Game Theory

Inside Oligopoly and added value Chapter 10

Course outline

demand Basic Model Cost/Market structure Managerial perspective Organization of firm Managerial Microeconomics markets Strategic analysis Game Theory Marginal analysis Basic Oligopoly models

Additional topics

Applying economics Methodology Matching theory

Lecture Outline
1.

2.
3. 4. 5. 6. 7. 8.

Basics Prisoners Dilemma and Dominant Strategy Nash Equilibrium Some types of games Randomized strategies Backward induction and SPNE Strategic moves Added value
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1. Game and Game Theory

What is a game?

Players Strategies (rules + capabilities) Payoffs (outcomes)

Game Theory: set of ideas and principles that guides strategic thinking.

The Game of Business

Reference:
Adam M. Brandenburger and Barry J. Nalebuff COOPETITION, 1996.

1. Strategic vs. Non-strategic

Compare the two decisions:

How to peal an apple. How to play chess.

1. Strategic interaction

Failure to consider strategic interactions: The paper Industry. Self-inflicted cyclical market: When demand does rise, all the companies tend to throw piles of money into new capacity in attempts to maintain market shareThen all suffer together from excess capacity. CFO of International Paper: If youre thinking about building a new paper facility, youre going to base your decision on some assumptions about economic growth., what we never seem to factor in, however, is the response of our competitors. Who else is going build a plant or machine at the same time?

1. Understand the game you are in

A game in strategic form (simultaneous-move game) --- Three basic elements: players, strategies, payoffs. A game in extensive form (sequential-move game) --- In addition to the above three basic elements, it specifies the sequences of the moves.

1. Battle of sexes
Husband
football opera

football
Wife opera

4, 3
2, 2

0, 0
3, 4

1. Battle of sexesExtensive form

{H: A"Football" , W:B"Football",C"Opera"} N.E. , S.P.N.E.

football B wife
>

(H: 4,W:3)

football
A husband opera

>

(H:4,W:3)

opera

(H:2, W:2) (H:0, W:0)

C wife
(H:3,W;4)

football
X
>

opera (H:3, W:4)

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2. Prisoners Dilemma
Susan
confess confess Alan Do not confess -$2000, $1000 0, 0 -$1000, -$1000 Do not confess $1000, -$2000

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Dominant strategy

A dominant strategy is a strategy that generates best payoffs than all other strategies, regardless of the choices of the other players. Examples: The Prisoners dilemma game

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2. Prisoners Dilemma In Business

Cartels dilemma:
Player 2 Follow quota Follow quota 15,10 Produce more 10,13

Player1 Produce more 19,5 12,8

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2. Coca-Cola vs. Pepsi Co.

Pepsi Ad Ad Coca-Cola No Ad 2.5, 4.5 4, 4 3, 3 No Ad 4.5, 2.5

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3. Nash Equilibrium

A Nash equilibrium is a set of strategies such that, given that the other players choose their Nash equilibrium strategies, each player prefers her or his own Nash equilibrium strategy.

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3. Finding Nash equilibrium

How to find the preferred strategies for player 1? Answer the following two questions. (assume player 2 only has two strategies)

If player 2s strategy is the left one, what is player 1s best reply? (draw an arrow to the best strategy or circle player 1s best payoff) If player 2s strategy is the right one, what is Player 1s best reply? (do the same as above).

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3. Finding Nash Equilibrium

Do the same to find player 2s best reply (preferred strategy). The Nash equilibrium (equilibria) exists where the two arrows (circles) meet in the same cell.

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3. Nash equilibirum

In a game in strategic form, when there is no dominant strategy equilibrium, Nash equilibrium is a reasonable prediction.

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3. Remarks on Nash Equilibrium

Nash equilibrium is a self-enforcing agreement.

No agent can benefit from deviating unilaterally. (stable)

Nash equilibrium is a non-cooperative outcome and players may jointly prefer a cooperative outcome to Nash equilibrium outcome. e.g., Prisoners dilemma

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3. Remarks on Nash Equilibrium

There may be more than one Nash equilibrium.

Battle for evening news, coordination game, one-shot Nash bargaining game.

There may be no Nash equilibrium (in pure strategy)

Matching pennies game

If randomized strategies are considered, there always exists at least one Nash equilibrium.

