Project Report

Course: Game Theory and Mechanism Design

Submitted By: Aditya Malik & Sayed Ibrahim

Title: Game Theoretic approach to green taxes production decision of a
monopolistic company

1. Introduction & Motivation

We all know that climate change due Green house gases is not a myth anymore, and these gases
are degrading our environment at an alarming rate. To save our environment from these harmful
gases, governmental agencies have put in place various laws and regulations, and many NGOs have
stepped forward to educate industries on regulating the carbon footprint. For example, for last
two decades, the United Nations(UN), European Union(EU), US Environment Protection Agency
(EPA) and a various agencies from many other countries are actively working to control carbon
emission. Other than raising public awareness, these organizations have taken initiative and enacted
laws to curb the emission. For example:- EPA, alongside with National Highway Traffic Safety
Administration (NHTSA), is working towards production of high mileage, clean and green vehicle.
It has also partnered with private sectors through voluntary energy and climate programs. EPA
also evaluates the viability and effectiveness of standards and policies implemented to reduce GHG.
Under its emission taxation & trading system-cap and trade-EU caps industries from releasing
GHGs above a permissible limit, and permits industries to trade their savings on carbon footprint
to other industries. With many other countries adopting cap-and-trade mechanism, this trade
system is expected to be of US $2trillion in worth by 2025. These initiatives have encouraged
industries to follow green practices at their work places and plants by regulating their emission
amount in multiple ways such as, adopting more energy efficient equipment, green facilities and
vehicles. Furthermore, firms can incorporate carbon emission factor while making their day-to-day
operations decisions such as production quantity. From research view point, the field is relatively
new and several researchers have looked into the objective of reducing carbon emission majorly
in five ways: (i) manufacturers select suppliers based on assessment of suppliers GHGs emission,
(ii) minimizing travel distance, time or fuel consumption as part of green supplychain network and
transportation routes design (iii) green facility design by adopting green manufacturing practices,
regular maintenance of machinery, installation of energy efficient equipment at warehouses and
efficient facility layout to avoid congestion, (iv) by designing products specifications that leads to
less emission while production, packaging, transportation & return, increasing awareness by labeling
of products with associated CO2 footprint, and finally (v) using energy efficient transportation modes
and type, inter-modal transportation. All these research questions focuses on single player, where

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each decision maker has one goal of minimizing(maximizing) their cost(profit) function, and there is
no interaction among various decision papers. In this report, we too focus on regulating the carbon
emission, however, from the perspective of game theoretic approach with two players: Government,
who decides the carbon cost per unit weight, and manufacturer, who decides how much to produce.

2. Literature Review

In simple words, Game theory can be described as a field of mathematical modeling based
decision making in which various decision makers interact each other and influence the final outcome.
It has been used as a tool to solve problems in diverse fields such as economics, marketing, biology,
supply chain and many others. In this report, we focus on application of application of game theory
to a supply chain decision problem. To provide a stint to the work done so far in this field, we refer
provide a brief literature review. We first invite readers to refer to the work of Cachon and Netessine
(2006). In their work, Esmaeili et al. (2009) study the relationship between seller and buyer through
cooperative and non-cooperative Stackelberg games. Hennet and Arda (2008) evaluates various
contracts between multiple players in a supply chain. The work of Leng and Zhu (2009) studies
the coordination between retailer and suppliers with side-payment contracts. Yue et al. (2006)
study the coordination between manufacturer and supplier in case of cooperative advertisement and
manufacturer offers discount on prices to consumers. Though, the literature on game theory based
analysis in supply chain is considerably mature, the application from green supply chain perspective
is still in primary stages. Zhao et al. (2012) develops an approach to assist manufacturing in
deciding the appropriate strategies to reduce carbon emission. The work of ZHU and DOU (2007)
provides an evolutionary model to investigate the response of a corporation towards the greening
of supply chain when offered with subsidies and imposed with penalties. Then Chen and Sheu
(2009) studies the same relationship, however, with differential game model. Given the financial
intervention by government, Sheu (2011) provides negotiated output between manufacturers and
reverse logistics agents in supply chain. This work uses asymmetrical bargaining model to reach
the outcome. For instance, Barari et al. (2012) develop a framework that establishes a coordination
between manufacturer and retailer in such a way that both achieve maximum profit while complying
to the green practices. The above mentioned works, though motivate our approach, do-not study
how government and industry should interact in deciding the carbon taxation, which is the focus of
our work, and in next sections we present this interaction through various forms of game.

3. Description and formulation of the game

As per EPA (https://www3.epa.gov/), Industries are one of the major major cause of Green
house gases (GHGs) emission in US in the year 2014, contributing to 21% of the 6,870 Million

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Metric Tons of CO2 equivalent. The emission amount at an industry is divided into two classes:
direct emission that is result of the activities at the facility of the company, and indirect emission
that is result of operations that assist the company but these are-not at the site of the company. For
example:- for a manufacturer, emission from production processes at manufacturing site is considered
under category of direct emission, and emission at the supplier site under indirect emission for the
manufacturer. Although, researchers include indirect emission as well in a supply chain optimization
problems with manufacturer as a sole decision, for this report, we consider the manufacturers
decision that would only regulate the direct emission levels. And as we can safely claim that
primary goal of any manufacturer is to maximize profit, this would potentially lead to a huge rise
in GHGs, because emission levels are directly related to the amount of production. In theory, in a
consumer economy government intervention through regulations and policies tends to restrict the
market growth, however, this is one scenario when government intervention is of utmost important.
Through the various games, we are going observe that how government establishes a reasonable
taxation policy so as to encourage manufacturer to follow green practices at their sites. During
the literature review, we didnt come across any other game with similar objectives, hence we
brainstormed the pay-off functions for both the players, and would like to present two models to
study this interactions.

