Game Theory &

Strategic Behaviour
Objective
■ On completion of this presentation we
should:
⮚understand the place of game theory in
Economics
⮚be able to represent and solve simple games
⮚apply game theory to the issue of collusion
⮚be able to take a game-theoretic approach to
entry deterrence
History
■ The earliest example of game theory is the study of a
duopoly by Antoine Cournot in 1838
■ Mathematician Emile Borel suggested a formal theory of
games in 1921, which was furthered by the
mathematician John von Neumann in 1928
■ In 1944, John von Neumann and the economist Oskar
Morgenstern published the monumental volume Theory
of Games and Economic Behavior . This book provided
the basic terminology and problem setup that is still in
use today.
History (Contd…)

Oskar Morgenstern
History (Contd…)
■ In the 1950s and 1960s, game theory was broadened
theoretically and applied to problems of war and politics.
Since the 1970s, it has driven a revolution in economic
theory

■ Game theory received special attention in 1994 with the

awarding of the Nobel prize in economics to Nash, John
Harsanyi, and Reinhard Selten
Basic Terminologies
■ Player : The decision maker; manager in
oligopoly
■ Strategy : Actions that affect the sales and
profitability of the firm & its rivals
■ Pay-off Matrix : Summarises outcomes of
all possible combinations
of strategies
Basic Terminologies ( Contd...)
■ Zero Sum Game: one in which the gain of one
player comes at the expense & is exactly equal
to the loss of the other player.
E.g. Cricket match between India & Pakistan
■ Non zero sum game: if the gain or losses of one
firm do not come at the expense of or provide
equal benefits to the other firm.
E.g. Pipeline project between India & Iran
What is Game Theory?

“No individual is an island”

■ Players work independently being aware of their
interdependence

■ Bad news:
Knowing game theory does not guarantee winning

■ Good news:
Framework for thinking about strategic interaction
What is Game Theory? (Contd…)
■ Game theory is the general theory of
strategic behavior
⮚Generally depicted in mathematical form
⮚Plays an important role in modern
economics
■ A technique to evaluate situations in which
individuals & organisations have
conflicting objectives
Assumptions of Game Theory
■ Players are economically rational
■ Player can:
⮚Assess outcomes
⮚Calculate paths to outcomes
⮚Choose actions that yield their most-preferred
outcome, given the actions of other players
Nash Equilibrium
■ It was developed by John Nash
■ Occurs when each player's strategy is
optimal, given the strategies of the other
players.
⮚A player's best response (or best strategy) is
the strategy that maximizes that player's
payoff, given the strategies of other players.
Nash Equilibrium (Contd…)
■ Nash equilibrium is a set of strategies such
that none of the players in a game can
improve their pay-off, given the strategies of
the other participants

No ΔP Price Inc.

No ΔP 40, 30 60, -20

Price Inc. -10, 50 80, 60

The Equilibrium for an Oligopoly

■ A Nash equilibrium is a situation in which

economic actors interacting with one
another each choose their best strategy
given the strategies that all the others
have chosen.
Prisoner’s Dilemma
■ Mr. Tucker created the Prisoners'
Dilemma to illustrate the difficulty
of analyzing certain kinds of
games
■ He began with a little story of two
burglars; Mr. Al & Mr. Bob
Prisoner’s Dilemma (Contd…)
Prisoner’s Dilemma
Mr. AL
Confess Not Confess

Confess 4, 4 1, 8
Mr. BOB
Not 8, 1 3, 3
Confess
Dominant Strategy
■ If a player has a best option, regardless of what
other players do, this is referred to as a
dominant strategy

■ It is optimal, no matter what the other players do

■ If such strategy exist, player and other

participants will adopt it
Dominant Strategy (Contd…)
■ For e.g. – Online selling
– Retailing

By adopting this strategy Dell has captured 50% of

the U.S. PC market & 14% of the world PC market

Pay-off Matrix
Firm B
No Price Δ Price Inc.

No Price Δ 40, 30 80, -20

Firm A

Price Inc. -10, 50 100, 40

The Prisoners’ Dilemma

■ The dominant strategy is the best strategy

for a player to follow regardless of the
strategies chosen by the other players.
The Prisoners’ Dilemma

■ Cooperation is difficult to maintain,

because cooperation is not in the best
interest of the individual player.
 Figure 3 An Oligopoly Game

Iraq’s Decision

High Low
Production
Iraq gets $40 billion Production
Iraq gets $30 billion

High
Productio
n
Iran gets $40 billion Iran gets $60 billion
Iran’s
Decision Iraq gets $60 billion Iraq gets $50 billion

Lo
w
Productio
n
Iran gets $30 billion Iran gets $50 billion

Copyright©2003 Southwestern/Thomson
Oligopolies as a Prisoners’ Dilemma

■ Self-interest makes it difficult for the

oligopoly to maintain a cooperative
outcome with low production, high prices,
and monopoly profits.
 Figure 4 An Arms-Race Game

Decision of the United States

(U.S.)
Arm Disarm

U.S. at risk U.S. at risk and weak

Arm

Decision
USSR at USSR safe and powerful
of the
risk
Soviet Union U.S. safe and powerful U.S. safe
(USSR)

Disarm
USSR at risk and USSR
weak safe

Copyright©2003 Southwestern/Thomson
 Figure 5 An Advertising Game

Marlboro’ s Decision

Advertise Don’t Advertise

Marlboro gets $3 Marlboro gets $2

billion profit billion profit
Advertise
Camel gets $3 Camel gets $5
Camel’s billion profit billion profit
Decisio
Marlboro gets $5 Marlboro gets $4
n
billion profit billion profit
Don’t
Advertise
Camel gets $2 Camel gets $4
billion profit billion profit

Copyright©2003 Southwestern/Thomson
 Figure 6 A Common-Resource Game

Exxo ’s Decision
n
Drill Two Wells Drill One Well

Exxon gets $4 Exxon gets $3

million million
Drill Two profit profit
Wells
Texaco gets $4 Texaco gets $6
Texaco’s million million
Decisio profit profit
Exxon gets $6 Exxon gets $5
n
million million
Drill One profit profit
Well
Texaco gets $3 Texaco gets $5
million million
profit profit

Copyright©2003 Southwestern/Thomson
Why People Sometimes Cooperate

■ Firms that care about future profits will

cooperate in repeated games rather than
cheating in a single game to achieve a
one-time gain.
 Figure 7 Jack and Jill Oligopoly Game

Jack’s Decision

Sell 40 Gallons Sell 30 Gallons

Jack gets Jack gets

$1,600 profit $1,500 profit
Sell 40
Gallons
Jill gets Jill gets
Jill’s $1,600 profit $2,000 profit
Decisio Jack gets Jack gets
n
$2,000 profit $1,800 profit
Sell 30
Gallons
Jill gets Jill gets
$1,500 profit $1,800 profit

Copyright©2003 Southwestern/Thomson
Dominated Strategy
■ A dominated strategy is an alternative that
yields a lower payoff than some other
strategies, no matter what the other players in
the game do
■ If there is a dominated strategy, the game can
be simplified by avoiding it
■ Less no. of options makes easy identification of
equilibrium or use other techniques to analyse
outcome
Thank You