Managerial

Economics
Tirthatanmoy Das Lecture 15 May 30, 2022

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Previous class

Key concepts..
q Price discrimination: 1st , 2nd, 3rd degree

q Economics of coupons and rebates

q Monopolistic competition

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 Game theory

Helps strategic managerial decisions…

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Why would a manager care?

q Consequence of a manager’s decision (e.g. profit) depends on own

action as well as the actions of others or rivals

q Thus, strategic managerial decisions must explicitly consider the

actions likely to be taken by their rivals in response to their
decisions to maximize their payoffs

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Why would a manager care?

q Interactive: When the consequence of a manager’s decision depends

on both the manager’s own action and the actions of others

q There are no unconditional optimal strategies in game theory; the

optimality of a strategy depends on the situation in which it is
implemented

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Gaming and strategic decisions

q Game: Situation in which players (participants) make strategic

decisions that take into account each other’s actions and responses

q The players: A player is an entity that makes decisions; models

describe the number and identities of players. Players are rational

q Payoff: Value associated with a possible outcome

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Gaming and strategic decisions

q Strategy: Rule or plan of action for playing a game

q Optimal strategy: Strategy that maximizes a player’s expected

payoff

q The order of play: Play may be simultaneous or non-simultaneous,

that is, sequential

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The idea

If I believe that my competitors are rational and act to maximize their

own payoffs, how should I take their behavior into account when making
my decisions?

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Two types of game

q Noncooperative game: Game in which negotiation and

enforcement of binding contracts are not possible

q Example: Two competitive firms take each others likely behavior

into account and setting their prices. Each firm knows that by
undercutting its competitor it can gain market share, but also may
face price war

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Two types of game

q Cooperative game: Game in which participants can negotiate

binding contracts that allow them to plan joint strategies

q Example: Two firms negotiating a joint investments to develop a

new technology. If they sign a contract to divide the profit from
their joint investment, a co-operative outcome is reached that make
both parties better off

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Pure strategy and mixed strategy

q Pure strategy: Strategy in which a player makes a specific choice

or takes a specific action

q Mixed strategy: Strategy in which a player makes a random choice

among two or more possible actions, based on a set of chosen
probabilities

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Noncooperative game

q Simultaneous game: Where players move simultaneously

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Noncooperative game

q Sequential game: Where players move in turn, responding to each

other’s actions and reactions

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Solution concepts and equilibria

q Solution Concepts: The key to the solution of game theory problems

is the anticipation of the behavior of others

Equilibria:
q Equilibrium: When no player has an incentive to unilaterally
change his or her strategy
q No player is able to improve his or her payoff by unilaterally
changing strategy
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Noncooperative game

How to go about finding the equilibrium or equilibria?:

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Dominant strategies

q Dominant strategy: Strategy that is optimal no matter what an

opponent does

q Advertising is a dominant strategy for Firm A. The same is true for

Firm B. Can you verify these claims? 16
Equilibrium in dominant strategies

q Equilibrium in dominant strategies: Outcome of a game in which

each firm is doing the best it can regardless of what its
competitors are doing

q Equilibrium: both firms will advertise

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No dominant strategies

q Unfortunately, not every game has a dominant strategy for each player
Firm2
Ad No Ad
Ad (10,5) (15,0)
Firm 1
No Ad (6,8) (20,2)

q Here firm 1 does not have a dominant strategy. Can you verify this claim?
What about firm 2?
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No dominant strategies

q What would be the equilibrium here?

Firm2
Ad No Ad
Ad (10,5) (15,0)
Firm 1
No Ad (6,8) (20,2)

q Claim: Both firm A and B choose to advertise. Why?

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Nash equilibrium

q Nash equilibrium: Set of strategies or actions in which each player

does the best it can given its competitors’ actions, that is no player
has an incentive to unilaterally change his or her strategy

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Nash equilibrium

q Dominant Strategies: I’m doing the best I can no matter what you
do. You’re doing the best you can no matter what I do

q Nash Equilibrium: I’m doing the best I can given what you are
doing. You’re doing the best you can given what I am doing

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Nash equilibrium

q Example: product choice problem

q New variations of cereal can be successfully introduced—provided

that each variation is introduced by only one firm

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Example: Nash equilibrium

q Nash equilibria:
q Firm 1: sweet; Firm 2: crispy
q Firm 1: crispy; Firm 2: sweet

q However, not clear whether one or the other will be attained.

Perhaps firms may ’signal’ each other

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Prisoner’s dilemma

q Game theory example in which two prisoners must decide

separately whether to confess to a crime

q If a prisoner confesses, he will receive a lighter sentence and his

accomplice will receive a heavier one

q But if neither confesses, sentences will be lighter than if both

confess
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Prisoner’s dilemma

q Example:

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Prisoner’s dilemma

q If Prisoner A does not confess, he risks being taken advantage of

by his former accomplice

q Likewise, Prisoner A always comes out ahead by confessing, so

Prisoner B must worry that by not confessing, she will be taken
advantage of

q Therefore, both prisoners will probably confess and go to jail for

five years
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