Week 4 - Game theory

What is Game Theory

Study of behaviour in situations of interdependence

Game theory helps us

predict outcomes in strategic situations

Who created game theory

John Van Newmann - 1937

Nash equilibrium

Taking best action, given the action of the other firm

Strategic Moves

Moves that influence other players choice as they affect expectations of how you’ll behave

Dominant strategy

Choosing strategy thats better no matter what strategy the other player chooses

Dominated strategy

One player has another strategy with a higher payoff no matter what the other player does

In game w/2 strategies

Player has 1 dominant and 1 dominated

In game w/more than 2 strategies

Player may have dominated strategy but no dominant strategy

Game Theory features

1. Rules

2. Strategies

3. Payoffs

4. Outcomes

Payoff matrix

Table that shows every payoff for each possible action for each player

Collusion

Firms enter into collusive agreement to form cartels

In a collusion, firms

• Agree to restrict output & raise prices

• Therefore they have higher profit

Sequential games

Players move in turn & respond to other players reactions/moves

How to solve sequential games

• Backward induction

  • Work backwards from final move

• Rollback equilibrium

  • Helps find best solution

• Play the game to find best strategies

In single period games

1 firm cant punish another for cheating

In repeated games

Firms can devise a strategy in one period dependant on rivals actions from previous period

Constable Market

Firms have free entry/exit and existing firms face threat of comp from new entrants

Strategic entry deterance

Behaviour by existing firms makes entry of new firms less likely