GAME THEORY

Game Theory
Basic Concepts The payoff matrix The Nash Equilibrium Dominant Strategies Dominated Strategies Maximin Strategies Mixed Strategies

Game Theory and Oligopoly

Non co-operative games :Prisoners Dilemma Cooperative Games: Enforcing a Cartel Repeated games : dealing with cheaters Sequential games :The advantage of being first

Game Theory and Economics

Game theory is the study of how people behave in strategic situations. Strategic decisions are those in which each person, in deciding what actions to take, must consider how others might respond to that action.

Game Theory and Economics

If the market is composed by a small number of firms, each firm must act strategically. Each firm affects the market price changing the quantity produced. Suppose 2 firms are producing 100 units. If one of the firms decides to increase the production by 10 units. The market supply will increase from 200 to 210 and the price has to drop to reach an equilibrium.

Game Theory and Economics

Therefore, it also affects the profits of other firms. Each firm knows that its profit depends not only on how much it produced but also on how much the other firms produce.

What is a Game?
A game is a situation where the participants payoffs depend not only on their decisions, but also on their rivals decisions. This is called Strategic Interactions:
My optimal decisions will depend on what others do in the game.

A Game
Four elements to describe a game:
players; rules: when each player moves, what are the possible moves, what is known to each player before moving; outcomes of the moves; payoffs of each possible outcome: how much money each player receive for any specific outcome.

Players and their actions

A situation of competitive rivalry must involve two or more players whose choice of actions affect each other. A player can be a firm, an interest group or coalition, a military leader, government official. Games generally consider only one kind of action e.g., number of daily departures, fares, in-flight services, schedules, advertising, choice of hubs, ordering planes, expanding terminals, use of computerized reservations systems, mergers and acquisitions, and human resource decisions.

Outcomes and Payoffs

The firms action, together with the actions of its rivals, determine its payoff In the standard business game, the payoff can be in the form of profit, market share, ratings points, In war games, the payoff might be measured in enemy killed or territory seized. In political games, payoffs may be measured in votes or campaign contributions.

Underlying rules
The rules of the game define the range of possible outcomes and payoffs For example, collusion to fix prices or a merger among direct rivals in a concentrated market structure may be against the rules. Another set of rules specifies whether players move sequentially or simultaneously, who moves first, and what does each player know about the other players preference and prior to actions?

Game theory in business

In applying game theory to the behaviour of firms we can suggest that firms face a number of strategic choices which govern their ability to achieve a desired pay-off, including: Decisions on price and output, such as whether to: Raise Lower Hold Decisions on products, such as whether to: Keep existing products Develop new ones

Decisions on promoting products, such as whether to: Spend more on advertising Spend less Keep spending constant Firms could derive a range of possible pay-offs from their strategy choices, including: More profits for shareholders Greater market share Improved chances of survival Getting rid of a rival

Matching pennies
Each player selects one side of a coin; if the coins match player 1 wins and gets 1 dollar from player 2; if the coins dont match player 2 wins and gets 1 dollar from player 1.

Matrix Representation of Matching Pennies

Player 2 Head Head Player 1 Tail -1,1 1,-1 1,-1 Tail -1,1

Boeing-Airbus game
Boeing and Airbus have to decide whether to invest in the development of a Super Jumbo for long distance travel; if they both develop successfully the new plane, their profits will drop by 50 millions a year; if only one develop the Super Jumbo, it will make 80 millions a year in additional profits, whereas the profits of the other firm will drop by 30 millions a year; if no firm develops the plane, nothing changes.

Matrix Representation of Boeing-Airbus game

Airbus Develop Develop Boeing Do not develop -50,-50 -30,80

Do not develop
80,-30 0,0

Solutions of the Games

To predict what will be the solution/outcome of the game we need some tools:
dominated and dominant strategies; Nash equilibrium.

Prisoners Dilemma
Two individuals have been arrested for possession of guns. The police suspects that they have committed 10 bank robberies; if nobody confesses the police, they will be jailed for 2 years. if only one confesses, hell go free and his partner will be jailed for 40 years. if they both confess, they get 16 years

Matrix Representation of Prisoners Dilemma

B Confess Confess C Do not Confess 16,16 40,0

Do not Confess
0,40 2,2

We want to predict the outcome of the game

Suppose that C decides to confess. What is the best decision for B?

B Confess Confess C Do not Confess 16,16 40,0 Do not Confess 0,40 2,2

We want to predict the outcome of the game

Suppose that C decides to remain silent. What is the best decision for B?

B Confess Confess C Do not Confess 16,16 40,0 Do not Confess 0,40 2,2

We want to predict the outcome of the game

Suppose that B decides to confess. What is the best decision for C?

B Confess Confess C Do not Confess 16,16 40,0 Do not Confess 0,40 2,2

We want to predict the outcome of the game

Suppose that B decides to remain silent. What is the best decision for C?

