MGEC Session10 SeqandRepGames

MGEC: Sequential and Repeated Games
Deepal Basak
Economics and Public Policy Area

Indian School of Business
Term 1, 2017-18
Deepal Basak (ISB) MGEC: Sequential and Repeated Games Term 1, 2017-18 1 / 31
Sequential and Repeated Games
Microsoft announces a new product coming up in six months. Forcing

its competitors.

its competitors.
Didi threatens to start price war with Uber to deter entry. Credible?

its competitors.
Regulators warned they would let banks fail, but ultimately capitalized
them when the banks failure threatened the financial system.

its competitors.
Regulators warned they would let banks fail, but ultimately capitalized
them when the banks failure threatened the financial system.
Firms compete with each other for years, making price and quantity
decisions. Can they collude based on future promise/punishment?
For example, P&G and Kemberly Clark
Where are we in this course?
6 Individual behaviour
7 Public goods
8 Market competition
9 Simultaneous games
10 Sequential and Repeated Games

I Sequential moves games
I Backwards induction
I Credible commitments
I Repeated Game
I Games of incomplete information
Capacity Game with Three Choices
Player 2: Toyota
Build Large Build Small Do Not Build
Player 1: Build Large 0,0 12,8 18,9

Honda Build Small 8,12 16,16 20,15
Do Not Build 9,18 15,20 18,18
Sequential Move Games
Game Tree
Honda Payo Toyota Payo
L 0 0
S
Toyota 12 8
DNB
L 18 9
L 8 12
S S
Honda Toyota 16 16
DNB
20 15
DNB
L 9 18
S
Toyota 15 20
DNB
18 18
Game Tree
Definition
A game tree shows the dierent strategies that each player can follow in the
game and the order in which those strategies get chosen.
Game trees solved by starting at the end of the tree

For each decision point, find the optimal decision for player at that point
Solution to a sequential game diers from that of a simultaneous game

I Why? The first mover can force second movers hand
I Illustrates value of commitment (i.e. limiting ones own actions) rather
than flexibility
Game Tree
L 0 0
S
Toyota 12 8
DNB
L 18 9
L 8 12
S S
Honda Toyota 16 16
DNB
20 15
DNB
L 9 18
S
Toyota 15 20
DNB
18 18
Game Tree
L 0 0
S
Toyota 12 8
DNB
L 18 9
L 8 12
S S
Honda Toyota 16 16
DNB
20 15
DNB
L 9 18
S
Toyota 15 20
DNB
18 18
Burn your own bridge
This can be a strategic move provided Toyota observes and

understands that Honda has made a commitment to build large
strategy
If Toyota can reverse its investment and build small after Honda does
not enter, this strategy will not work. Note that Honda could have
made $20M by bluffing if it can convince Toyota
Of Course, Toyota understands this and wont believe unless Hondas
intention to build large is backed by credible action
I Creating specialized assets that cannot be redeployed for alternative
uses
I Stake your reputation
I Contracts such as Most Favored Customer Clause
Definition
In a sequential game, players make decisions (or select a strategy) in a
predefined order, and in which at least some players can observe the moves of
players who preceded them.
Definition
In a sequential game, players make decisions (or select a strategy) in a
predefined order, and in which at least some players can observe the moves of
players who preceded them.
If no players observe the moves of previous players, then the game is

