Game Theory & Oligopoly

Numerical on competition and

monopoly
P = 100-q
Tc = 40q

What is game theory

Study of rational behavior in situations in
which your choices affect others & their
choices affect you (so-called games)

Framework for thinking about strategic

interaction

About Game Theory

Game theory studies competitive and cooperative
behavior in strategic environments, where the
fortunes of several players are intertwined.
The field of game theory began around 1900
when mathematicians began asking whether
there are optimal strategies for parlor games
such as chess and poker
The first comprehensive formulation of the
subject came in 1944 with the publication of the
book Theory of Games and Economic Behavior by
famous mathematician John von Neumann and
eminent economist Oskar Morgenstern.

 Since then, game theory has been applied to many other

fields, including political science, military strategy, law,
computer science, and biology, among other areas.
In 1994 three pioneers in game theory were awarded a
Nobel Prize, marking the arrival of the field.
In 2005, two more Game Theorists were awarded the
Nobel
Pick up a business magazine or book and there is a good
chance that it will use some game theory jargon: zero-sum
game, Prisoners Dilemma, win-win game, etc.
We will be learning the underlying theory in the course, and
using it to understand the principles of strategic behaviour
in business.

Terminology and
Assumptions

Strategies
Rationality
Payoffs
Equilibrium
Common knowledge

Assumptions
Rationality
Complete knowledge of ones interests
Flawless calculation of what actions best
serve those interests
Does not imply players are selfish, short
sighted
Applies to repeated interactions

Calculation of own self interest

requires knowledge of others value
systems

 Common Knowledge
Common understanding of the key
elements of the game

List of players
Strategies
Payoffs
Assumption that each player is a rational
maximizer

The Simultaneous Game

The strategic environment

Who are the players?

(Decision makers)
What strategies are available?
(Feasible actions)
What are the outcomes? ( What happens)
What are the payoffs?
(Objectives)

 Dominant strategy : Outperforms all

other strategies available to you no
matter what other players do
Dominated strategy: Is outperformed
by at least one other strategies
available to you no matter what
other players do
If a player has a dominant strategies
all other strategies are dominated

Analyzing Games: NC1...

2 X 2: Player 1 plays Up or Down
Player 2 plays Left or Right. Payoffs:
(U,L)=(4,1), (U,R)=(3,2), (D,L)=(2,0)
& (D,R)=(1,5).

Game NC1

 Denote payoff to player 1 when Player 1

chooses U and other player chooses L by
P(U,L)
U is a dominant strategy for Player 1
because

P(U,L)>P(D,L) &
P(U, R) > P(D, R)
Similarly denoting payoff to player 2 by Q,
R is a dominant strategy for Player 2 because
Q(U, R) > Q( U, L) &
Q(D, R) > Q( D, L)

Analyzing Games: NC2

2 X 2: Player 1 plays Up or Down
Player 2 plays Left or Right. Payoffs:
(U,L)=(4,2), (U,R)=(3,1), (D,L)=(2,0)
& (D,R)=(1,5).

NC2

Nash Equilibrium

(U,L) is a Nash Equilibrium of the game if and only i

P(U, L) P( D, L) & Q(U, L) Q( U, R)

Nash Equilibrium

Player 1 thinks : can I do better by unilateral deviation?

Player 2 thinks : can I do better by unilateral deviation?
If answer to both questions is no then (U, L) is a Nash
Equilibrium

Cournot Duopoly: quantity

competition
Firm 1
P= 100 q1-q2
TC = 40q1

Firm 2
P= 100 q1-q2
TC = 40q2

Equilibrium is a choice of q1,q2 s.t

firm 1 maximizes S1 given q2 and
firm 2 maximizes S2 given q1

Equilibrium

S1 = (100-q1-q2)q1
dS1/dq1 = 60-2q1-q2
S2 = (100-q1-q2)q2
dS2/dq2 = 60-2q2-q1
Solving (1) and (2)
Q1* =q2* = 20
P* = 60
S1*=S2* = 400

40q1
=0 (1)
40q2
=0 (2)

Best response curves

q2

Firm 1
Best response

30
Firm 2
Best response

20

20

30

q1

Solving (1) and (2)

Q1* =q2* = 20
P* = 60
S1*=S2* = 400

Impact of cost reduction

Suppose Firm 1 reduces total cost to
30q1
q2
Firm 1 NEW
Best response
30
Firm 2
Best response

20

20

30

35

q1

Lets play!

 Please form 6 groups with about 8

members each
Select one communicator who will be
responsible for communicating group
decisions on how to play
Each group will play the following game
against one other group 7 times
The identity of the corresponding group is
not known but the same group will stay
the same

Rules of the Game

Each group has a red card and a
black card.
Choose one of the two cards (without
knowing what others have chosen).
If you have chosen a red card I will
give you 10 rupees.
If you have chosen a black card I will
give your partner 30 rupees

 At the end of each round the payoffs

will be communicated to each group
The group will get a couple of
minutes for consultation and then
have to play again

The Incentive!
The members of the best group will
get a kit kat each!

Cartel
Both decide to produce a lower
output to achieve monopoly profit
and divide the profit equally
Both agree that they will produce 15
units each
Suppose one firm breaks the
agreement?

Firm 2

15

20

15

Cartel

20

Firm 1:450,
Firm 2: 450

F1: 375
F2: 500

F1:500,
F2: 375

F1: 400
F2: 400

Firm 1
Both firms will produce 20