Intermediate Microeconomics,

Games and Behaviour

Week 2

Strategic interaction
Strategic interaction in single encounters
Application: Oligopoly theory
Cournot competition
Bertrand competition with homogeneous products
Bertrand with competition heterogeneous products

Application: Strategic Interaction between

individuals
Provision of a public good

Question
Suppose you are in a team of 4 people.
You each have 10 Euros
You can either keep these 10 Euros, or invest all
or some of the 10 Euros into a joint project of
your team.
The joint project will generate a profit which is
twice the sum of all contributions.
The projects profit will be given in equal shares
to all members of your group.
How much do you contribute??

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How much do you contribute?

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F.
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H.
I.
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Markets with only a few sellers

Until now mainly:
many sellers (competitive market) price takers, setting q by
equating P=MC
only one seller (monopoly) price setters, Q is such that
MR=MC
In both cases: dont bother about what competition is doing.

Now (and the next two weeks):

- only a few sellers (oligopoly)
- to keep things as uncomplicated as possible:
N = 2 (duopoly)

Oligopoly
In oligopolistic markets, the products may or may
not be differentiated
What matters is that only a few firms account for
most or all of total production
In some oligopolistic markets, some or all firms
earn substantial profits over the long run because
barriers to entry make it difficult or impossible for
new firms to enter

Why so few firms?

Scale economies may make it unprofitable for more than
a few firms to coexist in the market;
Patents or access to a technology may exclude potential
competitors. The need to spend money for name
recognition and market reputation may discourage entry
by new firms.

These are natural entry barriersthey are basic to the

structure of the particular market.
In addition, incumbent firms may take strategic actions to
deter entry.

Oligopoly
Crucial in case of oligopoly:
- behaviour of a firm depends on how one
firm thinks that other firms will react
Suppose duopoly:
which PE and which QE?
How to solve this problem?
The solutions depend on the assumptions
made

Strategic Interaction among

Oligopolists
In an oligopolistic market, a firm sets price or
output based partly on strategic considerations
regarding the behaviour of its competitors.

Game Theory Toolbox 1

Static Games with Complete Information

Decision Theory vs Game Theory

Decision theory:
1 decision-maker
environment exogenous

Game theory:
More than 1 decision-maker
environment endogenous (what others do,
depends on what I do)

Elements of a game
1. The players:
- how many players are there?
- does nature/chance play a role?
2. The rules of the game
- A complete description of what the players can do,
the set of all possible actions and the timing.
- The information that players have available when
chosing their actions.
3. A description of the payoff consequences of each
player for every possible combination of actions
chosen by all players playing the game.

4. A description of all players preferences over payoffs.

Games of complete information

A game of complete information requires that the
following four components be common knowledge
among all players of the game:

1. all the possible actions of all the players,

2. all the possible outcomes

3. how each combination of actions of all players

affects which outcome will materialize, and
4. the preferences of each and every player over
outcomes.

Normal form representation

Simultaneous decisions are represented in
the strategic or normal form of the game.

players
H
H

1
L

player 1s actions

2
a

L
b

B
c

player 2s actions

player 2s payoff for HL

player 1s payoff for LL

Firms competing in quantities:

set-up a game

Example: Two firms compete for consumers

Albert Heijn and Jumbo compete for consumers by offering their
products in different quantities to the market. Given the law of
demand, demand and thus price will be high when the total
quantity on the market is low prices, and vice versa. The
managers of the two chains have to decide about the quantities,
without really knowing which quantity the competitor chooses.

Albert Heijn versus Jumbo

The strategic game that corresponds to this strategic situation is:
Players: Albert Heijn and Jumbo
Actions: Each players set of actions is {12 units, 16 units}
Preferences over outcomes:
For each player the action profile in which this player
chooses 16, while the other one chooses 12, is ranked
highest,
For each player the action profile in which this player
chooses 12, while the other one chooses 16, is ranked
lowest.
Second best is a profile in which both choose 12.
Third best is a profile in which both choose 16.