simultaneous
If every player observes the moves of every other player who has gone before
her, the game is one of perfect information
If some (but not all) players observe prior moves, while others move
simultaneously, the game is one of imperfect information
Sequential games are represented by game trees (the extensive form) and
solved using the concept of backwards induction
Source: Adapted from gametheory.net
Strategic Foresight: Backwards Induction
Definition
Backward induction is the process of reasoning backwards, in the opposite
sequence as events, from the final step of a problem, to determine the sequence
of optimal actions.
Centipede Game
P1
(1, 1)
Game to continue until a player stops or each has 3 coins
Centipede Game
P1 C P2
S S
(1, 1) (0, 3)
Centipede Game
P1 C P2 C P1
S S S
(1, 1) (0, 3) (2, 2)
Centipede Game
P1 C P2 C P1 C P2
S S S S
(1, 1) (0, 3) (2, 2) (1, 4)
Centipede Game
P1 C P2 C P1 C P2 C
(3, 3)
S S S S
(1, 1) (0, 3) (2, 2) (1, 4)
Centipede Game
P1 C P2 C P1 C P2 C
(3, 3)
S S S S
(1, 1) (0, 3) (2, 2) (1, 4)
Centipede Game
P1 C P2 C P1 C P2 C
(3, 3)
S S S S
(1, 1) (0, 3) (2, 2) (1, 4)
Centipede Game
P1 C P2 C P1 C P2 C
(3, 3)
S S S S
(1, 1) (0, 3) (2, 2) (1, 4)
Centipede Game
P1 C P2 C P1 C P2 C
(3, 3)
S S S S
(1, 1) (0, 3) (2, 2) (1, 4)
Game ends in the first move
Game of Flags
There are 13 Flags

Two players
Each player can remove 1,2 or 3 flags at a time
Move alternately
The last one to finish is the loser
Credible Commitment
Definition
A commitment is credible when the costs of falsely making a commitment are
greater than the associated benefits.
Allied-Barkley Price War
Credible commitments
First move: Allied decides whether to maintain or drop prices

Second move: Barkley decides whether to maintain or drop prices
First move: Allied decides whether to maintain or drop prices

Second move: Barkley decides whether to maintain or drop prices
Barkley threatens to drop prices if Allied does so
Does Barkley have a credible threat?
Source: Chapter 14, Allen et al.
30, 50
Maintain Price
Barkley
Maintain Price Drop Price

20, 70
Allied
Drop Price
40, 30
Maintain Price
Barkley
Drop Price
15, 20

30, 50
Maintain Price
Barkley

20, 70
Allied
Drop Price
40, 30
Maintain Price
Barkley
Drop Price
15, 20

30, 50
Maintain Price
Barkley

20, 70
Allied
Drop Price
40, 30
Maintain Price
Barkley
Drop Price
15, 20

Repeated Interactions
Managers and suppliers/employees/creditors interact with each

other repeatedly over years.
Business success may depend on repeat business from the same

customer multiple times. For example, consumer goods.
Firms might compete with each other in the same markets over
decades.
Repeated Games
Definition
A repeated game consists of some number of repetitions of some base game
(called a stage game).
Trust, reputation, promises, threats and reciprocity are relevant only with
repeated play
Repeated Games
Tit for Tat

Imagine Kingfisher and Carlsberg come with an implicit understanding
that they will keep the price high (at 6) but if one undercuts, then the
other will also cut the price down (to 4) and will keep it that way forever
Repeated Games
Tit for Tat

Imagine Kingfisher and Carlsberg come with an implicit understanding
that they will keep the price high (at 6) but if one undercuts, then the
other will also cut the price down (to 4) and will keep it that way forever
Undercutting brings some benefit today (4 in our example) but future

punishment is too severe
Thus, the two managers can sustain cooperation and keep a high
price by playing Tit for Tat
Same argument applies to Prisoners Dilemma in general
Finite Horizon Repeated Games
Recall that players do not cooperate if there is no future

Can we cooperate when we know the relationship ends after tomorrow?

We know that we will not cooperate tomorrow. So, why today?

