Microeconomics Week 10: Game Theory and Competitive Strategies

Introduction to Game Theory and Competitive Strategies

  • Overview of the course week focusing on game theory and competitive strategies.

Importance of Game Theory

  • Learning from the last week's discussion on oligopoly through the prisoner's dilemma:
    • Rational decision-making leads to a dominant strategy that may not yield the best outcome.
    • Illustrates the conflict between rational choices and collective payoff.

Key Themes for the Session

  1. Strategic Thinking
    • Importance of thinking strategically in decision-making.
  2. Nash Equilibrium
    • Introduction to the concept of Nash Equilibrium.
  3. Repeated Games
    • Explanation of sustainable cartels and their longevity.
  4. Sequential Games
    • Understanding the decision-making processes through sequential moves.

Strategic Thinking

  • Strategic thinking is essential because:
    • Decisions of one stakeholder affect others (interdependence).
    • Example of dining (shared bill) illustrating decision-making:
    • Individual preferences, budgets, and collective decisions lead to potential increased costs.

Understanding Game Theory

  • Game theory as a tool for modeling real-life situations:
    • Developed from marginal analysis perspectives.
    • Key contributors: Mathematical theories from von Neumann and Nash in the mid-20th century.

Application to Oligopoly Behavior

  • Significant changes in understanding economics through game theory:
    • Oligopolistic firms (few firms with market power) are affected by the decisions of other firms.
    • Examples include Coca-Cola and Pepsi, or Boeing and Airbus where mutual dependence in strategies exists.

Strategic Overview of Game Theory

  • Prisoner's Dilemma Example
    • Strategic situations where cooperation could lead to better outcomes, but rational self-interest leads to worse outcomes (dominant strategy).

Nash Equilibrium

  • Definition:
    • A situation where no player has an incentive to deviate from their chosen strategy given the strategy of the other player.
  • Steps to solve for Nash Equilibrium using an example:
    • Analyze the payoffs to determine if any player would want to change their strategy based on the other's move.

Exercises and Applications of Nash Equilibrium

  1. Game Setup: Class vs. Lecturer
    • Strategies and possible outcomes analyzed.
    • Focused on payoff matrices to identify strategy effectiveness.
  2. Identifying Best Outcomes: Various strategy comparisons.
  3. Resulting Nash Equilibrium:
    • Identified based on players' incentives to change their strategy.
    • Conclusive outcomes where neither player gains by changing strategy.

Repeated Games and Cartels

  • Explanation on how repeated interactions can lead to sustainable cartels:
    • Firms may collude to maintain higher prices instead of falling into competition due to trust built over time.
  • Punishment Feasible in repeated games to constrain cheating in collusion — preventing crises in the cartel’s operation.

Coordination Games

  • Characterized by the necessity of players making coordinated choices for improved outcomes.
  • Example: Battle of the Sexes (couple deciding between two events).
    • Outcomes depend on reaching agreements that maximize joint utility.

Sequential Games

  • Definition:
    • Players make decisions in order, affecting subsequent choices.
  • Solutions derived through backward induction method — deciding last and facilitating retrievable game outcomes.
  • Use of trees to depict decision-making processes visually clarified the sequential dependency between actions.

Example of a Sequential Game - The Incumbent and Entrant Scenario

  • Game Structure:
    • Entering or exiting the market decisions and the subsequent actions of incumbents.
  • Solutions illustrating that the order of decisions influences outcome stability.

Conclusion

  • Key learnings from sessions on:
    • Strategic behavior in oligopolies and potential entities.
    • Identification and application of Nash Equilibrium.
    • Exploring further into sequential games with moving first for potential incumbents.
    • Illustrating existing realities with game theory perspectives.

Lessons learned

  • The application of theories in real-life market decision-making processes, underlining the impact of strategic thinking in economic models. Understanding of competitive strategies facilitated through game-theoretic approaches remains crucial in economic analysis.