The strategic situation of two

supermarkets in normal form
Pure Strategy

specific (non-probabilistic) choice available to a player

Example: AH - Jumbo Quantity competition

Jumbo
12

1s pure strategies: {12, 16}

2s pure strategies: {12, 16}

16

12

288
320
288
240

16

240
256
320
256

AH

Game is written down in terms of pure strategies.

However, strategies can be probabilistic (= mixed strategies)

Example: AH - Jumbo Quantity competition

Jumbo
12
12

288
288

AH
16

16

320
240

240
320

256
256

Given the above incentives, if Jumbo offers 12, what is

best action for AH?
Payoff for AH is highest when offering 16 units.

Example: AH - Jumbo Quantity competition

Jumbo
12
12

288
288

AH
16

16

320
240

240
320

256
256

Given the above incentives, if Jumbo offers 16, what is

best action for AH?
Payoff for AH is highest when offering 16 units.

Jumbo
12

16

288

12

288

AH

320
240

240

16

320

256
256

Now consider Jumbo:

For Jumbo, 16 leads to the highest payoff when AH is
offering 16 units:

U2(16|16) = 256 > U2(12|16) = 240

Dominant strategies
A dominant strategy is always optimal no matter what an
opponent does.
2
C

C
1
D

D
3

5
0

0
5

1
1

Player 1 has a dominant strategy:

If player 2 chooses C, for player 1 D is optimal: 5>3
If player 2 chooses D, for player 1 D is optimal: 1>0
Player 2 has a dominant strategy as well:
If player 1 chooses C, for player 2 D is optimal: 5>3
If player 1 chooses D, for player 2 D is optimal: 1>0

Dominant Strategies

Formal Definition: S1 strictly dominates S2 iff

(|) > (|)

If S1 strictly dominates S2, it will always give a higher payoff than S2,
regardless of the strategy player 2 uses.

Rationality assumptions

Both players have dominant Strategies

Nash equilibrium
Assumption needed:
The players themselves are rational.

No dominant strategies?

The existence of dominated strategies may

help to find the NE

We can eliminate strictly dominated strategies

since a rational player has no incentive to play them.

Iterated Dominance
If we can iteratively eliminate strictly dominated strategies until only
one exists per player, then the resulting strategies lead to an
equilibrium.

Example:
notice that D strictly dominates U cross out U

L
U

given that, L strictly dominates C cross out C

given that, D strictly dominates M cross out M

1
0

therefore, (D, L) is an equilibrium

-2

-1
4

1
5

5
1

R
3

given that, L strictly dominates R cross out R

4
3

2
4

2
6

Iterated eliminations of strictly

dominated strategies
We can use iterated eliminations of strictly dominated
strategies (IESDS) any number of rounds to come up with a
reasonable prediction.
If there is a unique solution after successive elimination this
solution is a Nash equilibrium!

Rationality assumptions
Dominated Strategies: IESDS Nash equilibrium

The players themselves are rational, and

Each player knows that the other player is rational
(i.e., their rationality is common knowledge)

Nash Equilibrium
A pair of strategies forms a Nash Equilibrium (NEQ) iff the
strategies are best responses to each other.

Note
No player has an incentive to deviate unilaterally from the NEQ.

(NEQ strategy maximizes each players utility, given that every

other person is choosing a NEQ strategy)

The NEQ is not necessarily the best or most preferred outcome for

each player.

John Nash (1928*)

Examples
2

Example 1:

For player 1, D strictly dominates C since

U1(D|C)=5 > 3 and U1(D|D)=1 > 0

Player 1 will not play C.
Same for player 2
Since D strictly dominates for both players,
DD is a Nash equilibrium.

C
1
D

D
3

0
0

1
1
2

Example 2:
Neither player has a dominated strategy.
However, dont need that for a Nash

equilibrium.
Still two pure strategy Nash equilibria.
How do we find these Nash equilibria?

