Using Game theory to analyze strategic decisions

• Basic elements of a game:

  • Players

  • Strategies available to each player

  • Payoffs each player receives for each possible combination of strategies

• Payoff matrix: table that describes the payoffs in a game for each possible combination of strategies.

  

• Dominant strategy: one that a yields a higher payoff no matter what the other players in a game choose.

• Dominated strategy: any other strategy available to a player who has a dominant a strategy.

• Nash equilibrium: any combination of strategy choices in which each player's choice is his/her best choice, given the other players' choices.

Prisoner’s dilemma

• Prisoner's dilemma: game in which each player has a dominant strategy, and when each plays it, the resulting payoffs are smaller than if each had played a dominated strategy.

• Cartel: coalition of firms that agree to restrict output for the purpose of earning an economic profit.

• Repeated prisoner's dilemma: standard prisoner's dilemma that confronts the same players repeatedly.

• Tit-for-tat: strategy for the repeated prisoner's dilemma in which players cooperate on the first move, then mimic their partner's last move on each successive move.

Games in which timing matters

• Decision tree = game tree: diagram that describes the possible moves in a game in sequence and lists the payoffs that correspond to each possible combination of moves.

  

• Credible threat: threat to take an action that is in the threatener's interest to carry out.

• Credible promise: promise to take an action that is in the promiser's interest to keep.

Commitment problems

• Commitment problem: situation in which people cannot achieve their goals because of an inability to make credible threats or promises.

• Commitment device: way of changing incentives so as to make otherwise empty threats or promises credible.