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4. Zero-sum vs. Positive-sum

A Zero-sum game is a strategic situation where one player can become better off only if another is made worse off.

A positive-sum game is a strategic situation where one player can become better off without another being made worse off.

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4. Matching Pennies (competition)

Player 2

head head Player 1 1, -1

tail -1, 1

tail

-1, 1

1, -1

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4. Discover versus Optima (coordination)

Merchants
Discover Discover Consumers 1, 1 Optima 0, 0

Optima

0,

1, 1
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4. Battle for the evening news (co-opetition)

TVB
7:30pm 8:00pm

7:30pm
ATV 8:00pm

1, 1
4, 3

3, 4
2.5, 2.5

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5. Randomized Strategy

Randomized Strategy (mixed strategy): is a strategy for choosing among the alternative pure strategies in accordance with specified probabilities.

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5. Nash Equilibrium in mixed strategies

In a mixed Nash equilibrium, an agent should be indifferent between his pure strategies (those strategies with positive probability in the equilibrium.) We can calculate agent 1s equilibrium strategy by finding probability for each of his pure strategy so that agent 2 gets the same expected payoff for each of agent 2s pure strategy.

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5. Matching Pennies in real life

Boeing and Airbus simultaneously must commit to an advertising campaign. The advertising either can focus on the negatives of the other companys planes or the positive aspects of the companies own planes. Boeing is the market leader and benefits when both firms choose the same strategy. Airbus does better when it can differentiate itself by choosing a different strategy.

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5. Incentive games
W

Shirks
Q

works
(1-Q)

Not monitor (-5, 20)

M P

(15, 10)

monitor
(1-P)

(0, 5)

(10, 10)

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5. Randomized strategies

Sometimes you have to mix your strategies.

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A sequential game
The Chain-Store Game
{k:in , CS:C} N.E. , S.P.N.E. (v) (v)
{k:out , CS:F} N.E. , Not S.P.N.E.

(CS: 5, k: 1)

out
k
Potential entrant

>

In
Chain Store
(CS:2,k:2)

(CS: 0,k:0)
X

>

Go to end of the game and track backward

(CS: 2,k:2)
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6. Backward Induction

Look ahead and reason back!

Anticipate where your initial decisions will ultimately lead, and use this information to calculate your best choice. Or call it :

Backward induction:

Looking forward to the final nodes and reasoning backward toward the initial node.

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6. subgame perfect Nash equilibrium

Subgame perfect Nash equilibrium: the equilibrium we arrive at by using backward induction. An equilibrium strategy in a game in extensive game is a sequence of the best strategies, where each strategy is decided at the corresponding node.

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6. It pays to think sequentially

Two college students drove to an out-of-town basketball game the day before an important exam. The students drank too much and were unprepared to take the exam. The decided to tell the teacher that a flat tire delayed their return. Being the understanding type, the professor said, No problem, take the test tomorrow. .

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6. Ultimatum Game

$1 to be divided between two players Player 1 proposes (x1, 1-x1), where x1 is his own share. Then, player 2 either agree or disagree.

If agreed, the $1 is divided as proposed. If no agreement, the $1 is taken away from the two. Each gets nothing. And game ends.

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6. Group study

What is your prediction about the outcome? How will you divide if you are player 1? How will you behave if you are player 2?

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6. Ultimatum Game

Experiment conducted in U.S., Slovenia, Japan, and Israel. 10 rounds. In each round, there are 1000 tokens ($10).

First round: the mode is 500 Tenth round: U.S. & Slovenia: 500 Japan: 450, 400 Israel: 400

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7. Strategic Move

An action to influence the beliefs or actions of other players in a favorable way.

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7. Strategic Moves

Unconditional Strategic moves Conditional Threat

Promise

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7.Unconditional strategic moves

Lithographers Incentive
Make more prints Buy Litho

Make prints consumers Litho Do not Do not

Do not

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7. Burning the bridge behind you

Prof. Chia-Wei Woo, doctor of Business Administration 2008 HKUST graduation ceremony In the citation: Before founding HKUST, Prof. Woo was the president of San Francisco State University. As for Prof Woo himself, he was blind to his own needs. He burned his bridges; he did what Winston Churchill would have approved: Leap, and the net will appear. But he did more. He leapt, but not before cutting his own net by spurning an offer from the California State University System to hold his university professorship in abeyance pending his return from his Hong Kong mission. To get top academics from across the world to join me in a reverse exodus to Hong Kong, I must first totally uproot myself. Otherwise how can others believe me? Such is his leadership style.

