1) Meaning of Game Theory and the concept of Dominant Strategy.

Discuss the rationales of

Game theory is the study of strategic decision-making where the outcome for one person or firm
depends not only on its own decision but also on the decision of others. Your slide defines strategy
as a plan for acting that responds to the reactions of others, and identifies the basic elements of a
game as players, strategies, and payoffs. In other words, game theory is used when people or firms
are interdependent and must think about what the other side may do before choosing their own
action.

The new PDF strengthens this idea through the example of oligopoly and price-fixing. It explains that
in a duopoly, each airline must choose either a high cartel price or a low competitive price while
knowing that the rival is making a similar choice. To understand such strategic settings, the text uses
both a game tree and a payoff matrix.

A dominant strategy is the action that is best for a player no matter what the other player does. The
new PDF defines dominant strategy as “an action that is the best choice for a player, no matter what
the other player does.” This is the core of rational choice in game theory. A rational player compares
outcomes under each possible action of the rival and chooses the strategy that gives the higher
payoff in every case.

The rationale of dominant strategy is therefore based on certainty and self-interest. A player may not
know what the other side will do, but if one action remains best in all cases, then that action
becomes the logical and rational choice. The price-fixing game in the new PDF is a very clear
example. In Figure 12.3 and Figure 12.6, Jack compares the payoffs from high and low price. If Jill
picks the high price, Jack earns more by choosing the low price. If Jill picks the low price, Jack again
earns more by choosing the low price. Therefore, low price is Jack’s dominant strategy. Jill, knowing
this, also chooses the low price, leading to the duopoly outcome.

Another example is the prisoner’s dilemma. In Figure 12.7, if Bonnie does not confess, Clyde is better
off confessing; if Bonnie does confess, Clyde is still better off confessing. So confessing is Clyde’s
dominant strategy, and Bonnie reasons the same way. This also matches the explanation in your
slides, which state that confession is the dominant strategy for both prisoners. Thus, dominant
strategy helps explain why rational individuals often choose the same action repeatedly even when
that outcome is not socially best.

Useful figures: Figure 12.3, Figure 12.6, Figure 12.7.

2) Discuss the concept of Prisoner’s Dilemma and Nash Equilibrium by taking an example of a
duopolist firm (Diagram and matrix).

The prisoner’s dilemma is a situation in which two players acting in their own self-interest end up
with an outcome that is worse for both than cooperation would have been. The new PDF explains
this through Bonnie and Clyde. If neither confesses, each gets 2 years in prison. If one confesses and
the other does not, the confessor gets 1 year while the other gets 10 years. If both confess, each gets
5 years. Since each prisoner fears that the other might confess, both choose to confess. This is why it
is called a dilemma: cooperation would make both better off, but rational self-interest pushes both
toward confession. This is shown in Figure 12.7 Payoff Matrix for the Prisoners’ Dilemma.
Nash equilibrium means an outcome in which each player is doing the best he or she can, given the
action of the other player. The new PDF defines it in exactly this way. In the prisoner’s dilemma, both
confessing is the Nash equilibrium because once one player confesses, the other cannot improve by
changing alone. Even though mutual silence would be better for both, it is not stable because each
has an incentive to deviate.

This same concept applies to a duopolist firm. The new PDF discusses a price-fixing game between
Jill and Jack in the airline market. If both charge the high price, each earns $9,000. If both charge the
low price, each earns $8,000. But if one charges the low price while the other charges the high price,
the low-price firm captures more of the market and earns $12,000, while the high-price firm earns
only $3,000. This is shown in Table 12.2, Figure 12.3 and especially Figure 12.6 Payoff Matrix for the
Price-Fixing Game.

Duopoly payoff matrix

Jack: High Price Jack: Low Price

Jill: High Price 9,000 ; 9,000 3,000 ; 12,000

Jill: Low Price 12,000 ; 3,000 8,000 ; 8,000

From this matrix, low price is the dominant strategy for each firm. If the rival chooses high price, low
price gives a higher payoff. If the rival chooses low price, low price still gives a higher payoff.
Therefore, both firms choose low price. That outcome is the Nash equilibrium. However, both firms
would be better off if both charged the high price and earned $9,000 each. This is the duopolists’
dilemma: individually rational decisions produce a less profitable collective outcome.

Useful figures: Figure 12.3, Figure 12.6, Figure 12.7; also Table 12.2.

3) Discuss the concept of a game tree. Discuss its three elements. Explain Nash equilibrium,
efficient outcome, and duopolist dilemma with the game tree.

A game tree is a graphical or extensive-form representation of a strategic situation. The new PDF
defines a game tree as “a graphical representation of the consequences of different actions in a
strategic setting.” Unlike a payoff matrix, which shows all possible outcomes in table form, a game
tree shows the sequence of decisions step by step. This makes it especially useful where one player
moves first and the other responds after observing that move.

The new PDF clearly explains the three components of a game tree using Figure 12.3. First, the
squares are decision nodes, showing which player is making a decision and what options are
available. Second, the arrows show the possible paths from one decision to another. Third, the
rectangles show the final payoffs or profits after the choices are made. This fits neatly with your
slides, which say that the main elements of game theory are players, strategies, and payoffs.

In the price-fixing game of Jill and Jack, shown in Figure 12.3, Jill first chooses either a high price or a
low price. Jack then responds with his own choice. Each terminal rectangle shows profits for both
firms. Rectangle 1 represents cartel pricing, where both choose high price and each gets $9,000.
Rectangle 4 represents the competitive duopoly outcome, where both choose low price and each
gets $8,000. Rectangles 2 and 3 represent underpricing outcomes, where one firm earns $12,000 and
the other only $3,000.
Using the game tree, we can identify the Nash equilibrium. Jack’s best response is always the low
price, regardless of Jill’s choice. So low price is his dominant strategy. Jill understands this, and
therefore she also chooses the low price. The equilibrium path is from square A to square C to
rectangle 4. This is the Nash equilibrium because each firm is doing the best it can given the action of
the other.

The efficient outcome, however, is different. Your slides define efficient outcome as one that
minimizes total social cost or maximizes combined payoffs. In this game, both firms choosing high
price in rectangle 1 gives a total profit of $18,000, while both choosing low price in rectangle 4 gives
a total of $16,000. So rectangle 1 is more efficient from the firms’ joint perspective. Yet it does not
occur because each firm fears being underpriced. That is the duopolists’ dilemma: both would be
better off if both chose high price, but each chooses low price because underpricing brings a large
gain and being underpriced brings a large loss.

Useful figure: Figure 12.3. For simultaneous comparison, you may also mention Figure 12.6.

Figure / table numbers you can mention in the exam

• Figure 12.1 – Cartel picks monopoly quantity and price

• Figure 12.2 – Competing duopolists pick a lower price

• Figure 12.3 – Game tree for the price-fixing game

• Table 12.2 – Duopolists’ profits when they choose different prices

• Figure 12.6 – Payoff matrix for the price-fixing game

• Figure 12.7 – Payoff matrix for the prisoners’ dilemma