1
L
R

1
1

0
0

Best Response to a Best Response to a

Consider what happens if two players iterate best responses:
1 chooses a strategy
2 chooses best response strategy
1 chooses its best response to that strategy
2 chooses its best response to that strategy

Eventually, this may stabilize:

1 will have strategy Si that is a best response to 2s tj
and
2s tj will be a best response to Si
Equilibrium: no one has an incentive to deviate

Best Response to a Best Response to a

Example:

2 starts with 12
1s best response to 12 is 16

Jumbo
12
12

288
288

AH
16

16

320
240

240
320

1s best response to 16 is 16
2s best response to 16 is 16

256
256

2s best response to 16 is 16

1s best response to 16 is 16

etc etc
Equilibrium: (16, 16)

Now assume that players, seeing the game, do this all in their
heads and identify the equilibrium strategies of the game.

Mutual-best-response property
of the Nash Equilibrium
For simple 2x2 games, just check whether anyone has incentive to deviate
from a particular outcome:
2
C

Prisoners Dilemma
1

D
Is CC a NEQ?

D
3

5
0

0
5

1
1

No. Given that 1 plays C, 2 would prefer D; same for 1.

Is DD a NEQ?

Yes. For both players, 1 > 0.

Mutual-best-response property
of the Nash Equilibrium
For simple 2x2 games, just check whether anyone has incentive to deviate
from a particular outcome:
2
L

Coordination game
1

R
Is LR a NEQ?

R
1

0
0

0
0

1
1

No. Given that 1 plays L, 2 would prefer L; same for 1.

Is LL a NEQ?

Yes. For both players, 1 > 0; note that RR is also a NEQ.

Assumptions
1. Players are rational: A rational player is one who chooses his
actions to maximize his payoff consistent with his beliefs about
what is going on in the game.
2. Common knowledge: the fact that players are rational and
intelligent is common knowledge among the players of the
game.
3. Self-enforcement: Any prediction (or equilibrium) of a solution
concept must be self-enforcing.

Maximin strategy
Strategy that maximizes the minimum gain that can be earned.
Thought experiment: consider one of your strategies.
What is your minimum payoff for that strategy?
Do this for all your possible strategies.
Find the maximum of the minimum payoffs.
L

Alice

Bob

300 400 450

300 130 0

100 200 100

120
400 200 120

0
420

150
0
100 20

Games with continuous strategies

Suppose
there are two players 1 and 2 with action sets
+
+
1 = and 2 =
players payoff functions are:
1 1 , 2
2 1 , 2

1
= (1 +
2 1 )1
2
1
= (1 +
1 2 )2
2

=> We cannot analyze the game in a matrix!

40

The best response functions

(reaction functions)
To find the best response of player 1 to any action of players 2,
we need to study player 1s profit as a function of its own action
s1 for given values of s2.
1 1 ,2
1

=1+

2 2

1 = 0 1 2 = 1

1
+ 2
2

Analogously for player 2:

2 1 ,2
1

=1+

2 1

2 = 0 2 1 = 1 +

2 1

41

Nash equilibrium is
the intersection of best-response functions
1
1 = 1 + 2
2

1 = 1 + 2 2 (1 )
1

1 = 1 + (1 + 1 )
2
2
1 = 2

and
analogously for
player 2

2
(1 , 2 )

1 (2 )
1

2 (1 )

42

Back to our application:

A. Strategic Interaction between firms:
Oligopoly competition la Cournot

Cournots model of oligopoly competition

Assumptions:
- homogeneous goods
- each firm treats the output of the other firm as fixed
- the firms decide simultaneously (meaning: without
knowledge of the competitors decision) how much to
produce
So:
q1 = q1 (q2)
q2 = q2 (q1)
Thus we have two equations with two unknowns and,
therefore, we can solve for q1 and q2 (and, given the market
demand curve) for the price (with p1 = p2 because the goods
are homogeneous).

Cournots model as a game between 2 players

Suppose
there are two firms 1 and 2 with action sets 1 +
and 2 + => quantity competition!
Inverse demand is given as (1 + 2) = (1 + 2)
Marginal production costs are identical and equal to c
Firms payoff functions are:
1 1 , 2 = 1 + 2 1 1 = ( 1 2 )1
2 1 , 2 = 1 + 2 2 2 = ( 1 2 )2

45

Find the best response functions

To find the best response of firm 1 to any action (output) of
firm 2, we need to study firm 1s profit as a function of its own
action (output) q1 for given values of q2.
If q2=0 : 1 1 , 0 = ( 1 )1

