Game Theory in Oligopoly Markets

Managerial Economics
GAME THEORY
The pricing and output behavior of oligopoly markets

oligopolistic or monopolistically competitive firm use a
strategy:
battle plan of actions (such as setting a price or quantity) it will take to
compete with other firms
oligopolies engage in a
game:
any competition between players (such as firms) in which strategic behavior
plays a major role
Game Theory
Economic optimization has two shortcomings when applied to actual
business situations
assumes factors such as reaction of competitors or tastes and preferences of
consumers remain constant
managers sometimes make decisions when other parties have more
information about market conditions
Game theory
set of tools used by economists, political scientists, military analysts,
and others to analyze decision making by players (such as firms)
who use strategies
these analytic tools can be used to analyze
oligopolistic games
scissor-paper-stone
coin-matching games
tic-tac-toe
elections
nuclear war
Game theory is based on the following modelling assumptions:
There are a few producers (players) in the industry (game).

Each player chooses an output or pricing strategy.
Each strategy produces a result (payoff) for that player.
The payoff for each player is dependent upon the strategy he/she
selects and that selected by other players.
Players-entities like individuals/firms that make choices.
Strategies-the choices made by the players (output/pricing, etc.).
Strategy combinations-a list of strategies for each player.
Payoff-the outcome (utility, profit, etc.) from selecting a strategy.
Elements of a Game
A game involves players making strategic decisions
Players are the decision-making units
A strategy is an option available to a player
Payoffs are the outcomes
Fundamental aspects of game theory
players are interdependent
uncertainty: other players actions are not entirely predictable
Types of games
zero-sum or non-zero-sum
cooperative or non-cooperative
two-person or n-person
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Game Theory
A payoff matrix is a table that describes the outcome for each player and for
each set of strategic choices.
A dominant strategy (DS) is a strategy that produces the optimal outcome
regardless of what the other players do.
A dominant strategy equilibrium (DSE) occurs if each player in a game
chooses its dominant strategy.
A Nash equilibrium occurs if every players strategy is optimal given its
competitors strategies.
A Normal Form of Game
Player 2
Strategy
Pl
ay
er
1
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12,11
11,12
14,13
11,10
10,11
12,12
10,15
10,13
13,14
A Normal Form of Game: Scenario Analysis

Suppose 1 thinks 2 will choose A.
Player 2
Strategy
Pl
ay
er
1
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12,11
11,12
14,13
11,10
10,11
12,12
10,15
10,13
13,14

Then 1 should choose a.
Player 1s best response to A is a.
Player 2
Strategy
Pl
ay
er
1
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12,11
11,12
14,13
11,10
10,11
12,12
10,15
10,13
13,14
10

Suppose 1 thinks 2 will choose B.
Player 2
Strategy
Pl
ay
er
1
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12,11
11,12
14,13
11,10
10,11
12,12
10,15
10,13
13,14
11

Then 1 should choose a.
Player 1s best response to B is a.
Player 2
Strategy
Pl
ay
er
1
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12,11
11,12
14,13
11,10
10,11
12,12
10,15
10,13
13,14
12

Suppose 1 thinks 2 will choose C...
Player 1s best response to C is a.
Player 2
Strategy
Pl
ay
er
1
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12,11
11,12
14,13
11,10
10,11
12,12
10,15
10,13
13,14
13
Dominant Strategy
Regardless of whether Player 2 chooses A, B, or C,
Player 1 is better off choosing a!
a is Player 1s Dominant Strategy!
Player 2
Strategy
Pl
ay
er
1
12,11
11,12
14,13
11,10
10,11
12,12
10,15
10,13
13,14
A dominant strategy is a strategy resulting in the highest payoff regardless of

the opponents action.
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14
Putting Yourself in your Rivals Shoes: The Outcome

What should player 2 do?
2 has no dominant strategy!
But 2 should reason that 1 will play a.
Therefore 2 should choose C.
Player 2
Strategy
Pl
ay
er
1
12,11
11,12
14,13
11,10
10,11
12,12
10,15
10,13
13,14
This outcome is called a Nash equilibrium:

a is player 1s best response to C.
C is player 2s best response to a.
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15
Two-player Nash Equilibrium

The Nash equilibrium is a condition describing the set of strategies in which no
player can improve her payoff by unilaterally changing her own strategy, given
the other players strategy.
Formally,
1(s*1,s*2) 1(s1,s*2) for all s1.
1(s*1,s*2) 1(s*1,s2) for all s2.
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16
Game with Dominant Strategy

Player 2
Play
er 1
Up
Middle
Down
Left
Middle
Right
4,3
2,1
3,0
5,1
8,4
9,6
6,2
3,6
2,8
Play
er 1
For player 2, the strategy Middle is dominated by the

strategy Right.
When you find a dominated strategy, it can be
eliminated from the game.
Player 2
3
Player 1
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Up
Player 2
Left
Right
4,3*
6,2
Left
Right
Up
4,3
6,2
Middle
2,1
3,6
Down
3,0
2,8
For player 1, the Up strategy dominates

both Middle and Down, so a dominant.
The Middle and Down rows can be
eliminated from player 1s strategy.
Player 1 has no choice but to move Up.

For Player 2, the dominant strategy is to move Left.
(Up, Left) or 4,3* is therefore the equilibrium payoff.
It is a Nash equilibrium where both players will settle
on a strategy and not want to move.
17
Prisoners Dilemma
The figures represent the jail time in
months for the two players.
What is the equilibrium outcome of this
Strategy
game?
The equilibrium results form a
Not
dominant strategy for both players.
Sus Confess
An easy way to find equilibrium is to
pec
draw arrows showing the direction of
t1
strategy preferences for each player.
Confess
Horizontal arrows show preferences of
player 2, vertical arrows show
preferences for player 1.
Where the two arrows meet, there is a
Nash equilibrium.
Suspect 2
Not
Confess
Confess
-1,-1
-9,0
0,-9
-6,-6
An Arms-race Game
Pakistan
Strategy
Arm
Disarm
Arm
India at Risk,
Pakistan at Risk
India Safe & Powerful,

Pakistan at Risk & Weak
Disarm
India at Risk & Weak,

Pakistan Safe & Powerful
India Safe,
Pakistan Safe
India
10/19/16
19

Game Theory in Oligopoly Markets

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Game Theory in Oligopoly Markets

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Managerial Economics

The pricing and output behavior of oligopoly markets

Game theory is based on the following modelling assumptions:

There are a few producers (players) in the industry (game).

A Normal Form of Game

A Normal Form of Game: Scenario Analysis

A Normal Form of Game: Scenario Analysis

A Normal Form of Game: Scenario Analysis

A Normal Form of Game: Scenario Analysis

A Normal Form of Game: Scenario Analysis

A dominant strategy is a strategy resulting in the highest payoff regardless of

Putting Yourself in your Rivals Shoes: The Outcome

This outcome is called a Nash equilibrium:

Two-player Nash Equilibrium

Game with Dominant Strategy

For player 2, the strategy Middle is dominated by the

For player 1, the Up strategy dominates

Player 1 has no choice but to move Up.

India Safe & Powerful,

India at Risk & Weak,

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