3.1.

Strategic Behavior

Matilde Machado

1
 3.1. Strategic Behavior
 The analysis of strategic behavior starts by
formulating a game.
 A game is made of:
 players
 Possible strategies for each player
 Utility functions for each player
 Set of rules such as: simultaneous,
sequential, who plays first;

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 3.1. Strategic Behavior
Example: Player 2

C D
A 3,0 1,-1
Player 1

B 4,2 -2,1

Strategies: player 1 = {A,B}

player 2 = {C,D}
Utilities: player 1: if he plays A =3 or 1; if B = 4,-2
player 2: if he plays C =0 or 2; if D =-1, 1

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 3.1. Strategic Behavior
Example (cont.):
Rules of the game: each player chooses his
strategy independently of the other. But of
course, the outcome is a function of both
players’ strategies. Therefore, there is an
interdependence between their strategies,
which is typical of game theory.
Solution: The equilibrium concept that is mostly
used is Nash equilibrium.

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 3.1. Strategic Behavior
Nash equilibrium– a vector of strategies (one
strategy for each player) is a Nash equilibrium if
none of the players can increase his utility
through a unilateral move (that is given the
strategy of the other player).
…. Back to the game…

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 3.1. Strategic Behavior
player 2

C D
player 1
A 3,0 1,-1

B 4,2 -2,1

player 2: If player 1 plays A → best response is C; u=0

If player 1 plays B → best response is C; u=2
 C is a dominant strategy to player 2
because it is always preferable to D
player 1: If player 2 plays C → best response is B; u=4
If player 2 plays D (which he won’t) → best response is A; u=1
{B,C} is the only Nash equilibrium of the game.

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 3.1. Strategic Behavior
Formally, {B,C} is a Nash equilibrium because:

U1 (b, c)  U1 (a, c) or alternativelly b  arg maxU1 (i, c)

i

U 2 (b, c)  U 2 (b, d ) or alternativelly c  arg maxU 2 (b, j )

j

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 3.1. Strategic Behavior
In Industrial Organization:
 Players are firms
 Strategies are going to be prices, quantities,
advertising, product quality, R&D, capacity, etc.
 Utilities are going to be profits

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 3.1. Strategic Behavior
An example:
Assume firms A and B are deciding whether or not
to launch an advertising campaign. The
campaign will cost 10 000 Euros. In case both
firms launch the campaign, firm A gets all the
benefits of the campaign and firm B will not
benefit from the campaign although it will incur
in costs. In case firm B launches the campaign
alone, then its profits will increase. The payoffs
of the game are the following:

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 3.1. Strategic Behavior

B
A A NA
A 190,-10 190,0

NA 100,110 100,100

¿What will firm A do? That depends on what firm B will do and vice-
versa (note that both firms know the payoff matrix). Each firm wishes
to maximize profit given what the other firm does and for that needs
to take into account what the other firm does. In order to solve for the
Nash equilibrium we need to construct the best response functions.
RA(A)=A; RA(NA)=A (Advertising is dominant for A) and for B:
RB(A)=NA; RB(NA)=A

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 3.1. Strategic Behavior
Generalizing in IO
 The profit function is continuous in the strategies
of the player and its rival’s.
 Strategies are going to be actions i.e. 1×1
vectors
i (ai , a j )  profit of firm i when it performs action ai
and its rival action aj where aiAi and ajAj.
 The pair (ai* , a*j ) is a Nash equilibrium iff:

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 3.1. Strategic Behavior
The pair (ai* , a*j ) is a Nash equilibrium iff:

 i
( ai
*
, a *
j )   i
( a i , a *
j ) a i  a i  Ai
*

 j * *

 ( a i , a j )   j
( a *
i , a j ) a j  a j  Aj
*

Or written a bit differently:

ai*  arg max  i (ai , a*j )

 ai
 *  ( a *
, a *
j ) are best responses respectively
a j  arg max  (ai , a j )
j * i

 aj

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 3.1. Strategic Behavior
If there are interior solutions, then:

 *  i (ai* , a*j )  2  i (ai* , a*j )

ai satisfies  0; 0
 ai ai 2


a* satisfies  j
( a *
, a *
)  2
 j
( a *
, a *
j)
 0; 0
i j i
 j a j a j 2

Lets assume that Ai=Aj= and i and j are
concave (i.e. iii<0 and jjj<0) for all values of ai
and aj  the FOC’s are enough to derive the
Nash equilibrium ( a system of 2 equations and
2 unknowns).
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 3.1. Strategic Behavior

Models of Strategic Behavior :

 Cournot model – quantity is the strategic
variable
 Bertrand model – price is the strategic variable
 Stackelberg model – it is the same as Cournot
but sequential
Note: In the standard Monopoly model we obtain the same result
regardless of the choice variable of the Monopolist (price or quantity)
this no longer holds for the Oligopoly models. The equilibrium depends
crucially on the strategic variable.
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