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# GAMES 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 himcan work
out his payoffin 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
equilibriumfirst proposed by John Nash.
The following slides show how to find the Nash equilibrium.

Bobs
view
of the
world

Bobs
view
of the
world

Arts
view
of the
world

Arts
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.
Duopoly captures the essence of oligopoly.
The figure on the next slide describes the demand and
cost situation in a natural duopoly.

Oligopoly Games
Part (a) shows each firms cost curves.
Part (b) shows the market demand curve.

Oligopoly Games
This industry is a natural duopoly.
Two firms can meet the market demand at the least cost.

Oligopoly Games
How does this market work?
What is the price and quantity produced in equilibrium?

Oligopoly Games
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
The first possible outcomeboth complyearns the
maximum economic profit, which is the same as a monopoly
would earn.

Oligopoly Games
To find that profit, we set marginal cost for the cartel equal to
marginal revenue for the cartel.

Oligopoly Games
The cartels marginal cost curve is the horizontal sum of the
MC curves of the two firms and the marginal revenue curve
is like that of a monopoly.

Oligopoly Games
The firms maximize economic profit by producing the
quantity at which MCI = MR.

Oligopoly Games
Each firm agrees to produce 2,000 units and each firm
shares the maximum economic profit.

Oligopoly Games
When each firm produces 2,000 units, the price is greater
than the firms marginal cost, so if one firm increased
output, its profit would increase.

Oligopoly Games
Thee figure below shows what happens when one firm
cheats and increases its output to 3,000 units. Industry
output rises to 5,000 and the price falls.

Oligopoly Games
For the complier, ATC now exceeds price.
For the cheat, price exceeds ATC.

Oligopoly Games
For the complier incurs an economic loss.
The cheat earns an increased economic profit.

Oligopoly Games
Either firm could cheat, so this figure shows two of the
possible outcomes.
Next, lets see the effects of both firms cheating.

Oligopoly Games
The figure below shows the outcome if both firms cheat
and increase their output to 3,000 units.

Oligopoly Games
Industry output is 6,000 units, the price falls, and both
firms earn zero economic profitthe same as in perfect
competition.

Oligopoly Games
Youve now seen the four possible 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

Tricks
view
of the
world

Tricks
view
of the
world

Gears
view
of the
world

Gears
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