Th3.4: Game Theory Flashcards
What does game theory explore?
the reactions of one player to changes in strategy by another player
What is the aim of game theory?
to examine the best strategy a firm can adopt for each assumption about it’s rivals behaviour and it provides insight into interdependent decision making that occurs in competitive markets
What is the best way of demonstrating this within game theory?
where duopoly exists in the market, so there are two identical firms
What are the two strategies a firm could take?
maximin policy or a maximax policy
What does the maximin policy involve?
firms working out the strategy where the worst possible outcome is the least bad
What does the maximax policy involve?
firms working out the policy with the best possible outcome
What is the dominant strategy?
if the maximin and maximax strategy end up with the same solution
However, what is it about dominant strategies?
they aren’t that common in real life and the best strategy for a firm tends to depend on what the other firm does
In some cases there is a Nash Equilibrium, which is…
where neither player is able to improve their position and has optimised their outcome based on the other players expected decision - have no incentive to change their behaviour unless someone else changes theirs
What game theory used as an explanation for?
why firms in oligopoly tend to have stable prices
Refer to PP
Look at Graph 37. Read the next bit and ensure you understand.
● In this case, there is no dominant strategy for X. The maximin strategy will be to keep
prices unchanged, as profits will not change, whilst the maximax policy is to raise
prices, as they could gain £5m. Most firms will want to reduce risk and so adopt the
maximin strategy; they will keep prices unchanged.
● Firm Y will also choose to leave its prices unchanged if it pursues a maximin strategy:
if they raise price they could lose £5m whilst the worst that could happen if they don’t
change is for profits to remain the same.
● Therefore, both firms will leave their price unchanged and there is a Nash equilibrium
since neither firm is able to improve their position given the position of the other
player.
Refer to PP
Look at Graph 37. Similar matrices can be drawn to show…
how firms are likely to undertake large amounts of advertising and research and development
