Game Theory

Arun Arora
Topics to be Discussed
• Gaming and Strategic Decisions
• Dominant Strategies
• The Nash Equilibrium
• Repeated Games
• Sequential Games
• Threats, Commitments, and Credibility
• Entry Deterrence
• Bargaining Strategy
• Auctions
Gaming and Strategic Decisions
• Game is any situation in which players (the participants) make
strategic decisions.
• Ex: firms competing with each other by setting prices, group of consumers
bidding against each other in an auction

• Strategic decisions result in payoffs to the players: outcomes that

generate rewards or benefits
Why GT is needed?
• To determine the optimal strategy for each player. The optimal
strategy for a player is the one that maximizes the expected payoff.

• Examples:
• For price setting firms, a strategy might be: “I’ll keep my price high as long as
my competitors do the same, but once a competitor lowers his price, I’ll lower
mine even more.”
• For a bidder at an auction, a strategy might be: “I’ll make a first bid of $2000
to convince the other bidders that I’m serious about winning, but I’ll drop out
if other bidders push the price above $5000.”
Few Questions that can address with GT
• Why do firms tend to collude in some markets and to compete
aggressively in others?

• How do some firms manage to deter entry by potential competitors?

• How should firms make pricing decisions when demand or cost

conditions are changing or new competitors are entering the market?
Understanding Market Structures
• Oligopoly Market in which only a few firms compete with one
another, and entry by new firms is impeded.

• Duopoly Market in which two firms compete with each other.

• Cartel Market in which some or all firms explicitly collude,

coordinating prices and output levels to maximize joint profits.
Noncooperative v. Cooperative Games
• Cooperative Game
• Players negotiate binding contracts that allow them to plan joint strategies
• Example: Buyer and seller negotiating the price of a good or service or a joint venture by
two firms
• Binding contracts are possible

• Non cooperative Game

• Negotiation and enforcement of binding contracts between players is not
possible
• Example: Two competing firms assuming the others behavior determine, independently,
pricing and advertising strategy to gain market share
• Binding contracts are not possible
Gaming and Strategic Decisions
• An Example: How to buy a dollar bill
1. Auction a dollar bill
2. Highest bidder receives the dollar in return for the amount bid
3. Second highest bidder must pay the amount he or she bid but gets nothing in return
4. How much would you bid for a dollar?
• Typically bid more for the dollar when faced with loss as second highest
bidder
Payoff Matrix: Advertising Game
• Dominant Strategy is one that is optimal
no matter what an opponent does.
• An Example
• A & B sell competing products Firm B Don’t
• They are deciding whether to undertake Advertise Advertise
advertising campaigns
Advertise 10, 5 15, 0
• Observations Firm A
• A: regardless of B, advertising is the best Don’t
• B: regardless of A, advertising is best Advertise 6, 8 10, 2

Equilibrium: Outcome of a game in which each firm is doing

the best it can regardless of what its competitors are doing
9
 Modified Advertising Game
• Game Without Dominant Strategy Firm B Don’t
• The optimal decision of a player without a Advertise Advertise
dominant strategy will depend on what the
other player does.
Advertise 10, 5 15, 0
• Revising the payoff matrix we can see a
situation where no dominant strategy exists Firm A
Don’t
Advertise 6, 8 20, 2
• Observations
• A: No dominant strategy; depends on B’s actions
• B: Dominant strategy is to Advertise
• Firm A determines B’s dominant strategy and makes
its decision accordingly
The Nash Equilibrium
• Dominant Strategy
• “I’m doing the best I can no matter what you do. You’re doing the best you
can no matter what I do.”
• Nash Equilibrium
• “I’m doing the best I can given what you are doing. You’re doing the best you
can given what I am doing.”
• None of the players have incentive to deviate from its Nash strategy,
therefore it is stable
Nash Equilibrium: Product Choice Problem
Firm 2
• Two cereal companies face a market in which Crispy Sweet
two new types of cereal can be successfully
introduced provided each type is introduced
by only one firm
Crispy -5, -5 10, 10
• Product Choice Problem
• Market for one producer of crispy cereal
• Market for one producer of sweet cereal Firm 1
• Each firm only has the resources to introduce one
cereal Sweet 10, 10 -5, -5
• Noncooperative

