GAME THEORY

Game Theory

Game theory is a tool for studying strategic behavior,

which is behavior that takes into account the expected
behavior of others and the mutual recognition of
interdependence.
What Is a Game?
All games share four features:
 Rules
 Strategies
 Payoffs
 Outcome.
Game Theory

The Prisoners’ Dilemma

The prisoners’ dilemma game illustrates the four features
of a game.
The rules describe the setting of the game, the actions the
players may take, and the consequences of those actions.
In the prisoners’ dilemma game, two prisoners (Art and
Bob) have been caught committing a petty crime.
Each is held in a separate cell and cannot communicate
with each other.
Game Theory

Each is told that both are suspected of committing a more

serious crime.
If one of them confesses, he will get a 1-year sentence for
cooperating while his accomplice get a 10-year sentence for
both crimes.
If both confess to the more serious crime, each receives 3
years in jail for both crimes.
If neither confesses, each receives a 2-year sentence for the
minor crime only.
Game Theory

In game theory, strategies are all the possible actions of

each player.
Art and Bob each have two possible actions:
 Confess to the larger crime
 Deny having committed the larger crime.
Because there are two players and two actions for each
player, there are four possible outcomes:
 Both confess
 Both deny
 Art confesses and Bob denies
 Bob confesses and Art denies
Game Theory

Each prisoner can work out what happens to him—can work

out his payoff—in each of the four possible outcomes.
We can tabulate these outcomes in a payoff matrix.
A payoff matrix is a table that shows the payoffs for every
possible action by each player for every possible action by
the other player.
The next slide shows the payoff matrix for this prisoners’
dilemma game.
Game Theory
Game Theory

If a player makes a rational choice in pursuit of his own best

interest, he chooses the action that is best for him, given any
action taken by the other player.
If both players are rational and choose their actions in this
way, the outcome is an equilibrium called Nash
equilibrium—first proposed by John Nash.
The following slides show how to find the Nash equilibrium.
Bob’s
view
of the
world
Bob’s
view
of the
world
Art’s
view
of the
world
Art’s
view
of the
world
Equilibrium
 Oligopoly Games
An Oligopoly Price-Fixing Game
A game like the prisoners’ dilemma is played in duopoly.
A duopoly is a market in which there are only two producers
that compete.
Suppose that the two firms enter into a collusive agreement.
A collusive agreement is an agreement between two (or
more) firms to restrict output, raise price, and increase
profits.
Such agreements are illegal in the United States and are
undertaken in secret.
Firms in a collusive agreement operate a cartel.
Oligopoly Games

The possible strategies are:

 Comply
 Cheat
Because each firm has two strategies, there are four
possible outcomes:
 Both comply
 Both cheat
 Trick complies and Gear cheats
 Gear complies and Trick cheats
Oligopoly Games

Here are the four possible hypothetical outcomes:

 If both comply, they make $2 million a week each.
 If both cheat, they earn zero economic profit.
 If Trick complies and Gear cheats, Trick incurs an
economic loss of $1 million and Gear makes an economic
profit of $4.5 million.
 If Gear complies and Trick cheats, Gear incurs an
economic loss of $1 million and Trick makes an economic
profit of $4.5 million.
The next slide shows the payoff matrix for the duopoly
game.
Payoff
Matrix
Trick’s
view
of the
world
Trick’s
view
of the
world
Gear’s
view
of the
world
Gear’s
view
of the
world
Equilibrium
Oligopoly Games

The Nash equilibrium is where both firms cheat.

The quantity and price are those of a competitive market,
and the firms earn normal profit!!!
THE END