Chapter 4 Game Theory

What Is Game Theory?

Game theory is a theoretical framework to conceive social situations among competing players and produce optimal
decision-making of independent and competing actors in a strategic setting. In some respects, game theory is the science
of strategy, or at least the optimal decision-making of independent and competing actors in a strategic setting. Using game
theory, real-world scenarios for such situations as pricing competition and product releases (and many more) can be laid out
and their outcomes predicted. From its function it is evident that game theory is largely used in the study of the human
decision making process. In economics however game theory tends to focus on sets of outcomes known as Nash
equilibrium that represent the most rational solutions to each situation. Scenarios include the prisoner's dilemma and the
dictator game among many others.

How Game Theory Works

The key pioneers of game theory were mathematician John von Neumann and economist Oskar Morgenstern in the 1940s.
Mathematician John Nash is regarded by many as providing the first significant extension of the von Neumann and
Morgenstern work. The focus of game theory is the game, which serves as a model of an interactive situation among
rational players. The key to game theory is that one player's payoff is contingent on the strategy implemented by the other
player. The game identifies the players' identities, preferences, and available strategies and how these strategies affect the
outcome. Depending on the model, various other requirements or assumptions may be necessary. Game theory has a wide
range of applications, including psychology, evolutionary biology, war, politics, economics, and business. Despite its many
advances, game theory is still a young and developing science. According to game theory, the actions and choices of all the
participants affect the outcome of each. It is assumed that all players within the game are rational and will strive to maximize
their payoffs in the game.

The Nash Equilibrium

Equilibrium in game theory refers to the Nash Theorem; a way in which people negotiate down to zero marginal gain. Nash
Equilibrium is therefore a concept that determines the most rational or optimal solution in a non-cooperative game in which
each player lacks any incentive to change his/her initial strategy. Under the Nash equilibrium, a player does not gain
anything from deviating from their initially chosen strategy, if other players also keep their chosen strategies unchanged. A
game may have multiple Nash equilibria or none of them. Nash equilibrium is an outcome reached that, once achieved,
means no player can increase payoff by changing decisions unilaterally. In Economics, this implies that people far more
frequently negotiate than compete in markets. Negotiation is important because Von Neuman demonstrated how ‘winner
take all’ scenarios are ultimately harmful to everyone because they eliminate players. It can also be thought of as "no
regrets," in the sense that once a decision is made, the player will have no regrets concerning decisions considering the
consequences.

The Nash equilibrium is reached over time, in most cases. However, once the Nash equilibrium is reached, it will not be
deviated from. After we learn how to find the Nash equilibrium, take a look at how a unilateral move would affect the
situation. Does it make any sense? It shouldn't, and that's why the Nash equilibrium is described as "no regrets." Generally,
there can be more than one equilibrium in a game. However, this usually occurs in games with more complex elements than
two choices by two players. In simultaneous games that are repeated over time, one of these multiple equilibria is reached
after some trial and error. This scenario of different choices overtime before reaching equilibrium is the most often played
out in the business world when two firms are determining prices for highly interchangeable products, such as airfare or soft
drinks.
Impact on Economics and Business

Game theory brought about a revolution in economics by addressing crucial problems in prior mathematical economic
models. For instance, neoclassical economics struggled to understand entrepreneurial anticipation and could not handle the
imperfect competition. Game theory turned attention away from steady-state equilibrium toward the market process.
Economists often use game theory to understand oligopoly firm behavior. It helps to predict likely outcomes when firms
engage in certain behaviors, such as price-fixing and collusion.
In business, game theory is beneficial for modeling competing behaviors between economic agents. Businesses often have
several strategic choices that affect their ability to realize economic gain. For example, businesses may face dilemmas such
as whether to retire existing products or develop new ones, lower prices relative to the competition, or employ new
marketing strategies.

Types of Game Theories

Although there are many types (e.g., symmetric/asymmetric, simultaneous/sequential, etc.) of game theories, cooperative
and non-cooperative game theories are the most common.

 Cooperative game theory - deals with how coalitions, or cooperative groups, interact when only the payoffs are
known. It is a game between coalitions of players rather than between individuals, and it questions how groups form
and how they allocate the payoff among players.
 Non-cooperative game theory - deals with how rational individuals or entities deal with each other to achieve their
own goals. The most common non-cooperative game is the strategic game, in which only the available strategies
and the outcomes that result from a combination of choices are listed. A simplistic example of a real-world non-
cooperative game is rock-paper-scissors.

