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Ch8. Game theory

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Ch8. Game theory

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23050066
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© © All Rights Reserved
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Chapter 8

GAME THEORY
Dr. Nguyen Bich Diep
[email protected]
GAME THEORY

• Game theory is concerned with the general analysis of strategic


interaction.
• Strategic interaction: a situation in which the pay-off of one economic agent is
dependent upon the choices of others.

• Different types of games:


• Simultaneous vs. sequential
• Perfect information vs. imperfect information
• Single-play vs. repeated
• Cooperative vs. non-cooperative
ELEMENTS OF A GAME

• Essential elements of a game:


• Players
• Strategies
• Payoffs
• Each player’s goal is to maximize their individual payoff.
NORMAL FORM GAMES

• The prisoners’ dilemma

Player B

Confess Deny

Confess -3,-3 0,-6


Player A
Deny -6,0 -1,-1
DOMINANT STRATEGIES

• Dominant strategy: a strategy for which the payoffs are always


greater than any other strategy no matter what the opponent does.
• Dominated strategy: a strategy for which the payoffs are always
lower than any other strategy no matter what the opponent does.
• Equilibrium in dominant strategies: outcome of a game in which
each player is doing the best it can regardless of the actions of its
opponent.
• Each player has a dominant strategy and plays it.
DOMINANT STRATEGIES

• Each player has a dominant strategy – Confess, and the game has a
dominant strategy equilibrium – (Confess, Confess).
• However, If they both chose Deny, both of them would have been
better off. In this case, the equilibrium in dominant strategies is not
Pareto efficient.
DOMINANT STRATEGIES

• Oligopolies as a prisoners’ dilemma

Firm B
High Low
production production
High
16,16 20,15
production
Firm A
Low
15,20 18,18
production
NASH EQUILIBRIUM

• Dominant strategy equilibria are nice when they happen, but they
don’t happen all that often.
• In many cases, a player’s optimal choice depends on what he thinks
the other players will do.
NASH EQUILIBRIUM

• An example

Player B

Sports Comedy

Sports 3,2 0,0


Player A
Comedy 0,0 2,3
NASH EQUILIBRIUM

• Nash equilibrium: a set of strategies (or actions): each player is


doing the best it can given the actions of its opponent.
• Player A’s choice is optimal, given player B’s choice, and player B’s choice is
optimal, given player A’ choice

• Because each player has no incentive to deviate from its Nash


strategy, the strategies are stable.
MIXED STRATEGIES

• Pure strategy: strategy in which a player makes a specific choice or


takes a specific action.
• Mixed strategy: strategy in which a player makes a random choice
among two or more possible actions, based on a set of chosen
probabilities.
• Some games do not have any Nash equilibria in pure strategies.
However, once we allow for mixed strategies, every game has at least
one Nash equilibrium.
MIXED STRATEGIES

• Patrolling game

Patroller

A B

A -1,1 1,-1 p
Attacker
B 1,-1 -1,1 1–p

q 1–q
MIXED STRATEGY EQUILIBRIUM

• For a mixed strategy to be a best response, the player must be


indifferent among the actions that this strategy uses. If the player is
not indifferent, then one of the actions must be yielding a higher
expected utility than the other, the player could do strictly better by
choosing the action with the higher utility with certainty.
MIXED STRATEGY EQUILIBRIUM

• In a mixed strategy equilibrium, the Attacker should be indifferent between A


and B or:
– 1q + 1(1 – q) = 1q + (– 1)(1 – q)
→ q = 1/2 (1)
• Similarly, the Patroller should have:
1p + (– 1)(1 – p) = – 1p + 1(1 – p)
→p = 1/2 (2)
• The mixed-strategy Nash equilibrium is [(1/2,1/2),(1/2,1/2)].
REPEATED GAMES

• In the preceding section, the players met only once and played the
prisoner’s dilemma game a single time. However, the situation is
different if the game is to be played repeatedly by the same players.
REPEATED GAMES

• “Tit for tat”: the policy of cooperating in the first round and then doing
whatever the other player did in the previous round.
• The tit-for-tat strategy enforces cooperation because it offers an
immediate punishment for defection. It is also a forgiving strategy: it
punishes the other player only once for each defection.
REPEATED GAMES

• Whether this kind of strategy will be viable depends on whether the


game is going to be played a fixed number of times or an indefinite
number of times.
ENFORCING A CARTEL

• Real-life cartels sometimes appear to employ tit-for-tat strategies.


When one firm tries to cheat, all firms will raise their output or cut their
prices so as to “punish” the defectors.
• In some cases, this kind of tit-for-tat strategy is able to support the
cartel arrangement for some time.
EXTENSIVE FORM GAMES

10,5

0,0
A

5,10
B

0,0

node (decision point) strategy player payoffs


BACKWARD INDUCTION

10,5

0,0
A

5,10
B

0,0
CREDIBLE THREATS

• Player B can threaten to play Decline if player A plays Split the bill. But
this threat is not credible, i.e., it is not rational for player A to believe
that player B will carry it out.
• Player B can make his threat credible by limiting his choices.
A GAME OF ENTRY DETERRENCE

1,9

Entrant
0,0
Incumbent
2,1
A GAME OF ENTRY DETERRENCE

• The equilibrium outcome is for the potential entrant to enter and the
incumbent not to fight.
• Suppose that the incumbent can purchase some extra production
capacity that will allow him to produce more output at his current
marginal cost and compete much more successfully against the new
entrant.
A GAME OF ENTRY DETERRENCE

1,9

Entrant
0,2
Incumbent
2,1
A GAME OF ENTRY DETERRENCE

• Now, because of the increased capacity, the threat of fighting is


credible. The sensible thing for the potential entrant to do is to stay
out.
• Although the incumbent will remain a monopolist and never have to
use his extra capacity, it is worthwhile to invest in the extra capacity in
order to make credible the threat of fighting if a new firm tries to enter
the market.

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