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7. Conditional strategic move

A conditional strategic move is an action under specified conditions to influence the beliefs of other players in a favorable way. A threat imposes costs under specified conditions to change the beliefs or actions of other players. A promise conveys benefits under specified conditions to change the beliefs or actions of other players.

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Poison Pill--threats

In 4/95, Dean Witter, Discover & Co. adopted a shareholder rights plan under which the acquisition by any party of 15% or more of the companys shares would give other shareholders the right to buy additional shares at a 50% discount. How this affects the likelihood of hostile takeover?

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7. FDIC--promises

The Federal Deposit Insurance Corporation (FDIC).

Guarantees each depositor up to $100,000 at participating banks.

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7. Promise

Oct. 14, 2008 Hong Kong deposit protection: http://www.info.gov.hk/hkma/eng/consumer/d eposit_protection_index.htm

January 1990: Chrysler: The guaranteed rebate.

If the rebate goes up in 1990, Chrysler will pay you the difference.

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8. A card game

Players: 60 students in Econ3014 and the instructor

The instructor keeps 60 black cards and distributes one red card to each of the students (all the cards are from Prof. Leonard Cheng ). Prof. Leonard Cheng agrees to put up $60,000 in prize money and offers to pay $1,000 to anyone either the instructor or a studentwho turns in a pair of cards, one black and one red. Students cannot get together and bargain as a group with the instructor.

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8. A card game

What would happen in the card game if the instructor lost three black cards? Example: The National Football League (NFL) and the big cities in N.A.

32 teams.

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8. Added Value

Q: How much can you hope to get in a game? A: Its hard to get more from a game than your added value.

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8. Added Value

Your added value =

The size of the pie (maximal total surplus ) when you are in the game minus The size of the pie when you are out of the game.

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8. Added Value of a Monopoly

What does it mean to have a monopoly? Without the monopoly, theres no game! So a monopolys added value is the whole pie. Can a monopoly get the whole pie? It depends on the added value of other players.

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8. Added value of a duopoly

Assume there are two sellers in a market for an identical product. Both have zero fixed cost and a constant cost of $1 per unit. There are 10 consumers. Each is willing to pay $10 for one unit of the product. What is the added value of one seller?

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8. Bitter Competition

Holland Sweetener Company and NutraSweet owned by Monsanto

Product Aspartame, a low-calorie, high-intensity sweetener NutraSweet made over half a billion dollars in 1985. NutraSweet was protected by a patent which was to be expired by 1987 in Europe and 1992 in the U.S.

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8. Bitter Competition

In 1986, Holland Sweetener Company invested a $50 million plant to make aspartame. In 1987, Holland attacked the European market, the aspartame price fell from $70 per pound to $22-$30 per pound. Were looking forward to moving the war into the U.S. every manufacturer likes to have at least two sources of supply

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8. Bitter Competition

However, just prior to the U.S. patent expiration, both Coke and Pepsi signed new long-term contracts with NutraSweet, which led to combined savings for Coke and Pepsi of $200 million annually.

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Topic Intended Learning Outcomes

9.1 Distinguish strategic vs. Non-strategic decisions. 9.2 Construct Prisoners Dilemma game and give 3 examples of Prisoners Dilemma game in reality. 9.3 Define and identify dominant strategy. 9.4 Define and identify/calculate best reply and Nash equilibrium. 9.5 Distinguish Zero-sum vs. Positive-sum games. 9.6 Give examples of games representing competition, coordination, and co-opetition relationship. 9.7Calculate Nash equilibrium in mixed strategies.

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Topic Intended Learning Outcomes

9.8 Use back-ward induction and calculate/identify subgame perfect Nash equilibrium. 9.9 Distinguish unconditional vs. conditional strategic moves and give examples of strategic moves. 9.10 Define and calculate Added value.

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