ECON1268 PRICE THEORY

THIRD SEMESTER 2013

GAME THEORY
EXERCISE 9
SUGGESTED SOLUTIONS
1. In a two-firm industry each firm has two strategies with which to compete.
Payoffs to each firm are represented by the payoff matrix:

D
1
D
2

R
1
3, 5 0, 6
R
2
6, 0 1, 2
(i) If each firm acts independently what will be the solution to the game?
ANSWER:
If each firm acts independently, no effort will be made to co-operate, therefore
short run profit maximisation will be the outcome.
Firm R: will try to gain the largest payoff available to it by adopting
strategy R
2
Firm D: will do likewise and play strategy D
2
ECON1268 Exercise 9A Third Semester 2013 1
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The outcome using strategy R
2
D
2
is (1, 2)
ECON1268 Exercise 9A Third Semester 2013 2
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(ii) Demonstrate, using the payoff table, why individuals acting in their own
self-interest will frequently bring about a situation that, while possibly
satisfactory to each individual, is not the best that can be achieved?
ANSWER:
By acting in their own self interest the two firms will achieve the poorest
result possible, i.e. 1 + 2 = 3 (in this example).
If one of the players can dominate the game, it may be possible for the player
to obtain six. For example, if player R had a dominant position in the
market, perhaps through controlling some important input or patent,
they could force player D to accept zero or be forced out of the market.
D would prefer the competitive solution (1,2)
If one of the players cannot dominate, then the competitive solution will
result.
The best that can be achieved is (3, 5) i.e. strategies R
1
D
1
. This outcome can
only be achieved if firms recognise their mutual interdependence and
cooperate.
(iii) If the two firms recognised their interdependence and desired to bring
about the best result that can be achieved how would they go about this?
ANSWER:
Recognition of their interdependence will lead to an outcome of R
1
D
1
where a
total of 3 + 5 = 8 can be achieved.
Player D stands to gain the most - an extra three units in moving from D
2
to
D
1
.
R gains two units which is likely to induce them to co-operate and choose
strategy R
1
If, however, R felt that they deserved more than two extra units, then R would
continue to use R
2
until D offers more.
The outcome of the game will depend on the bargaining strength of the
players.
ECON1268 Exercise 9A Third Semester 2013 3
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2. Suppose there are two firms in an industry (duopoly) and each duopolist is faced
with the decision of spending either a little or a lot on advertising, so that there
are four possible outcomes (profit levels), this is given in the following table.
Firm 2
Low Advertising High Advertising
Expenditure Expenditure
Low Ad. Expn.
1
= $10,
2
= $10
1
= $4,
2
= $17
Firm 1
High Ad. Expn.
1
= $17,
2
= $4
1
= $8,
2
= $8
(i) What is the best strategy for each firm to employ if both firms wish to
maximise their long-term profitability? What strategy should firm 2 adopt
if its approach is short-term?
ANSWER:
To maximise long term profitability - we look for the combination of profits
accruing to both firms that will produce the largest possible payoff.
This is (17,4) or (4,17) yielding a payoff of 21.
The problem here is deciding who should get what!
If one firm can dominate the other it might be able to force its competitor to
always choose low advertising while it opts for high advertising.
In a long run situation this is unlikely to be the case since the competition could
react with high advertising expenditure also, causing a profit reduction
for the firm.
In the short run each firm will try to maximise its profits, so each will employ a
strategy that endeavours to achieve this:
- both will choose high advertising expenditure in the hope of getting a
profit of 17 units
- the result will be each achieving a profit of eight units.
ECON1268 Exercise 9A Third Semester 2013 4
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(ii) If both firms intend to continue in the industry indefinitely what is the most
likely profit outcome? Why?
ANSWER:
If the game is played for infinitely, there will be a tendency for the players to
bring about some order so that both will be better off.
If both firms always go for high advertising expenditure then best total they can
achieve is 8 + 8 = 16 units.
This is not the maximum available so there is an incentive to enter into some tacit
arrangement to get a share of the winnings = 5 units (i.e. 21 - 16).
For example, each firm may take it in turns to use a high advertising expenditure
strategy.
Co-operation is better.
(iii) In what way does a firm's reputation in an industry affect the decisions of
others in the industry and also potential entrants?
ANSWER:
Reputation is used as a signal to other firms in the industry and potential
entrants.
A reputation for giving in will attract aggressive behaviour from competitors.
A firm can maintain order in an industry by having a reputation for aggressive
marketing strategies aimed at competitors who try to undercut or take
some of its market share.
A potential entrant will be discouraged by the knowledge that previous entrants
met with aggressive actions, e.g. price reduced significantly by the existing
firms.
A reputation makes for a threat. For a threat to be effective it must be credible
(believed).
ECON1268 Exercise 9A Third Semester 2013 5
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3. Assume the following Pay off matrix for two vehicle manufacturing companies,
where the payoffs relate to profits.