Game study is the study of strategic interaction where one player’s decision depends on what the other player does. What
the opponent does also depends upon what he thinks the first player will do.
 Dominant strategy – Sometimes, the best strategy will be the same no matter how other players act. This is known
as the dominant strategy where one choice clearly gives a player better result than other choices. The dominant
strategy is the best strategy chosen by players. When both parties have dominant strategies, equilibrium is stable
as neither party has a motive to change. In the dominant strategy, each player is unaware of the other's optimal
strategy and simply chooses the best strategy. In some cases however, the dominant strategy may also be the
Nash equilibrium.
 Nash equilibrium – A Nash equilibrium takes place when each player remains in the same position as long as no
other player chooses a different action. Each player would be worse off by doing so and, therefore, chooses not to
move. In the Nash equilibrium each player knows the strategy of their opponent and uses that knowledge to form
their own strategy. Nash equilibrium can occur when a group fully cooperates or when no members of a group
cooperate.

Examples of Game Theory in Economics

Price war
This is a similar outcome but for two firms that can keep prices high and stable or start a price war. The best outcome for
both firms is (a) $40, $40. However, when prices are stable, if one firm cuts price (starts price war) it will see profits rise to
$60. However, the other firm who keeps prices high will lose market share and get zero profits. Therefore, the firm who
loses out will almost certainly retaliate and the outcome will move to (d) with both firms just making $3 profit. Therefore,
there is strong incentive to avoid price war.
Co-ordination playoff
In this example, if neither firm invest, they will make $50 each. However, if they both invest in new technology, which will
become new market standard, they will both get substantially better pay off (a) with $200 each. However, if one firm invests
in new technology and the other doesn’t, then they will be left with $0 (it is not widely shared). In this case, the firm will
probably start investing too, as they would be better off. The key thing is whether one firm is willing to take the plunge and
make zero profits in the short-run. It may not be able to afford this outcome. The issue with this game theory dilemma is that
there are strong rewards from co-operating. But, in the real world, for various reasons, co-operation may not be there.

Matching pennies
This is a game with two players. They both put a penny on the table. If the pennies are Heads/heads or tails/tails – then
Player A wins both pennies. He gains 1, (player B loses 1). If the pennies are mixed (heads/tails) or tails/heads then player
B wins both pennies. This is an example of a zero-sum game – the net benefit is always zero. For everyone who gains,
there is an equal and opposite loss.

Zero-sum game
In this situation, we have another zero-sum game situation. If a firm enters or leaves, there is always a net benefit of zero.
For firm A, its dominant strategy is to enter the market, because 1 is greater than -2. For firm B, its dominant strategy is also
to enter the market because -1 is greater than -3. Firm B would prefer both firms to leave the market so it can get to zero.
But, in this model, it can’t do that because it knows if A enters, it will have to enter or face the costs of -3.

Tariff or trade war?

In this case, if both countries, pursue low tariffs, the outcome is £3m net welfare for each country. If A increases tariff, then
its net welfare will be £2m, and country B who keeps low tariffs will make £1.5m. If B retaliates and also increases tariffs, it
will make itself worse of – welfare falls to £1m, but it will effectively punish A whose welfare falls from £2m to £1m. If firms
wish to maximize welfare, they would stick to low tariffs. That is their dominant strategy and Nash equilibrium. However, in
the real world, there may be political pressures (e.g. protect domestic industry, even at expense of higher prices for
consumers, which encourages countries to place tariffs.

Prisoner’s dilemma
The prisoner’s dilemma is a classic example of game theory. There are two prisoners held in solitary confinement. They can
either confess to crime or stay silent (not confess). If both stay silent, they both get light sentence of 1 year. If they both
confess, they get 5 years each. However, if one confesses to the crime and betrays the other, then the one who confesses
is given immunity for giving information. But the other who remained silent gets 20 years. Therefore, a prisoner would only
choose to remain silent, if they can guarantee the other prisoner will remain silent. The dominant strategy for both players is
to confess. At worst they will get 5 years, at best they will get 0 years. The Nash equilibrium is confess/confess (5 years
each). Because if a player acted unilaterally, it would be worse off.

