Module-Micro 29-Econ 65:

Game Theory
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Key Economic Concepts
Game theory is a method of modeling how oligopolists make
strategic choices in situations where outcomes are
interdependent.
A dominant strategy is one that is always best for a player, no
matter the strategy of a rival player.
A Nash equilibrium outcome is the outcome where all players
are happy with their choice, given the choice of the rival.
A Prisoners’ Dilemma is a game such that players pursue their
dominant strategy and the game comes to Nash equilibrium.
However, the outcome is an undesirable one and could have
been avoided through some kind of cooperative agreement
(collusion).
When games are repeated, firms can escape a Prisoners’
Dilemma with tacit collusion. One popular theory of behavior in
repeated games is known as “tit for
Urbanski tat”.
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Module Organization
I.Games Oligopolists Play
A. The Prisoners’ Dilemma
B. Overcoming the Prisoners’ Dilemma: Repeated
Interaction and Tacit Collusion

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I. Games Oligopolists Play
When two firms are close rivals, the choices of each affect the
outcomes for each. In other words, they are mutually
interdependent.
For example, if a retailer like Target lowers the price of a
Nintendo Wii, it expects to steal customers from a store like Best
Buy. And this prompts Best Buy to match the lower price on the
Wii and maybe even offer something else to entice customers
away from Target.

These strategies and mutually interdependent outcomes can be

studied with game theory.
Here is one simple definition of game theory.
Game Theory: study of how interdependent decision
makers make choices.
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I. Games Oligopolists Play
Draw a payoff matrix for this game show:
I. Games Oligopolists Play
Draw a payoff matrix for this game show:

STEAL SPLIT
SPLIT STEAL
I. Game Oligopolists Play
Dominant Strategy? NO

MAN
STEAL SPLIT
SPLIT STEAL

$0 $100,000
WOMAN

$0 $0
$0 $50,000
$100,000 $50,000
A dominant strategy is one that is always best for a player, no matter
the strategy of a rival player.
 A. Prisoners’ Dilemma
Dominant Strategy ?:
1 year is better then 5 years,
6 months is better then 3 years

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B. Overcoming the Prisoners’ Dilemma:
Repeated Interaction and Tacit Collusion
Suppose there are only two gas stations in a small rural town of Boonetuckey. These
gas stations, Margaret’s Quickee Stop and Pam’s Pump Station, are duopolists in the
gasoline market and they each sell 50% of all of the gas in town.
At 8am each gas station posts one of two prices, a high price (PH) or a low price (PL).
Once the price is posted, it cannot be changed until tomorrow. Customers only care
about which station has the lowest price, so the low-price station will drastically outsell
the high-price station.
The dominant strategy for each firm is to Price Low, and this is a Prisoners’ Dilemma.
If they were able to cooperate and monitor each other, probably over time, they might
be able to attain Price High profits.
B. Overcoming the Prisoners’ Dilemma:
Repeated Interaction and Tacit Collusion
Tacit collusion: over time, they begin to trust each other
and just understand that PH is better for both.
What happens to this agreement? Surely someone
(probably Pam) is going to be tempted by the $100
that could be earned by reneging on the agreement and
setting PL one morning. How should Margaret
react? She would probably seek vengeance.

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Practice Question #1
1. Each player has an incentive to choose an action
that, when both players choose it, makes them both worse
off. This situation describes

a. a dominant strategy.

b. the prisoners’ dilemma.

c. interdependence.

d. Nash equilibrium.

e. tit for tat.

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Practice Question #2
2. Which of the following types of oligopoly behavior is/are
illegal?
I. tacit collusion
II. cartel formation
III. tit for tat
a. I only

b. II only

c. III only

d. I and II only

e. I, II, and III Urbanski School of Economics

Practice Question #3
3. A situation in which each player in a game chooses the
action that maximizes his or her payoff, given the actions of
the other players, ignoring the effects of his or her action on
the payoffs received by others, is known as a:
a. dominant strategy.

b. cooperative equilibrium.

c. Nash equilibrium.

d. strategic situation.

e. prisoners’ dilemma.
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 Practice Question #4
Based on the payoff matrix
provided, You will

a. market whether or not your

competitor markets.

b. not market only if your competitor

markets.

c. not market only if your competitor

didn’t market.

d. not market regardless of whether

or not your competitor marketed.

e. market only if your competitorUrbanski

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not market.
Practice Question #5
5. Which of the following is true on
the basis of the payoff matrix
provided ?
a. your competitor has no dominant
strategy, but You do.

b. You have no dominant

strategy, but your competitor does.

c. Both you and your competitor

have a dominant strategy.

d. Neither you nor your competitor

has a dominant strategy.

e. your competitor has a dominant

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strategy only if you market.
Practice Question #6
6. If you market and your
competitor decides not to
market your profit will be.
a. $0

b. $100

c. $200

d. $400

e. $500 Urbanski School of Economics

2007 Free Response #2
Two airline companies, Airtouch and Windward, operate a route from City X to City
Y, transporting a mix of passengers and freight. They must file their schedules
with the National Transportation Board each year and cannot alter them during
that year. Those schedules are revealed after both companies have filed. Each
airline must choose between a morning and an evening departure. The relevant
payoff matrix appears below, with the first entry in each cell indicating Airtouch’s
daily profit and the second entry indicating Windwards’s daily profit.

a. In which market structure do these firms operate? Explain.

b. If Windward chooses an evening departure, which departure time is better for
Airtouch?
c. Identify the dominant strategy for Windward.
d. Is choosing an evening departure a dominant strategy for Airtouch? Explain.
e. If both firms know all of the information in the payoff matrix but do not cooperate,
what will be Windward’s daily profit?
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2007 Free Response #2

a. In which market structure do these firms operate?

Explain.
ONE Point:
Identifying the market as an oligopoly because there
is interdependence-the behavior of each firm
affects the other. Urbanski School of Economics
2007 Free Response #2

(b) If Windward chooses an evening departure,

which departure time is better for Airtouch?
ONE Point:
Stating that an evening departure will be best for
Airtouch.
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2007 Free Response #2
A dominant strategy is one that is one that is always best for a player, no matter
the strategy of a rival player.

(c) Identify the dominant strategy for Windward.

ONE Point:
Stating that Winward’s dominant strategy is a
morning departure.

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2007 Free Response #2

d. Is choosing an evening departure a dominant strategy for

Airtouch? Explain.
TWO Points:
One point is earned for stating that choosing an evening
departure is not a dominant strategy for Airtouch.
ONE Point is earned for correctly reasoning that Airtouch does
not have a dominant strategy because its best payoff
depends on Windward’s choice (OR, more specifically
Windward chooses a morning departure, Airtouch is best off
choosing a morning departure).
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2007 Free Response #2
Dominant Strategy

(e) If both firms know all of the information in the

payoff matrix but do not cooperate, what will be
Windward’s daily profit?
ONE Point:
Identifying $700
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