1 (1 , 2 )

1 1 , 0
= 21
1
1
1 (0) = ( )
2

q2=0

A quadratic function
that is zero if q1=0
and when q1 = a-c

a-c

q1
46

Find the best response functions

If q2>0 : 1 1 , 2 = ( 1 2 )1

1 (1 , 2 )

A quadratic function that

is zero if 1 = 0 and
when 1 = 2

1 1 , 2
= 21 2
1
1
1 (2 ) = ( 2 )
2

q2=0

q2>0

2
2
2

a-c q2

a-c

q1
47

Find the best response functions of both firms

1 1 ,2
1

= 21 2 = 0 1 (2 ) =

2 1 ,2
2

= 22 1 = 0 2 (1 ) = 2 ( 1 )

1
(
2

2 )

48

Nash equilibrium as the intersection of

best-response functions
1
1 2 = ( 2 (1 ))
2
1
1
1 = ( ( 1 ))
2
2
1
1 = ( )
3

1 (2 )

and
analogously for
firm 2

(1, 2 )

2 (1 )

1
49

How do firms reach the equilibrium?

Cournot equilibrium is a Nash equilibrium:
Each firm does the best it can, given what its
competitors are doing.

Cournot model does not specify adjustment

process when not in equilibrium.

How do firms reach the equilibrium?

In P&R, the best response function is labelled the
reaction curve.
For an example of how to translate the
theoretical model into an empirical one and find
the reaction curves and the Cournot equilibrium,
see p. 461

How do firms reach the equilibrium?

Example from P&R:
Inverse market demand: P = 30 Q
MC1 = MC2 = 0 (NB: this is an exception!)
Firm 1:

1 1 , 2 = 30 1 + 1 1 = (30 1 2 )1
1 1 ,2
1

1
2

= 30 21 2 = 0 1 (2 ) = (302 )

Firm 2:
2 1 , 2 = 30 1 + 1 2 = (30 1 2 )2
1 1 ,2
2

1
2

= 30 22 1 = 0 2 (1 ) = (301 )

Intersection leads to Cournot equilibrium: 1 = 2 = 10

Nash equilibrium and other outcomes

Firm 2 in a
monopolist

Outcome under
perfect
competition

1 (2 )

Cournot
outcome
(1, 2 )

2 (1 )

Cartel with 5050 profit

sharing
1
53

Our example: Payoff Matrix in terms of profit

Jumbo

12

AH
1
1 = ( )
4

12

288,

1
( )
3

16

320,

1 =

1
1 = ( )
2
With = 48

24

16

24

240,

144,
128,

256,
192,
144

192

256

240
288,

288

320

288

0,
128

Another application:
B. Strategic Interaction between firms:
Oligopolistic pricing la Bertrand

Albert Heijn starts attack on Lidl

Saturday 7 sep 2013, Volkskrant

Albert Heijn lowers price of a thousand brand articles

Jumbo follows Albert Heijn in new price war

Thursday 12 sep 2013, NRC

NRC, September 12
"Ook nu is het de marktleider, Albert Heijn, die met veel
bombarie prijsverlagingen aankondigt. En ook nu ziet
de concurrentie zich genoodzaakt daarin mee te gaan."
Also now, it is the market leader, Albert Heijn, which
kicks up a fuss by announcing price cuts. And once
again the competitors see no other solution than to
follow

The History
Early 2000s: the leading Dutch supermarket chain Albert Heijn suffered from an
unfavourable and deteriorating price image, which was especially troublesome
in the light of the rise of hard discounters (Aldi and Lidl) and worsening
economic conditions.
After several years of a sliding market share, on October 20, 2003, Albert Heijn
decided to slash its prices for more than 1000 products.

Although Albert Heijns operation to decrease prices was undertaken in

complete secrecy, within two days, all major competitors matched or even
exceeded the price reductions.
The price war that followed was nationwide, entailing an 8.2% reduction in food
prices and resulting in the lowest inflation level in 15 years.
The loss in added value for the Dutch retailing industry is estimated to be
900M in one year, and more than 30,000 employees in the grocery industry
lost their jobs.

