Game Theory
CHAPTER FOUR
4. GAME THEORY
4.1 INTRODUCTION
In the oligopoly market we noted that competition is intense. That is, firms must consider the likely
responses of competitors when they make strategic decisions about price, advertising, and other
variables. In other words, the actions and reactions of a firm depend on the move and countermove
of the other firm just like a game. Thus the development and application of game theory is one of
the most exciting areas in microeconomics. This unit explains some of this theory and show how
firms can make strategic moves that give them an advantage over their competitors.
Definition and Concept of Game Theory
Games are played in business, politics, diplomacy and wars. The word game may convey an
impression that the subject is not important in the larger schemes (arrangement) of things that it
deals with trivial pursuits such as gambling and sports, when the world is full of more weighty
matters such as war, business, education, career and relationships. Actually all these weighty
matters are games.
Game theory is a branch of applied mathematics and the science of rational behavior in interactive
situation. Game is the science of strategic decision making. Any situation in which individuals must
make strategic choices and in which the final outcome will depend on what each person chooses to
do can be viewed as a game. Game is an action where there are two or more mutually aware players
and the outcome for each depends on the action of all. The reason for spending time on game theory
is that it is a tool designed for investigating the behavior of rational agents in setting for which each
agent’s best action depends upon what other agents are expected to do. As a result game theory will
prove to be very useful in investigating firm behavior in oligopolies and more generally, in providing
insight concerning the strategic behavior of firms.
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Game Theory
4.2. Concepts Used in Games Theories
The strategic form (normal form) of a game describes an economic setting by three elements:
1. Players: Players of a game are participants in the game.
They can be managers of firms that can make important decisions in the firms’ day to day
activities.
Each decision maker in a game is called a player. These players can be individuals (poker
game), firms (as in the Oligopolistic markets), or entire nation (as in the military conflict).
2. Strategies: Each course of action open to a player during a game is called a strategy.
Strategy is a decision rule of players.
A strategy tells a player how to behave in the settings being modeled or is a decision rule
that instructs a player how to behave over the course of the game.
For instance, a firm may set its strategy as a price of Birr 1000, spending Birr
200 on promoting a product, altering the packaging of the product, and so forth. Given
that firms are rational in the sense that they are motivated by profit maximization, they
decide to adopt the same or a different strategy as that of the competitors’. That is, the
firm will adopt a course of action that seems most advantageous under a given scenario.
3. Payoffs strategies: The final return to the players of a game at its conclusion is called “payoffs”.
Example the Payoffs for the firms can be profit. A player’s payoff function describes how
it evaluates different strategies. That is, given the strategies chosen by all players, a
player’s payoff function tells him his state of well-being (or welfare or utility) from players
having played those strategies. It is the objective, usually numerical, that a player in a game
aims to maximize.
4. Payoff matrix: A firm is a table that shows the payoffs accruing to the firm as a consequence of
each possible combination of course of actions adopted by the firm and by its competitor(s).
5. Zero – sum – game is a kind of game in which the gain earned by one player is exactly equal in
magnitude to the loss incurred by another player.
6. Positive – sum – game is a kind of game where the gain received by one of the players is
necessarily greater than the loss incurred by the other player.
7. Negative – sum – game is a type of game in which the loss incurred by one of the players
is necessarily greater than the gain received by the other player.
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Game Theory
Fundamental Assumptions of Game theory
Game theoretic analysis is built on two fundamental assumptions: These are
1. Rationality: game theory assumes that players are interested in maximizing their payoffs.
2. Common Knowledge: all players know the structure of the game and that their opponents are
rational.
The economic games that firms play can be either cooperative or non-cooperative. A game is
cooperative if the players can negotiate binding contracts that allow them to plan joint strategies.
A game is non cooperative if negotiation and enforcement of a binding contract are not possible.
Another cooperative game can be the negotiation of two firms in an industry for a joint
investment to develop a new technology.
If the firms can sign a binding contract to divide the profits from their joint investment, a
cooperative outcome that makes both parties better off is possible.
Dominant Strategies
Dominant strategy refers to the optimal choice for a player no matter what the opponent
does or the strategy that is optimal for a player no matter what an opponent does.
In any game each player has his own strategy that enables him to win the game. That means the
game’s likely outcome depends on the strategy the player follows. Thus knowing the strategy
help us determine how the rational behavior of each player will lead to an equilibrium solution.
Suppose firms A and B sell competing products and deciding whether to undertake advertising
campaigns. Each firm, however, will be affected by its competitor’s decision. The possible
outcomes of the game are illustrated by the payoff matrix in the table below.
There are two players (Firm A and Firm B) and two strategies open to them: Advertise and do
not advertise as shown by the following payoff matrix.
The figures in each cell are the payoffs, which are the outcome of the strategies chosen by the
firms (players). In this case, the payoffs show the level of profit, the first payoffs stand for the
first player, A and the second payoffs belong to the second player, firm B.