You will cutdown price tomorrow anyway. So, you cannot promise me a
reward if I do not cutdown my price today

You will cutdown price tomorrow anyway. So, you cannot promise me a
reward if I do not cutdown my price today
) No cooperation
Games of Incomplete Information
Definition
In a game of incomplete information, all players may not have the same
information.
Definition
In a game of incomplete information, all players may not have the same
information.
One way to summarize this asymmetric information is in terms of player

types, where other players that have dierent preference (payo) functions
I A competitor entering the market might be a low or high cost type
I A contract negotiator might be a tough or soft type
I A borrower might be responsible or irresponsible
Barkley has a tough reputation
Allieds strategies
Enter market Do not enter
Barkleys Fight 6,2 8,3

strategies (Price low)
No fight 5,4 2,3
(Price high)
Barkley has a soft reputation
Allieds strategies
Enter market Do not enter
Barkleys Fight 2,2 3,3

strategies (Price low)
No fight 7,4 4,3
(Price high)
Reputation in Games of Incomplete Information
If Barkley can build a reputation for being tough, it can deter Allied from
entering
Reputation is based on a players history of behaviour and involves inferring
future behaviour based on past behaviour
Act tough: Costly in the short run but has long run reward
Take-Aways from Todays Session
Backwards induction is the key to solving sequential problems.
Backwards induction can help determine if threats are credible.
In many business situations, managers interact with employees,

customers and competitors, creditors repeatedly.
In finite repeated games, solve last stage and work backwards.

In infinite repeated games, there is no final stage and so we cannot
use backwards induction.
In many business situations, managers interact with employees,

customers and competitors, creditors repeatedly.
In finite repeated games, solve last stage and work backwards.

In infinite repeated games, there is no final stage and so we cannot
use backwards induction.
Reputation building is key to solving games of incomplete information
References for Todays Class
Allen et al. Managerial Economics, Chapter 11 (Game Theory)
Pindyck and Rubinfeld Microeconomics, Chapter 12 (Game Theory and

Competitive Strategy)
Reference: Allen et al. Microeconomics for Managers, Chapter 23

(Credibility and Reputation)
Practice Problem 1
Two soft producers, York Cola and Renos Cola, secretly collude to fix prices. Each firm
must decide whether to abide by the agreement or cheat on it. The payo matrix is as
follows:
York Cola
Abide by agreement Cheat
Reno Abide by agreement $29 mm, $29 mm $26 mm, $30 mm

Cola
Cheat $30 mm, $26 mm $28 mm, $28 mm
a. What strategy will each firm choose, and what will be each firms profit?
b. Does it matter whether this agreement is for one period or for 2.5 periods?
c. Is this game an example of the prisoners dilemma?
Adapted from Allen et al., Chapter 11 on Game Theory.
Practice Problem 2
Problem 23.1 From David Kreps Microeconomics for Managers Chapter 23

(Credibility and Reputation). Solve for (a)-(e).
Final exam
What is the syllabus for the final exam?
I Material covered in Sessions 6 to 10 in the course.
I The scope of coverage is the material on the slides and/or discussed in
class, not material covered in the course pack.

I You need to know the concepts covered in Sessions 1 to 5, but are
unlikely to be tested on these directly.
Final exam

How should I study for the exam

I The best way is to study for the exam is to master the concepts and
learn to apply those concepts to solve numerical problems.
Final exam

How should I study for the exam

I The best way is to study for the exam is to master the concepts and
learn to apply those concepts to solve numerical problems.
I get that, but what exactly should I do to prepare?

I There is no right way to prepare. Think hard about the concepts that
have been taught. There is no way to solve numerical problems

without understanding the concepts.
I That being said, practicing problems is a good way to find your
conceptual blind spots. So practicing more problems is likely to benefit

your score.
Final exam
So which book should I practice from?

I Make sure youve mastered the problems from the slides and
homeworks.
I The recommended books in the syllabus are great sources of problems.
I If you feel youve exhausted those, check out more problems in the
back of the books in the LRC.
I The quiz is NOT representative of the types of problems on the exam.
Final exam
So which book should I practice from?

