Econ 2610 Principles of Microeconomics Yogesh Uppal Email

Econ 2610: Principles of Microeconomics Yogesh Uppal Email: yuppal@ysu. edu

Chapter 10 Games and Strategic Behavior

Strategies and Payoffs l Actions have payoffs that depend on l l The actions When they are taken The actions of others Some markets are characterized by interdependence l Apply to monopolistic competition and oligopoly

Game Theory l Basic elements of a game l l The players Their available strategies, actions, or decisions The payoff to each player for each possible action A dominant strategy is one that yields a higher payoff no matter what the other player does l Dominated strategy is any other strategy available to a player who has a dominant strategy

American and United – Scenario 1 l Players: United and American Airlines supplying service between Chicago and St. Louis l l l No other carriers Strategies: Increase advertising by $1, 000 or not Assumption l All payoffs are known to all parties

Payoff Matrix American Airlines Options United Airlines Options Raise Spending No Raise l l Raise Spending United: No Raise $5, 500 United $8, 000 American: $5, 500 American $2, 000 United: $6, 000 $2, 000 United: American: $8, 000 American: $6, 000 Payoff is symmetric Dominant strategy is raise advertising spending l Both companies are worse off

Equilibrium in a Game l Nash equilibrium is any combination of strategies in which each player’s strategy is her or his best choice, given the other player’s strategies l l Equilibrium occurs when each player follows his dominant strategy, if it exists Equilibrium does not require a dominant strategy

American and United – Scenario 2 American Airlines Options United Airlines Options Raise Spending No Raise l Raise Spending United: $3, 000 No Raise United $8, 000 American: $4, 000 American $3, 000 United: $5, 000 $4, 000 American: $5, 000 American: $2, 000 Same situation l l Different payoffs; non-symmetric America raises spending l United anticipates American action; does not raise

Prisoner's Dilemma Dominant strategy l The l Optimal strategy prisoner's dilemma has a dominant strategy The resulting payoffs are smaller than if each had stayed silent John's Options Henry's Options Confess Don't Confess H: 5 years H: 0 years J: 5 years H: 20 years J: 20 years H: 1 year J: 0 years J: 1 year

Cartels l A cartel is a coalition of firms that agree to restrict output to increase economic profit l Restrict total output l Allocate quotas to each player

Cartel in Action l Two suppliers of bottled water agree to split the market equally l Price is set at monopoly level l If one party charges less, he gets all of the market Marginal cost is zero Agreement is not legally enforceable

Bottled Water Cartel Mountain Spring's Options Aquapure's Options Charge $1 Charge $0. 90 Aquapure: $500 Mtn Spring: $500 Aquapure: $990 Mtn Spring: $0 Aquapure: $0 Mtn Spring: $990 Aquapure: $495 Mtn Spring: $495 Each party has an incentive to lower the price a little to increase its economic profits. Successive reductions result in price equal to marginal cost

Repeated Prisoner's Dilemma l Two players with repeated interactions l l Both players benefit from collaboration l l Tit-for-tat strategy limits defections Tit-for-tat strategy says my move in this round is whatever your move was in the last round l l Each has a stake in the future outcomes If you defected, I defect Tit-for-tat is rarely observed in the market l This strategy breaks down with more than two players or potential players

Simultaneous Decisions Dodge Viper's Options Chevy Corvette's Options Hybrid No hybrid Hybrid Chevy: Dodge: No Hybrid $60 M Chevy: $60 M Dodge: $70 M Chevy: $80 M Dodge: $80 M $70 M $50 M

Suppose Dodge Moves First Offer hybrid B Offer hybrid A Dodge decides Don’t offer hybrid C Chevrolet decides Don’t offer hybrid Offer hybrid Don’t offer hybrid D $60 million for Chevy $60 million for Dodge $70 million for Chevy E $80 million for Dodge F $80 million for Chevy $70 million for Dodge $50 million for Chevy G $50 million for Dodge Final Outcome

Threats and Promises l l Credible threat is a threat to take an action that is in the threatener's best interest to carry out A credible promise is a promise to take an action that is in the promiser's interest to carry out

Monopolistic Competition and Location l First mover advantage l l l With Viper and Corvette, firms did better if products were different Tic-tac-toe If the differentiator is time or location, the last mover may have the advantage l Suppose that customers go to the nearest convenience store l l Store A locates 1 mile from Freeway Where will Store B locate?

Store B's Location l A chooses its location New business plans to enter the market l l Location C minimizes customer's travel distance Location B maximizes customers A B ⅓ mile 800 people Freeway l 1 mile 1, 200 people ⅓ mile 800 people 1 mile 1, 200 people C ⅓ mile 800 people

Commitment l A commitment problem arises from an inability to make credible threats or promises l A commitment device changes incentives to make threats or promises credible l l l Uncertainty Extreme preferences Various business problems are commitment issues

Games and Strategic Behavior Prisoner's Dilemma Sequential Decisions Commitment Problems Game Theory Elements Equilibrium Dominant Strategy