Game Theory

Game Theory A set of tools that economist, political scientists, military analysts and others use to analyse players (firms) strategic decision making. Any competition between players (individuals or firms) in which strategic behaviour plays a major role. A move that a player makes at a specified stage of the game. Eg. How much output a firm produces in the current period. A battle plan that specifies the action that a player will make conditional on the information available at each move and for any possible contingency. The payoffs of a game is the players valuation of the outcome of the game such as profits for firms and utilities for individuals. A set of actions that a player takes to increase his or her payoff, taking into account the possible actions of other players. A piece of information known by all players, and it must be known by all players to be known by all players. A players optimal strategy depends on the actions of others. Eg. In an oligopolistic market firms monitor each others behaviour closely. *Game theory is used to study oligopolistic behaviour and not competitive or monopolistic behaviour. Rules of the game Determine the timing of players moves and actions that players can make at each move. Determines any players payoff given the combination of actions by all players. The payoff function is common knowledge amongst all players. The player who is about to move knows the full history of the game to this point, and that information is updated with subsequent action. Do not know how other players (firms) will act.

Game

Action

Strategy

Payoffs

Strategic Behaviour

Common Knowledge

Strategic Interdependence

Payoff function

Complete information

Perfect information

Imperfect information

Static games

Each firm acts only once and the firms act simultaneously. These firms have complete information about the payoff function but imperfect information about rivals moves. Firms move sequentially or repeatedly. Firms have complete information about the payoff function and at each move firms have perfect information about previous moves made by all firms. A strategy that produces a higher payoff than any other strategy the firm can use for every possible combinations of its rivals. All firms have strategies that lead to a profit but the profit is inferior to what they could achieve if they co-operated and persued alternative strategies. A strategy that maximises a firms payoff (profit) given its beliefs about rivals strategies. When all other firms use these strategies, no firm can obtain a higher profit by choosing a different strategy. Each firm chooses a single action with certainty. Firms choose amongst possible actions according to possibilities it assigns.

Dynamic games

Dominant Strategy

Prisoners Dilema

Best Response

Nash Equilibrium

Pure Strategy Mixed Strategy

Static games Choose actions simultaneously Complete info about payoff function Imperfect info about rivals moves Played once e.g. Cournot & Bertrand Normal-form representation Profit matrix

Dynamic games Players move sequentially, or simultaneously repeatedly Complete info about payoff function Perfect info about play of game to this point Sequential game e.g. Stackelberg Repeated game e.g. Repeated airline prisoners dilemma game Almost perfect info. Multiperiod game Signaling & threatening to punish

Profit for each depends on output chosen by firm AND rival. A noncooperative game of imperfect information. Each firm has to try & identify a dominant strategy: Strategy A strictly dominates Strategy B if it produces a profit at least as high as Strategy B, regardless of what the other firm does. Why is cooperation unlikely in a one-period game? No trust Prisoners dilemma: all players have dominant strategies that give rise to lower payoffs than they could have achieved had they cooperated.

E.g. Larry & Duncan get arrested: Larry Confess Stay silent Confess 2 2 0 5 1 0 1 Stay silent 5

Duncan

Pure strategy = each player chooses action with certainty More than one Nash equilibrium in pure strategies: Simultaneous entry game: 2 firms think of opening petrol station on highway site. Market can support 1 firm only. Who enters? 2 Nash equilibria in pure strategies (= each firm chooses one action with certainty) Cant predict outcome Chicken game

Cooperation depends on payoff function.