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Game Theory
Firm B
Advertise Don’t Advertise
Advertise
10,5 15,0
Firm A Don’t Advertise
6,8 10,2
The payoff matrix summarizes the possible outcomes of the game; the first number in each cell
is the payoff to firm A and the second is the payoff to firm B.
We can observe from this payoff matrix that if both firms decide to advertise, firm A will make
profits of 10, and firm B will make profits of 5.
If firm A advertises and firm B doesn’t, firm A will earn 15, and firm B will earn zero.
(Indicated by top right cell of the payoff matrix)
Firm A If firm B Adv. IIB = 5 Firm A If firm B Adv. IIB = 8
Adv. If firm B Not Adv. IIB = 0 Not Adv. If firm B Not Adv. IIB = 2
(Indicated by top left cell of the payoff matrix)
Dominant Strategy of firm B is to Advertise
Firm B If firm A Adv. IIA = 10 Firm B If firm A Adv. IIA = 15
Adv. If firm B Not Adv. IIA = 6 Not Adv. If firm A Not Adv. IIA = 10
Dominant Strategy of firm A is to Advertise
Therefore, the equilibrium solution of the above game is (Firm A, Firm B) = (10, 5)
Now let us look the dominant strategy of each firm.
First, consider firm A.
Firm A should clearly advertise because no matter what firm B does, firm A does best by
advertising (if firm B advertises, A earns a profit of 10 if it advertises, but only 6 if it
doesn’t),
If B dose not advertise A earns 15 if it advertises, but only 10 if it doesn’t). Thus,
advertising is a dominant strategy for firm A.
The same is true for firm B:
No matter what firm A does, firm B does best by advertising.
Therefore, assuming that both firms are rational, we know that the outcome for this game is
that both firms will advertise. This outcome is easy to determine because both firms have
dominant strategies.
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Game Theory
4.3. The Nash Equilibrium Concept
Equilibrium Concept: An equilibrium concept is a solution to a game. The equilibrium
concept identifies, out of the set of all possible strategies, the strategies that players are
actually likely to play. Solving equilibrium is similar to making a prediction about how the
game will be played.
Nash Equilibrium
In real world, not all games do have dominant strategy for each player. This can be noted
from the following payoff matrix. Although there are several ways to formalize equilibrium
concepts in game theory, the most commonly used approach was originally proposed by
Cournot’s in the 19th century and generalized in the early 1950s by John Nash.
Under Nash’s procedure, a pair of strategies, say, (a*, b*), is defined to be an equilibrium.
If a* represents player A’s best strategy when B plays b*, and b* represent B’s best
strategy when A plays a*.
Assuming that players are rational, a player chooses the strategy that gives him his highest
payoff.
In deciding which strategy is best, a player must take in to account the strategies that he
expects that other players to choose.
To capture this interdependence, the concept of Nash Equilibrium was developed.
It should be noted that by identifying the dominant strategies it is possible to arrive the
outcome of the game because dominant strategies are stable.
Not every game has a dominant strategy for each player. If we change the payoff (10, 2)
in the bottom right - hand corner into (20, 2) in the above table, firm A will not have a
dominant strategy but B does have.
A's optimal decision depends on what firm B does. If B advertises, then A does best by
advertising; but if B does not advertise, A does best by not advertising.
Since firm B has a dominant strategy- advertises, A concludes that B will advertise then
a will advertise.
The equilibrium is again that both firms will advertise. It is the logical outcome of the
game because firm A is doing the best it can , given firm B's decision; and firm B is
doing the best it can , given firm A's decision, this is called Nash equilibrium.
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Game Theory
Firm B
Advertise Don’t Advertise
Advertise
10,5 15,0
Firm A Don’t Advertise
6,8 20,2
Firm A If firm B Adv. IIB = 5 Firm A If firm B Adv. IIB = 8
Adv. If firm B Not Adv. IIB = 0 Not Adv. If firm B Not Adv. IIB = 2
Dominant Strategy of firm B is to Advertise
Firm B If firm A Adv. IIA = 10 Firm B If firm A Adv. IIA = 15
Adv. If firm B Not Adv. IIA = 6 Not Adv. If firm A Not Adv. IIA = 20
Firm A has no Dominant Strategy to maximize its payoffs.
On the other hand, in many games one or more players do not have a dominant strategy. We
therefore need a more general solution concept the Nash equilibrium.
Nash equilibrium again is a set of strategies (or actions) such that each player believes
(correctly) that it is doing the best it can, given the actions of its opponents.
Since each player has no incentive to deviate from its Nash strategy, the strategies are stable. In
the example shown in table above, the Nash equilibrium is that both firms advertise.
If you remember in Cournot’s equilibrium, each firm sets output or price while taking the
output or price of its competitors as fixed.
Once the firms have reached Cournot’s equilibrium, no firm has an incentive to change its
output or price unilaterally because each firm is doing the best it can give the decisions of its
competitors.
Therefore, Cournot’s equilibrium is also Nash equilibrium. Note that dominant strategy
equilibrium is a special case of Nash equilibrium.
