Lecture 6 - Game Theory

Question 1

What is game theory

Answer 1

A technique that deals with decision making in situations of interdependence and uncertainty (theory of strategic information)

Question 2

Examples of strategic thinking in the market

Answer 2

• Two firms with large market shares in an industry making decisions with respect to price and output
• Decision by a firm to enter a new market where there is risk that the incumbent firm(s) will try to fight entry
• Economic policy makers in a country contemplating whether to impose a tariff on imports

Question 3

What is a game

Answer 3

A situation where two or more decision makers (players) face choices between a number of possible actions at any stage of the game

• Two players competing for market share

Question 4

If a games played once what is it called

If a games played more than once (either finite times or infinitely) what is it called

Answer 4

• Played once = Single-period game
• Played more than once = Multiple period or repeated game

Question 5

What’s a simultaneous game

Answer 5

A game which all players choose their actions simultaneously before knowing the actions chosen by other players

Question 6

What’s a sequential game

Answer 6

A game which all players choose their actions in turn so that a player who moves later know the actions that were chosen by players who moved earlier

Question 7

What’s a zero-sum game

Answer 7

A game which the same of the gains and losses of all players is always zero (poker)

Question 8

What’s a strategy

Answer 8

A Set of rules telling the player which action to choose under each possible set of circumstances that might exist at any stage in the game

• Players aim to choose strategies that’ll maximise payoff

Examples of strategies,
- Advertising
- Pricing
- Output strategies

Question 9

The players face a situation of interdependence

What is interdependence

Answer 9

Each player is aware that the actions of other players can affect his/her payoff

Question 10

What is uncertainty

Answer 10

The time the player choose their own action he may not know which actions are being chosen by the other players

Question 11

What’s the outcome of the game

Answer 11

The set of strategies and actions that are actually chosen and the resulting payoffs

Question 12

What’s the equilibrium

Answer 12

A combination of strategies, actions and payoffs that is optimal for all players

Question 13

What’s the Nash equilibrium

Answer 13

• Neither firm can improve its payoff given the strategy chosen by the other firm (Max profits)
• A combination of players strategies that are the best responses to each other

Question 14

Describe prisoners dilemma

Answer 14

• 2 prisoners are suspected of a crime, police have insufficient evidence
• Prisoners are separated physically and there’s no communication between them
• If one of them confess and the other is silent, the silent criminal will be given maximum punishment
• If neither confess they’re both convicted of minor crime (1 year)
• If both confess they get 5 years

Question 15

What’s mixed strategies

Answer 15

Choose an action randomly (probabilities)

Question 16

What makes game theory relevant

Answer 16

The property of interdependence is the key defining characteristic of a game and it is this property along with uncertainty which makes it relevant for understanding decision-making for firms in oligopoly

• Strategies and actions concern the decision of price, output and things like advertising, R&D etc

Question 17

Why is collusion good for firms

Answer 17

Firms no longer need to speculate about the likely reactions of rivals

• Leaves open the possibility of firms colluding to raise prices (price-fixing) or restrict quantities
• Way of easing pressure of competition
• There are abnormal profits to be made under monopoly
• Clear incentives to make pacts to try achieve monopoly profits

Question 18

What is collusion

Answer 18

An explicit or implicit (tacit) agreement to avoid/ease competition

• ## Eliminates uncertainties of independent action and reduces the complexities of interdependence

Question 19

What’s tacit collusion

Answer 19

Collusive outcome that requires no formal agreement and no direct communication between firms

• May develop through personal contacts, religion, ethnic origin, social class, social groupings

Question 20

Factors conducive to cartel formation

Answer 20

• Degree of seller concentration
• Number of firms in the industry
• Product characteristics
• Market shares
• Degree of similarity in firms cost structures

Question 21

What is explicit and implicit collusion

Answer 21

Explicit = Two or more firms in same industry formally agree to control the market

Implicit = Two or more firms in same industry control the market through informal, interdependent actions

Question 22

What’s the downside of colluding tacitly (implicit)

Answer 22

Collusion may not be stable - promises to restrict output may not be credible as participants renege on agreements