Bertrands model of oligopoly competition

Assumptions:
- homogeneous goods
- each firm treats the price of the other firm
as fixed
- the firms decide simultaneously what price
to charge (meaning without knowledge of
the competitors decision)
- All consumers buy at the firm offering the
lowest price (no market frictions)

Bertrands model as a game between 2 players

Suppose
there are two firms 1 and 2 with action sets p1=+
and p2= + => price competition!
Demand is given as = for > , with pi
being the lowest price.
Marginal production costs are identical and equal to
< .
firms payoff functions are:

1 , 2

( )( )
1
=
( )( )
2
0

with j = 2 if i = 1, and j = 1 if i = 2.

<
=
>
62

The Nash equilibrium of the Bertrand game

1. (1 , 2 ) = , is a Nash equilibrium: if one firm charges a price c,
then the other firm can do no better than charge the price c also,
because if it raises its price it sells nothing and when it lowers its
price it incurs a loss.
2. No other pair (1 , 2 ) is a Nash equilibrium:
If < : profit is negative and can be increased by raising price
to c.
If = and > : firm i can increase its profit from zero to
positive by raising the price.
If > and > : suppose , then firm i can increase
its payoff by lowering its price below or even to .

63

Price competition with heterogeneous goods

Assumptions:
- heterogenous goods
- each firm treats the price of the other firm as
fixed
- the firms decide simultaneously what price to
charge
So:
1 = 1 (2)
2 = 2 (1)
I.e. two equations with two unknowns

Price competition with heterogeneous goods:

example
Two duopolists, fixed costs = 20, no variable costs (= MC =0)

Demand firm 1: 1 (1, 2 ) = 12 21 + 2

Demand firm 2: 2(1, 2 ) = 12 22 + 1
1 = 11(1, 2 ) 20 = 121 2 12 + 12 20
1
= 12 4 1 + 2 = 0
1
Firm 1s reaction curve: 1 = 3
Firm 2s reaction curve: 2 = 3

1
+
4
1
+
4

2
1

Bertrand Nash equilibrium with

heterogeneous products
1

1 = 3 + 4 2 (1) 1 = 3 + 4 (3 + 4 1 ) 1 = 4
and
analogously for
firm 2

1 (2 )
(1 , 2 )

2 (1 )

1
66

Another application:
C. Strategic Interaction between individuals:
Provision of a public good

Provision of a public good

Assumptions:
- There are 4 citizens , , ,
- each citizen can contribute k 1, 10 units to
the provision of a public good, with , , , =
1,2,3,4.
- The citizens benefit of contributing to the public
good is
1 , 2 , 3 , 4

2
= 10 + (1 + 2 + 3 + 4 )
4

 To maximize total wealth of all citizens:

1 1 , 2 , 3 , 4 + 2 1 , 2 , 3 , 4 + 3 1 , 2 , 3 , 4 + 3 1 , 2 , 3 , 4

8
= 40 1 2 3 4 + (1 + 2 + 3 + 4 )
4

Maximized when 1 = 2 = 3 = 4 = 10
Contributing to the public good has a higher social benefit than
keep the contribution on the private accounts.
What if each citizen gets to decide whether to contribute?
Each citizen will contribute as long as the cost of contributing to
that citizen is outweighed by the gains for that citizen.

Find the best response functions

To find the best response of citizen 1 to any contribution of
citizens 2 and 3 we need to find the citizens best response
function:

1 , 2 , 3 , 4
1
= = 0

2
In the Nash equilibrium of this game each citizen will not
contribute anything to the public good.

70

A conflict over scarce resources

Game theory can be used to explain overuse of shared
resources.
Extend the Prisoners Dilemma to more than two players.

How much do you contribute?

A.

23.0%

B.

3.0%

C.

2.0%

D.

E.

F.

G.

3.0%

H.

4.0%

I.

3.0%

J.

4.0%

K.

10

4.0%
2.0%
14.0%

38.0%

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you have started a session.
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It is possible to move, resize and
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download/.

Thank you for your attention!

Next week:
Sequential strategic interaction
Applications
1. Dynamic oligopoly theory (van Stackelberg,
Entry)
2. Bargaining