The Prisoners’ Dilemma
A classic example in game theory, called the prisoners’ dilemma, illustrates the problem
oligopolistic firms’ face. It goes as follows: two prisoners have been accused of collaborating
in a crime. They were in separate jail cells and cannot communicate with each other. Each has
been asked to confess to the crime.
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Game Theory
The payoff matrix in table below summarizes the possible outcomes. Table showing the pay-
off matrix for prisoners’ dilemma.
Person B
Confess Don’t confess
Confess -5, -5 -1, -10
Person A
Don't Confess -10, -1 -2, -2
The payoffs are negatives because they show the number of years one will spend in prison.
Obviously, in numeric example -1 is greater than -10 (i.e,-1> -10) implies spending one year in
prison is preferred to spending 10 years in prison.
Pri. A If Prisoner B Confess, -5 Pri. A If Prisoner B Confess, -1
Conf. If Prisoner B Don’t Confess, -10 Don’t Conf If Prisoner B Don’t Confess, -2
Dominant Strategy of Prisoner B is to Confess
Pri. B If Prisoner A Confess, -5 Pri. A If Prisoner B Confess, -1
Conf. If Prisoner A Don’t Confess, -10 Don’t Conf If Prisoner B Don’t Confess, -2
Dominant Strategy of Prisoner A is to Confess. Now let us look the game.
If both prisoners confess, each will receive a term of five years. On the other hand, if one
prisoner confesses and the other does not, the one who confesses will receive a term of only one
year, while the other will go to prison for ten years. If you were one of these prisoners, what
would you do- confess or not confess?
It is very difficult to determine. As the table shows these prisoners face a dilemma. If they could
only both agree not to confess, then each would go to jail for only two years. But they can't talk
to each other, and even if they could, can they trust each other?
If prisoner A does not confess, s/he risks being taken advantage of by his/her former accomplice.
After all, no matter what prisoner A does, prisoner B comes out ahead by confessing. Similarly,
prisoner A always comes out ahead by confessing, so prisoner B must worry that by not
confessing, s/he will be taken advantage of. Therefore, both prisoners will probably confess, and
go to jail for five years.
Oligopolistic firms often find themselves in a prisoner's dilemma. They must decide whether to
compete aggressively, attempting to capture a larger share of the market at the competitors'
expense, or to "cooperate" and compete more passively, i.e. they can set high prices and limiting
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Game Theory
output, they will make higher profits than if they compete aggressively. Let us look the following
game that is played by firm 1 and firm 2.
Firm 2
Charge Birr 4 Charge Birr6
Charge Birr 4 12,12 20,4
Firm 1 Charge Birr 6 4,20 16,16
Now let us assume that both firms have reached the agreement to cooperate by charging birr
6 for a product they sell and each one will receive birr16 Profits. However, if one firm cheats
the other by charging 4 (the other charged as before 6) it would increase its profit while the
profit of the other will fall down. That is, if firm 1 charge 4 and firm 2 keeps its promise
(charging 6) firm 1 will increase its profit from 16 to 20.
On the other round, if firm 2 cheats firm 1 by charging 4 it increases its profit from 16 to 20
while the profit of firm 1 falls down from 16 to 4. Since both have the strong incentive to
cheat the other, the final outcome will be to charge 4 and both will have a profit of 12 which
is less than the cooperative profits, 16. Have you noted that the result of this game is similar
to the prisoners’ dilemma?
Summary
Game theory is a tool that is used for examining strategic behavior in economic
circumstances
A game is any situation in which players (participants) make strategic decisions i.e. decisions
that take into account each other’s actions and responses.
A game is cooperative, if the player can communicate and arrange binding contracts
otherwise, it is non-cooperatives.
Strategic decisions result in payoffs to the players and the optimal strategy for a player is the
one that maximizes her expected payoff.
A Nash equilibrium is a set of strategies such that all players are doing their best given the
strategies of the other players. We will say that a pair of strategies is a Nash equilibrium if
A’s choice is optimal given B’s choice, and B’s choice is optimal given A’s choice.
Equilibrium in dominant strategy is a special case of Nash equilibrium.
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Game Theory
A dominant strategy is a strategy that will maximize the expected payoff of a player no
matter what the other player does.
The prisoner’s dilemma is a type of game that is very much help fully in understanding
oligopoly behavior. In particular, it helps explain why firms have a tendency to cheat on
cartel agreement. However, if the game is repeated indefinitely, then firms may not cheat.
When the game is repeated a fixed known number of times, on the other hand cheating
solution is return.
The dominant strategy equilibrium can be found by eliminating dominated strategies of each
player alternatively mostly in the case of more than three strategies case.
A pure strategy is strategy in which a player makes a specific choice or takes a specific
action with probability equal to one. Whereas, mixed strategies are those in which a player
makes a random choice among two or more possible actions, based on a set of chosen
probabilities.
Nash equilibrium in mixed strategies refers to an equilibrium in which each agent chooses
the optimal frequency with which to play his strategies given the frequency choices of the
other agent.
A game said to be sequential game if player move in turn. While simultaneous game a case
where a player move at the same time by assuming a given strategic choose for the other
player.