I Make sure youve mastered the problems from the slides and
homeworks.
I The recommended books in the syllabus are great sources of problems.
I If you feel youve exhausted those, check out more problems in the
back of the books in the LRC.
I The quiz is NOT representative of the types of problems on the exam.
Which book do you use to set problems for the exam?

I While I sometimes borrow problems from other professors for
homeworks, I write the entire exam paper myself.
Final exam
So what exactly is going to be on the exam?
I There will be 10 problems, each of medium to short length, each worth
10 points.
I You need to work quickly to complete all problems in 3 hours.
I For this, your understanding of the concepts should be solid.
Final exam
10 points.
Why is the exam closed book, closed notes, closed friend?

I To test your understanding of the concepts.
I The calculations are supposed to be easy. If you find yourself stuck on
the math, feel free to leave a fraction as such.
Final exam
10 points.
Why is the exam closed book, closed notes, closed friend?

I To test your understanding of the concepts.
I The calculations are supposed to be easy. If you find yourself stuck on
the math, feel free to leave a fraction as such.
Are the questions difficult?

I Some questions are easy, others are difficult. Which are which will
most probably be dierent for everyone.
I Your best strategy is to first complete the questions you think are short
and easy. Then tackle the ones where you will need more time.
Good Luck and Stay in Touch

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MGEC: Sequential and Repeated Games

Economics and Public Policy Area

Microsoft announces a new product coming up in six months. Forcing

Microsoft announces a new product coming up in six months. Forcing

Microsoft announces a new product coming up in six months. Forcing

Microsoft announces a new product coming up in six months. Forcing

10 Sequential and Repeated Games

Build Large Build Small Do Not Build

Player 1: Build Large 0,0 12,8 18,9

Honda Payo Toyota Payo

Game trees solved by starting at the end of the tree

Solution to a sequential game diers from that of a simultaneous game

Honda Payo Toyota Payo

Honda Payo Toyota Payo

This can be a strategic move provided Toyota observes and

If no players observe the moves of previous players, then the game is

Source: Adapted from gametheory.net

Game to continue until a player stops or each has 3 coins

Game to continue until a player stops or each has 3 coins

(1, 1) (0, 3) (2, 2)

Game to continue until a player stops or each has 3 coins

(1, 1) (0, 3) (2, 2) (1, 4)

Game to continue until a player stops or each has 3 coins

(1, 1) (0, 3) (2, 2) (1, 4)

Game to continue until a player stops or each has 3 coins

(1, 1) (0, 3) (2, 2) (1, 4)

Game to continue until a player stops or each has 3 coins

(1, 1) (0, 3) (2, 2) (1, 4)

Game to continue until a player stops or each has 3 coins

(1, 1) (0, 3) (2, 2) (1, 4)

Game to continue until a player stops or each has 3 coins

(1, 1) (0, 3) (2, 2) (1, 4)

Game ends in the first move

There are 13 Flags

First move: Allied decides whether to maintain or drop prices

First move: Allied decides whether to maintain or drop prices

Barkley threatens to drop prices if Allied does so

Does Barkley have a credible threat?

Source: Chapter 14, Allen et al.

Maintain Price Drop Price

Source: Chapter 14, Allen et al.

Maintain Price Drop Price

Source: Chapter 14, Allen et al.

Maintain Price Drop Price

Source: Chapter 14, Allen et al.

Managers and suppliers/employees/creditors interact with each

Business success may depend on repeat business from the same

Tit for Tat

Tit for Tat

Undercutting brings some benefit today (4 in our example) but future

Recall that players do not cooperate if there is no future

Recall that players do not cooperate if there is no future

Recall that players do not cooperate if there is no future

Recall that players do not cooperate if there is no future

Recall that players do not cooperate if there is no future

One way to summarize this asymmetric information is in terms of player

Enter market Do not enter

Barkleys Fight 6,2 8,3

Source: Chapter 14, Allen et al.

Enter market Do not enter

Barkleys Fight 2,2 3,3

Source: Chapter 14, Allen et al.