B Confess Confess C Do not Confess 16,16 40,0 Do not Confess 0,40 2,2

Outcome of the Game

B Confess Confess C Do not Confess 16,16 40,0 Do not Confess 0,40 2,2

Dominated and Dominant Strategy

Dominant Strategy:
a strategy that gives best possible payoffs no matter what the opponent does;

Dominated Strategy:
a strategy is dominated if there exists another strategy that is dominant.

So far we have only assumed that each player is rational to determine the outcome of the game.

Nash Equilibrium
A list of strategies, one for each player, is a Nash equilibrium if each players strategy maximizes his (or her) payoff given the strategies selected by the other players and if this condition holds for all players simultaneously.

Any outcome that is best response for both players is a Nash equilibrium

Nash Equilibrium
The decisions of the players are a Nash Equilibrium if no individual prefers a different choice. In other words, each player is choosing the best strategy, given the strategies chosen by the other players.

Dominant strategy
Confess is the dominant strategy in this case, since it gives the shortest sentence irrespective of whether the other prisoner selects the confess or do not confess strategy

Price wars in a duopoly

The preceding is what we call a noncooperative game. Cooperation among duopolists is a strategy that maximizes joint profits. So why do price wars break out?

The payoff matrix for a running shoe duopoly

NIKE High Price High Price Low Price $10 million, $10 million $12 million, $5 million Low Price $5 million, $12 million $7 million, $7 million

REEBOK

Notice that low price is the dominant strategy

Advertising rivalry
Pizza Planet and Luigis are rivals in the
market for home-delivered pizza. Each rival seeks to gain an advantage through advertising (product differentiation). Advertising is presumed NOT to affect market demand--only market share.

Market share depends on the intensity of advertising relative to ones rival.

Let P = $15 Q = 100 pizzas (market quantity-demanded)

AC (w/o advertising expense) = $5.

Hence:

/Pizza = (TR - TC)/Q = ($1500 - $500)/100 = $10

If neither seller advertises, each will sell 50 pizzas and earn a profit of $500. However, advertising could potentially increase sales to 75 pizzas.

The payoff matrix for a pizza duopoly

PIZZA PLANET Low Advertising LUIGIS Low Advertising High Advertising $400, $400 $550, $150 High Advertising $150, $550 $300, $300

Notice that high advertising is the dominant strategy

Nash Equilibrium and the Shoe, Pizza Duopoly Games

A Nash equilibrium is given by the lowlow strategy in the running shoe duopoly game

A Nash equilibrium is given by the highhigh strategy in the pizza duopoly game.

Dominated Strategy
Example Example of an iterated deletion of dominated strategy equilibrium.doc

Maximin Strategy
This strategy is based on the fact that sometimes it is more prudent to maximize the minimum gains achievable in a gaming situation. Let's take the Meat and Potatoes example to appreciate this strategy.

Dominant Strategy -? ; Nash Equilibrium - ?

Nash Equilibrium is based on the fact that both M and P behave rationally. However, can P always count on M being rational?
Can P take the risk of selling potatoes if he is conservative and afraid that M may not behave rationally ? No. So, what does P do? P will sell meat, for he is assured of making at least $80,000. In this scenario, P is pursuing a Maximin Strategy of maximizing the minimum gains that can be earned.

Mixed Strategies
A mixed strategy is an assignment of a probability to each pure strategy. This allows for a player to randomly select a pure strategy.

 ..\Reference\mixed strategies.pdf

Game theory and Oligopoly

Non Cooperative Games Cooperative Games Repeated Games Sequential games

Non Cooperative games

The Prisoners Dilemma model This model explains a number of interesting phenomena in business

Example:
Firm 2
Low- level Advg Low level advg High level Advg

30, 30 40,10

10,40 20,20

Firm 1

High level advg

Cooperative Games: Enforcing a Cartel

The experience of the pan-masala industry during the 1980s is an interesting example of how a non cooperative game was turned, by government policy, into a cooperative game. For many years, the major pan-masala manufacturers had been spending large sums on TV advertising to promote their products. Much of this advertising was mutually offsetting, so the firms probably were in the Prisoners Dilemma. They would have been better off if they had reduced their advertising expenditures, but no one firm could afford to do so unless there was some assurance that their lead would be followed by the other firms. In mid-1980s, the government banned advertising of pan-masala on Doordarshan. Initially, the companies fought the ban, but it soon became apparent that any lost sales were more than made up by the savings in advertising. With this ban, the government did for panmasala manufacturers what they were unable to do for themselvesenforce a reduction in advertising expenditure.

Repeated Games- Dealing with cheaters

What is the optimal strategy for firms playing non cooperaive repeated games? AN approach described as tit-for-tat TIT FOR TAT is a very simple strategy, which cooperates on the first round, and thereafter simply copies what its opponent did on the previous round thereby rewarding cooperation with more cooperation and punishing defection with defection.

 EXAMPLE of tit for tat pricing.doc

Sequential Games
The advantage of being first
Firm2 No new product No New product 2,2 Introduce new Firm 1 product 10, (5) Introduce new product (5), 10 (7), (7)

Assumption: Maximin Strategy