• If firm 1 hears firm 2 is introducing a new sweet cereal,

its best action is to make crispy
• Bottom left corner is Nash equilibrium
• What is other Nash Equilibrium?
Maximin Strategy
• Maximin Strategies - Scenario Firm 2
• Two firms compete selling file-encryption software Don’t invest Invest
• They both use the same encryption standard (files
encrypted by one software can be read by the other -
advantage to consumers) Don’t invest 0, 0 -10, 10
• Firm 1 has a much larger market share than Firm 2
• Both are considering investing in a new encryption Firm 1
standard
Invest -100, 0 20, 10
• Observations
• Dominant strategy Firm 2: Invest
• Nash equilibrium
• Firm 1: invest
• Firm 2: Invest
• If Firm 2 does not invest, Firm 1 incurs significant losses
• Firm 1 might play don’t invest
• Minimize losses to 10 – maximin strategy
Maximin Strategy
• If Player 2 is not rational or completely
informed Firm 2
• Firm 1’s maximin strategy is to not invest Don’t invest Invest
• Firm 2’s maximin strategy is to invest.
• If 1 knows 2 is using a maximin strategy, 1
would invest Don’t invest 0, 0 -10, 10

• If firm 1 is unsure about what firm 2 will Firm 1

do, it can assign probabilities to each Invest -100, 0 20, 10

possible action
• Could use a strategy that maximizes its
expected payoff
• Firm 1’s strategy depends critically on its
assessment of probabilities for firm 2
Mixed Strategy
• Pure Strategy
• Player makes a specific choice or takes a specific action
• Mixed Strategy
• Player makes a random choice among two or more possible actions, based on
a set of chosen probabilities

• Pure strategy: No Nash equilibrium

• No combination of head and tails leaves both players better off
• Mixed strategy: Random choice is a Nash equilibrium
Matching Pennies Player B
Heads Tails

• Player A might flip coin playing heads

Heads 1, -1 -1, 1
with ½ probability and tails with ½
probability. Player A

• If both players follow this strategy, there Tails -1, 1 1, -1

is a Nash equilibrium – both player will be
doing the best they can given what they
opponent is doing.
• Although the outcome is random, the
expected payoff is 0 for each player.
Mixed Strategy
• One reason to consider mixed strategies is when there is a game that
do not have any Nash equilibriums in pure strategy.
• When allowing for mixed strategies, every game has a Nash
equilibrium
• Mixed strategies popular for games like poker
• A firm might not find it reasonable
Repeated Games
• Game in which actions are taken and payoffs received over and over
again
• Oligopolistic firms play a repeated game.
• With each repetition of the Prisoners’ Dilemma, firms can develop
reputations about their behavior and study the behavior of their
competitors.
• Conclusion
• Cooperation is difficult at best since these factors may change in the long-run.
• Need a small number of firms
• Need stable demand and cost conditions
• This could lead to price wars if don’t have them
Sequential Games
• Players move in turn, responding to each other’s actions and reactions
• Ex: Stackelberg model (ch. 12)
• Responding to a competitor’s ad campaign
• Entry decisions
• Responding to regulatory policy

• Going back to the product choice problem

• Two new (sweet, crispy) cereals
• Successful only if each firm produces one cereal
• Sweet will sell better
• Both still profitable with only one producer
Modified Product Choice Problem
Firm 2
• If firms both announce their decision Crispy Sweet

independently and simultaneously,

they will both pick sweet cereal and Crispy
-5, -5 10, 20
both will lose money
• What if firm 1 sped up production Sweet
20, 10 -5, -5
and introduced new cereal first
• Now there is a sequential game
• Firm 1 think about what firm 2 will do
Extensive Form of a Game
• Representation of possible moves in a game in the form of a
decision tree
• Allows one to work backward from the best outcome for Firm 1
• Product Choice Game in Extensive Form:
Crispy -5, -5
Crispy Firm 2
Sweet 10, 20
Firm 1
Crispy 20, 10
Sweet Firm 2
Sweet -5, -5
Sequential Games
• The Advantage of Moving First
• The first firm can choose a large level of output thereby forcing second firm to
choose a small level.
• Can show the first mover advantage by revising the Stackelberg model and
comparing to Cournot

• Cournot Model: Oligopoly model in which firms produce a homogeneous

good, each firm treats the output of its competitors as fixed, and all firms
decide simultaneously how much to produce.
Threats, Commitments, and Credibility
• Strategic Moves
• What actions can a firm take to gain advantage in the marketplace?
• Deter entry
• Induce competitors to reduce output, leave, raise price
• Implicit agreements that benefit one firm