Firm B
Offer passenger
airbags
Don't offer passenger
airbags
Don't offer passenger
airbags
15 , 15 5 , 5
Firm A
Offer passenger
airbags
10 , 10 15 , 15
(a) does either firm have a dominant strategy?
ANSWER: No.
(b) does this game have a Nash equilibrium?
Explain your answer.
ANSWER:
Yes, this game has two Nash equilibria: Firm A offers passenger airbags and
Firm B does not offer then OR Firm B offers passenger airbags and Firm A does
not.
In this market the payoffs are symmetrical, but the two firms are better off
appealing to different parts of the market. If one firm offers airbags for safety -
conscious buyers, the other does better by offering cars without standard airbags
for cost - conscious buyers.
If both firms appeal to the one side of the market, they are better off offering
airbags.
To find a Nash equilibrium, we look for a strategy for each firm, such that given
the strategy of the other, neither firm wants to change its own strategy.
There are two such situations - where one firm offers airbags and the other
doesnt. Since each firm is doing the best for itself given the choice of the other,
these situations are Nash equilibria.
ECON1268 Exercise 9A Third Semester 2013 6
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4 (a) Two firms at the Kuala Lumpur International Airport have franchises to
carry passengers to and from hotels in the city of Kuala Lumpur. These
two firms, Metro Limo and Urban Limo operate nine passenger vans.
These duopolists cannot compete with price, but they can compete
through advertising. Their payoff matrix is shown below:
Urban Limo
Advertise Dont Advertise
Advertise 25 , 15 30, 0
Metro Limo
Dont Advertise 15, 20 40, 5
(i) Does each firm have a dominant strategy? Explain what is meant
by the term 'dominant strategy', and what the strategy is.
Metro Limo has no dominant strategy. If Urban Limo advertises,
then Metro Limo does best by advertising; but if Urban Limo does
not advertise, then Metro Limo should not advertise.
Urban Limo has a dominant strategy it should advertise.
(ii) What is the Nash equilibrium? Explain where the Nash
equilibrium occurs in the pay off matrix.
The Nash equilibrium is for both firms to advertise. Each does best,
25 and 15, respectively, by advertising, given what the other firm
does.
(iii) Explain the difference between a dominant strategy and a Nash
equilibrium.
Dominant strategy: Im doing the best I can regardless of what you
equilbirum: do
You are doing the best you can regardless of
what I do
Nash equilibrium: Im doing the best I can given what you are
doing
You are doing the best you can given what I am
doing
ECON1268 Exercise 9A Third Semester 2013 7
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(b) The concept of Nash equilibrium has a certain logic. Unfortunately it
also has a number of problems. Discuss.
There are at least three identified problems:
1. a game may have more than one Nash equilibrium
2. there are games with no Nash equilibrium
3. the outcome may not be Pareto efficient
(c) Why is market conduct in oligopolistic industries likened to a game?
Because what a firm is going to do depends on what it expects other
firms are going to do and how it expects other firms are going to
react to its own actions. The key concepts are:
mutual interdependence
expectations and perceptions
strategic behaviour
5. Apple and Samsung are the two largest smart phone producers in the world.
Each firm is considering whether or not to advertise its latest smart phone (for
example, the Galaxy S4 and the iPhone 6). Their pay off matrix (in millions of
dollars per week) is as follows:
Apple
Advertise Dont advertise
Advertise 4, 36 4, 30
Samsung
Dont advertise 0, 0 8, 4
(a) Does this game have a dominant strategy? Why is an equilibrium stable
in dominant strategies?
Samsung: no dominant strategy
Apple: no dominant strategy
Dominant strategies are stable because each firm is doing the best it
can regardless of what the other firm does. This implies that there is
not incentive to change.
(b) What outcomes, if any, are Nash equilibria? Explain the difference
between a dominant strategy and a Nash equilibrium.
ECON1268 Exercise 9A Third Semester 2013 8
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Nash equilibria (4, 36) and (8, 4)
ECON1268 Exercise 9A Third Semester 2013 9
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(c) Draw the extended form of the game assuming that Samsung moves
first. What is the likely outcome of this game? Discuss the possibilities
for strategic behaviour that may be adopted by the firms.
The extended form of the game is:
By backwards induction, Samsung will choose Dont Advertise
(and receive $8 million) because if it doesnt advertise Apple will
then do best by selecting Dont Advertise.
Apple would clearly prefer that Samsung choose Advertise because
then Apple could also choose Advertise and receive $36 million.
However, if Apple threatens to Advertise if Samsung plays Dont
advertise, Apples profits would drop to zero. So Apples threat is
not credible (believable).
Another possibility for strategic behavior is that Apple could offer to
contribute slightly more than $4 million to Samsungs advertising
costs if advertises. Suppose that Apple offers to pay $5 million to
Samsung if it advertises: after adding/deducting the contribution to
Samsungs advertising costs, the payoffs each firm receives are (9,
31).
ECON1268 Exercise 9A Third Semester 2013 10
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Samsung
Apple
Apple
Advertise
Dont
Advertise
Advertise
Dont
Advertise
(4, 36)
(4, 30)
Advertise
Dont
Advertise
(0, 0)
(8, 4)