3.1. Model I

Game parameters:

Players ={ Government, Company }.

Strategy or Action Profile (A(g), A(c))

Governments action A(g) = t, where t R is the carbon taxation $ per tonne.

Companys action A(c) = q where q R is the production level of the manufacturer.

Payoff profile denoted by (uG , uM ) :

Governments payoff function ug is a mapping from the strategy profile to a real number
ug = A(g) A(c) R. We assume that the payoff function of the government consist of
total earnings from carbon taxation, minus the perceived reputation of the government
among industry minus perceived reputation of government among citizen.

ug = (t, q) l(t) s(q)

where,

(t, q) : represents earning from carbon taxation that government will receive from
manufacturer

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 l(t) is perceived reputation of the government among industry as a whole. Since,
rise in carbon taxes would incur extra burden on industry, government may lose its
support from various major industry players in forthcoming elections.
Last term in the uG is the social cost of polluting the environment. If government
impose less taxes then manufacturer would be inclined to produce more and hence, it
would cause more pollution, which is-not perceived positively by citizens, and would
influence the outcome in forthcoming elections.

Companys payoff function uc is a mapping from the strategy profile to a real number
uc = A(g) A(c) R . Here, we assume that the payoff function of the company consist
of sales revenue minus production cost, and minus emission taxes.

uc = (q)q c(q) (t, q)

where, (t, q) is a function that maps the quantity produced with the price. Production
cost is denoted computed by cp (q), which is a function of quantity and returns the pro-
duction cost. (t, q) is a mapping from t and q to the carbon emission taxes which is
the amount of money the company have to give to the government due to the emissions
generated. Moreover, we assume that (q) is concave over q. On the other hand , we
assume that both cp (q) and (t, q) are convex over q.

3.2. Model II

Game parameters:

4. Game theoretic analysis

In this section, for both models I II, we present the Nash Equilibrium(NE) output for different
games that we have studied in the course.

4.1. Model I

For, Model I, we assume various functions as:

For company: (q) = ( q); c(q) = cq; (t, q) = Ktq. Thus, the pay-off function for the
company is: uC = ( q)q cq Ktq

For government: (t, q) = Ktq; l(t) = Lt2 ; s(q) = Sq 2 . This gives the pay-off function for the
government as: uG = Ktq Lt2 Sq 2

Using the above pay-off functions we demonstrate the nash Equilibrium outcomes for three games:
Cournot model, Stackelberg model and bayesian model with two types of government- Corrupt &
Honest.

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1. Cournot Game:
First we solve for Cournot model in which both players move simultaneously to decide their
equilibrium strategy. This requires differentiating both uG & uC with respect to t and q,
respectively to give us the following expressions:

duG duC
= kq 2lt = q c kt q (1)
dt dq

Equating both derivatives in eq1 equal to zero, and solving for t and q gives us the following
Nash equilibrium strategy:

K( c) 2L( c)
t = q = (2)
4L + K 2 4L + K 2

Next, we find the relationship among the constant such that the pay-off values for both players
is positive. This is done by simplifying the pay-off functions with the equilibrium strategies

t & q . Put t and q from eq2 into uG and uC , respectively. With this substitution we get:

( c)2 L(K 2 4LS) 4L2 ( c)2

uG = uC = (3)
(4L + K 2 )2 (4L + K 2 )2

From equation 3, we can establish that for both uG and uC to be positive we need: K 2 4LS
and c.

2. Stackelberg Game:
Unlike Cournot, two player stackelberg game is a sequential game with one leader and one
follower. We assume that government is a leader, it first decides carbon taxation and company
as a follower responds to the carbon price in terms of quantity of product it will produce. We
use backward induction methodology to solve this game. It requires to first solve the problem
for follower assuming that leader has played his strategy. To find followers best response take
first order condition on pay-off function of company (uC ). This gives us q as:

q = ( c Kt)/2 (4)

substituting eq4 in expression uG would give the pay-off function of government in variable
t. Solving that pay-off function using the first order condition with respect to t would give
optimal value of government strategy, t :

K( c)(S + 1)
t = (5)
(K 2 (S + 2) + 4L)

Next, substitute optimal t from eq5 into eq4 to obtain optimal value of q as:

(K 2 + 4L)( c)
q = (6)
(2K 2 (S + 2) + 8L)

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 3. Bayesian Game:
Next we would like to discuss the equilibrium strategy for the company when she is not
sure of the type of government. We assume that the government has two types: Corrupt
with probability 3/4, and Honest with probability 1/4. A corrupt government is going to be
influenced easily by major industry player and would result in a taxation policy which would
care less about the social cost of polluting the environment. On the other hand, an honest or a
strong government would put the environmental concerns first, and regulate emission through
stringent taxation policy.

5. Conclusion

References

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