• How To Make the First Move

• Demonstrate Commitment
• Firm 1 must do more than announcement to confirm that they will produce sweet
cereal
• Invest in expensive advertising campaign
• Buy large order of sugar and send invoice to firm 2
• Commitment must be enough to induce firm 2 to make the decision firm 1 wants it
to make
 Pricing of Computers and Word Processors
Empty Threats Firm 2
If a firm will be worse off if it High Price Low Price
charges a low price, the threat
of a low price is not credible in
the eyes of the competitors.
High Price 100, 80 80, 100
When firms know the payoffs
of each others actions, firms Firm 1
cannot make threats the other
firm knows they will not follow. Low Price 20, 0 10, 20
In our example, firm 1 will
always charge high price and
firm 2 knows it
Bargaining Strategy
• Bargaining situation can depend on Firm 2
Produce A Produce B
ability to affect relative bargaining
position Produce A 40, 5 50, 50
Firm 1
• Consider two firms introducing one of
two complementary goods.
Produce B 60, 40 5, 45
• Firm 1 has cost advantage in Good A
• Firm 2 has cost advantage in Good B
Wal-Mart Stores’ Preemptive Investment
Strategy
Company X
• How did Wal-Mart become the largest Enter Don’t enter
retailer in the U.S. when many
established retail chains were closing Enter -10, -10 20, 0
their doors? Wal-Mart
• Gained monopoly power by opening in Don’t enter 0, 20 0, 0
small town with no threat of other
discount competition
• Preemptive game with Nash equilibrium
• Two Nash equilibrium
• Low left
• Upper right
Entry Deterrence
Potential Entrant ($80
fixed costs)

• Barriers to entry important for Enter Stay out

monopoly power High price

• Economies of scale, patents and licenses, (accommodation) 100, 20 200, 0
access to critical inputs Incumbent

• Firms can also deter entry Low Price

70, -10 130, 0
• To deter entry, the incumbent firm
(warfare)

must convince any potential competitor 28

that entry will be unprofitable.

• Although, not credible because once X has
entered, it is in your best interest to
accommodate and maintain high price but
could threaten X with warfare if enter market
Entry Deterrence
Potential Entrant
• What if make an investment before entry to Enter Stay out
increase my capacity
• Irrevocable commitment
High price
• Gives new payoff matrix since profits will be (accommodation) 50, 20 150, 0
reduced by investment Incumbent
• Threat is completely credible Low Price
70, -10 130, 0
• Rational for firm X to stay out of market (warfare)

• If incumbent has reputation of price cutting

competitors even at loss, then threat will be
credible.
• Short run losses may be offset by long run
gains as monopolist
Entry Deterrence: Development of a New
Aircraft Airbus
Don’t produce
• Production of commercial airlines exhibit Produce

significant economies of scale

• Airbus and Boeing considering new aircraft Produce -10, -10 100, 0
• Suppose not economical for both firms to Boeing
produce the new aircraft
Don’t produce 0, 120 0, 0
• Boeing has head start
• Boeing will produce
• Airbus will not produce
Development of a Aircraft
After European Subsidy
• Governments can change outcome of game
• European government agrees to subsidize Airbus
Airbus
before Boeing decides to produce Produce Don’t produce
• With Airbus being subsidized, the payoff matrix for
the two firms would differ significantly.
Produce -10, 10 100, 0
Boeing
• Airbus will produce
• Boeing will not produce Don’t produce 0, 120 0, 0
Private-value auction
• bidder knows individual valuations of object, but valuations differ
from bidder to bidder
• Each bidder must choose bidding strategy
• Payoff for winning is reservation price minus price paid
• Payoff for losing is zero
• Bidding truthfully is dominant strategy
• Pay based on value of second highest bidder so no incentive not to bid
reservation price
• Risk to bidding higher than reservation price
Common Value Auctions
• Winner’s Curse
• The winner is worse off because they over estimated the value of the item and
thereby overbid
• Must reduce bid by amount equal to the expected error of the winning bidder
• If lot of variation in other bidders than estimates are fairly imprecise
• Rs 100 is being auctioned
• The highest bidder receives the dollar in return for the amount bid
• However, the second-highest bidder must also hand over the amount that
he or she bid—and get nothing in return.
• winner’s curse Situation in which the winner of a common value auction is worse
off as a consequence of overestimating the value of the item and thereby
overbidding.
Maximizing Auction Revenue
• Common Value Auction
• Use open rather than sealed bid
• Generate greater revenue
• Reveal information about true value reducing concern of winner’s curse
• Private value auction
• Protect against loss if bidders unaware of value
• Increase size of bids by letting bidders think item is valuable
• No sale could make bidders think item is low quality
• Encourage many bidders to increase expected bid of winner
Bidding and Collusion
• Buyers can allow benefit from collusion
• Can be done legally through buying groups
• Can be done illegally through collusive agreements that violate antitrust laws
• Collusion not easy because large incentive to cheat
• Repeated auctions allow for penalizing participants that break agreement
Internet Auctions
• Popularity of auctions has skyrocketed with growth of internet
• Most popular site is ebay
• Dominates online person-person auction industry
• Subject to large network externalities
• Choose auction site with largest number of potential bidders
Thank You!!!