Lecture 6 - Game Theory Flashcards
What is game theory
A technique that deals with decision making in situations of interdependence and uncertainty (theory of strategic information)
Examples of strategic thinking in the market
- 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
What is a game
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
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
- Played once = Single-period game
- Played more than once = Multiple period or repeated game
What’s a simultaneous game
A game which all players choose their actions simultaneously before knowing the actions chosen by other players
What’s a sequential game
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
What’s a zero-sum game
A game which the same of the gains and losses of all players is always zero (poker)
What’s a strategy
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
The players face a situation of interdependence
What is interdependence
Each player is aware that the actions of other players can affect his/her payoff
What is uncertainty
The time the player choose their own action he may not know which actions are being chosen by the other players
What’s the outcome of the game
The set of strategies and actions that are actually chosen and the resulting payoffs
What’s the equilibrium
A combination of strategies, actions and payoffs that is optimal for all players
What’s the Nash equilibrium
- 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
Describe prisoners dilemma
- 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
What’s mixed strategies
Choose an action randomly (probabilities)
What makes game theory relevant
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
Why is collusion good for firms
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
What is collusion
An explicit or implicit (tacit) agreement to avoid/ease competition
- ## Eliminates uncertainties of independent action and reduces the complexities of interdependence
What’s tacit collusion
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
Factors conducive to cartel formation
- Degree of seller concentration
- Number of firms in the industry
- Product characteristics
- Market shares
- Degree of similarity in firms cost structures
What is explicit and implicit collusion
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
What’s the downside of colluding tacitly (implicit)
Collusion may not be stable - promises to restrict output may not be credible as participants renege on agreements
