Simplest Example

 Sequential move in a game

 Subgame Perfect Equilibrium

 Backwards Induction
 Trust Game

(0,0) (5,5)

Honor
No Trust

Trust
Lender Do not Honor
Borrower

(-5,10)
Pirate’s Treasure

 Five pirates discover a treasure of 100 gold coins and

must decide how to split it
 The pirates are ranked in order of seniority
 The most senior pirate proposes how to split the
treasure
 All pirates vote yes or no to the proposal
 If yes wins or there is a tie, the gold is split accordingly
 If no win, the proposing pirate is thrown overboard and
the game is played again with the next most senior
pirate making a proposal
Pirate’s Treasure

 What is the equilibrium?

 Work backwards from the end to find the subgame

perfect Nash equilibrium

 Pirate 1 offers 98 gold coins for himself, 1 gold coin for

pirate 3, and 1 gold coin for pirate 5
Threats, Commitments, and
Credibility
 Strategic Moves
 What actions can a firm take to gain advantage in the
marketplace?
 Deter entry
 Induce competitors to reduce output, leave, raise price
 Implicit agreements that benefit one firm
Threats, Commitments, and
Credibility
 Strategic Move

 Action that gives a player an advantage by

constraining his behavior

 Firm 1 must constrain his behavior to the extent

Firm 2 is convinced that he is committed
Threats, Commitments, and
Credibility
 How To Make the First Move
 Demonstrate Commitment
 Firm 1 must do more than announce they will produce sweet
cereal
 Invest in expensive advertising campaign
 Buy large order of sugar and send invoice to firm 2
 Commitment must be enough to induce firm 2 to make the
decision firm 1 wants it to make
Threats, Commitments, and
Credibility
 Empty Threats
 If a firm will be worse off if it charges a low price, the threat of a low
price is not credible in the eyes of the competitors.

 When firms know the payoffs of each others actions, firms cannot
make threats the other firm knows they will not follow.

 In our example, firm 1 will always charge high price and firm 2 knows
it
Pricing of Computers and Word
Processors
Firm 2
High Price Low Price

High Price 100, 80 80, 100

Firm 1

Low Price 20, 30 10, 20

Threats, Commitments, and
Credibility
 Sometimes firms can make credible threats
 Scenario
 Race Car Motors, Inc. (RCM) produces cars
 Far Out Engines (FOE) produces specialty car engines and
sells most of them to RCM
 Sequential game with RCM as the leader
 FOE has no power to threaten to build big since RCM controls
output.
 Production Choice Problem
Race Car Motors
Small cars Big cars

Small
engines 3, 6 3, 0
Far Out Engines

Big
engines
1, 1 8, 3
Threats, Commitments, and
Credibility
 RCM does best by producing small cars

 Knows that Far Out will then produce small engines

 Far Out prefers to make big engines

 Can Far Out induce Race Car to produce big cars

instead?
Threats, Commitments, and
Credibility
 Suppose Far Out threatens to produce big engines no
matter what RCM does
 Not credible since once RCM announces they are producing
small cars, FO will not have incentive to carry out threat.
 Can make threat credible by altering pay off matrix by
constraining its own choices
 Shutting down or destroying some small engine production
capacity
 Modified Production Choice Problem
Race Car Motors
Small cars Big cars

Small
engines 0, 0 0, 0
Far Out Engines
Big
engines 1, 1 8, 3
Role of Reputation

 If Far Out gets the reputation of being irrational

 They threaten to produce large engines not matter what Race
Car does

 Threat might be credible because irrational people

don’t always make profit maximizing decisions

 A party thought to be crazy can lead to a significant

advantage
Modified Production Choice Problem

 Strategic commitments can be effective but not

without risk
 Rely heavily on accurate knowledge of payoff matrix and
industry
 May have competitors out there that they don’t know about
and lose sale
To Understand the Game Tree

 An incumbent firm and a potential entrant who is

going enter the market
 Entrant chooses action first
 The incumbent firm can fight or not
 Outcome (E,A)
Repeated Game

 Repeated Prisoner’s Dilemma game (finite)

 Infinitely repeated game

 Discount factor,
 Prisoner B
Confess Don’t Confess
Confess Don’t Confess

Confess -5, -5 -1, -10

Prisoner A

-5, -5 -1, -10

Don’t
Confess -10, -1 -2, -2 -10, -1 -2, -2
Finitely Repeated Prisoner’s Dilemma

 Solve with backwards induction

 Only equilibrium is to repeat the static Nash

Infinitely Repeated Prisoner’s
Dilemma
 Payoff is the sum of the discounted payoffs

 Playing Static Nash each period is an equilibrium

 There is another equilibrium with collusion

 Requires sufficient patience
 Long-term v.s. short-term interest

T=1

-1-(-2)=1

………
𝛿( −2
−
−5
1− 𝛿 1 − 𝛿 )
=3 δ /(1 − 𝛿)
Collusion

 Collusion is possible as long as the gain from

deviating is smaller than the punishment

 The higher the discount factor (more patience) the

more the future punishment matters relative to the
short term gain from deviating