12

Game Theory
Introduction 12
Chapter 11 introduced the concept of strategic interaction among firms
that have some market power but compete with each other.
• Determining equilibrium requires more than equating supply with demand.
• Each firm must also choose its best strategy (price or quantity), given the
choices of all other firms.

Game theory is focused on understanding strategic interaction.

• The study of strategic interactions among two or more actors
• Examine behavior when players are making strategic decisions—actions
based on anticipation of others’ actions.
• Concepts can be applied to market situations, as well as any number of
human (and nonhuman) interactions.
We will study three basic categories of games.
Introduction 12
Simultaneous games
• The participants choose their actions simultaneously without knowing their
opponents’ strategies.
• The Cournot and Bertrand models from Chapter 11 are simultaneous games.

Repeated games
• A series of simultaneous games among the same set of economic actors
• Successful collusion (e.g., functioning cartels) is made possible by the cyclic
repetition of output decisions.

Sequential games
• Games in which players take turns making decisions
• The Stackelberg model from Chapter 11 is a sequential game.
Introduction 12
Some things to remember
• Game theory is all about seeing the world through the eyes of your opponent.
• As with consumer theory, we assume players are rationally self-interested.
• Finally, rules often determine the outcome of a game; therefore, it is very
important to understand the timing of moves, allowable actions, and so on.
What is a Game? 12.1
Every game shares three elements:
1. Players
• A player is a participant in an economic game who must decide his or
her actions based on the actions of others.

2. Strategy
• The action taken by a player
• Strategies may be simple or complex, and they depend on the actions
(anticipated or actual) of other players.

3. Payoff
• The outcome a player receives from playing the game
• The payoff to one player depends on the actions of other players;
otherwise the former would have no incentive to act strategically.
What is a Game? 12.1
Dominant and Dominated Strategies
Predicting behavior in games relies on finding the optimal strategy for
the different players.
• The action that results in the highest expected payoff
Dominant strategy
• A winning strategy for a player, regardless of his or her opponents’ strategies
‒ If a player has a dominant strategy, that strategy is always chosen.

Dominated strategy
• A losing strategy for a player, regardless of his or her opponents’ strategies
‒ Dominated strategies are never chosen, and once identified, can be ignored.
• If there is a dominant strategy, all other strategies are dominated.

 If there is a dominated strategy, must there be a dominant strategy?

‒ Not necessarily.
What is a Game? 12.1
A payoff matrix is a table that lists the players, strategies, and payoffs
of an economic game.
• For example, consider the decisions facing Warner Bros. and Disney
regarding advertising for animated movies.
‒ It is reasonable to assume that animated movies are competing with
one another for young viewers.
What is a Game? 12.1

In this game, Warner Bros. (payoffs in red) has a dominant strategy of

advertising, regardless of what Disney does.
Nash Equilibrium in One-Period
Games 12.2
When individuals or firms engaged in strategic competition have
dominant strategies, determining equilibrium is easy.
However, in most games, the optimal strategy for a player depends on
the actions of the other player or players.
• In these cases, we rely on the stronger concept of Nash equilibrium
introduced in the last chapter.
• The Nash equilibrium requires that an action be the best thing a player can
do given the action the opponent is taking.

The first step to finding a Nash equilibrium is to understand the three

elements of the game: players, strategies, and payoffs.
• A common way to do this is to use the normal form: organize an economic
game into its players, strategies, and payoffs in a payoff matrix.
Nash Equilibrium in One-Period
Games 12.2
Tips for Finding a Nash Equilibrium: The Check Method
• Always analyze players’ strategy and payoff combinations one at a time.

Call our players Row and Column, and assume each has two actions available.
What should Row do?
• If Column chooses action A, what is the best action for Row? Check off the payoff for
that action.
• If Column chooses action B, what is the best action for Row? Check off that option.
‒ Repeat these steps for Column.

If one of the boxes has two check marks, that is the Nash equilibrium. If there is
more than one box with two check marks, there is no pure strategy Nash
equilibrium.
• Pure strategy: A strategy that results in an equilibrium after a single action.
Nash Equilibrium in One-Period
Games 12.2
Predicting outcomes of a game is relatively straightforward when there is
only one Nash equilibrium. What if there is more than one?

Multiple Equilibria
Consider the Warner Bros./Disney rivalry discussed previously.
• Suppose that firms are deciding when to release a film.
• The available periods are May, December, and March.
Nash Equilibrium in One-Period
Games 12.2

Disney and Warner Bros. have symmetrical payoffs, and it appears there
are two Nash equilibria so no pure strategy.
• December/May and May/December
What about March?
• March is a dominated strategy for each firm.
• This means we can simplify the game.
Nash Equilibrium in One-Period
Games 12.2

There are now two equilibria.

• If Disney believes Warner Bros. will be releasing in May, Disney should release in
December, and vice versa.
• Neither firm has an incentive to deviate from these two release date combinations.

With the tools presented thus far, there is no way to determine which
equilibrium occurs.