Decision Tree
Another way of describing game theory is through a decision tree. In this example, Firm A can choose to enter or leave.
Firm B (the incumbent can then decide to fight (cut prices) or accommodate. If it fights, both firms make a loss (-4, -3).
Therefore the dominant strategy for Firm B appears to be accommodate, leaving both firms with (1,1). However, firm B may
make the calculation that it is worth making a temporary loss, in order to try and force the new firm out of business. Also, if
firm B fights, it may deter other entrants.

Decision Tree
In this decision tree, player 1 can go high or low. If player 1 goes high, the dominant strategy for player 2 is to go high (3,5).
If player 1 goes low, the dominant strategy for player 2 is to go high (10,4). Therefore, player 1 will choose low, because it
knows that is the best choice.

Dominant strategy
A dominant strategy occurs when there is an optimal choice of strategy for each player no matter what the other does. If P2
chooses left P1 will choose UP. If P2 chooses right P1 will choose UP. Therefore UP is a dominant strategy for P1. P2 will
always choose right no matter what P1 does. The unique equilibrium is (up, left). This is best for both.

Nash Equilibrium
A Nash equilibrium occurs when the payoff to player one is the best given the other’s choice. In this case If P1 chooses
down, P2 will choose right. If P1 choose UP, P2 will choose right. But, if P2 choose right, P1 will want to choose down. The
Nash equilibrium will be downright, (5,5) despite UP left being the optimal Pareto outcome.
 

Collusion and game theory

If firms are competitive and they set low price - they will both make £4m. If they collude and set high price, then they will
both double their profits and make £8m. However, if during collusion, firm A undercuts the collusive price and sets a low
price – it is able to sell more. In this case, firm A benefits from the best of both worlds. Prices are high because firm B is
setting high price, but firm A is also selling large quantities because it is undercutting its rival. In this case, firm A makes
£10m and firm B only makes £2m. Therefore, firm B is unlikely to keep prices high and the market reverts to both setting
low prices. The optimal outcome for the firms is to collude (high price, high price)

Repeated Games and Game Theory

If games are repeated then there is the possibility of punishing people for cheating, this will provide an incentive for sticking
to the Pareto optimal approach. However, if they are repeated a finite number of times then there will be an incentive to
cheat. If the game is played 10 times then the player will defect on the 10th round so why cooperate. So, therefore, you may
as well defect on round 9 and so round 8 as well. If it is played an infinite number of times then it will be different. The best
strategy then is to play tit for tat. If a player defects in one round you retaliate in the next round. In other words, you do
whatever your opponent does and this is an incentive to enforce the cartel.

Game Theory: A game of entry deterrence

If a new firm enters the market then the payoff will depend on whether the incumbent fights or accepts. If the incumbent
fights they both get 0. If it does not fight then the incumbent gets 1 and the entrant gets 2. Therefore the equilibrium (most
rational) is for the new firm to enter and the incumbent to accept. However, if the incumbent can give a credible threat that
he will fight then he may be able to persuade the entrant to stay out. He could do this by investing in extra capacity, which
would give him a bigger payoff in a price war. This would deter entry. So although the monopolist would never use this he
would prevent entry.

Game Theory can be used for pricing strategies

Game theory and the kinked (curly) demand curve. In oligopoly, (a market dominated by a small number of large sellers)
firms may be deciding whether to cut prices, increase prices or keep them static. The kinked demand curve model suggests
the most likely outcome is for price stability. This is because If firms increase the price, others don’t – Therefore demand
falls significantly. (demand is elastic). If firms cut price, you would gain an increase in market share. Other firms don’t want
to allow this. Therefore, they cut prices as well. Basically causing a price war where everybody loses out. Therefore, in
oligopoly, an important feature of firms decisions is the impact of interdependence. Decisions of one firm significantly impact
on others.
War vs Peace
In this case, the best outcome for both parties is Peace, Peace (a) – both get 100. However, if you think there might be war,
it is better to strike first. Because if you strike first and start the war, you get 50, whereas the loser gets – 50. If there is
tension between the two, and you distrust the other country, then it could encourage a country to start a war and deviate
from the best strategy for both.