Chapter 10

Game theory and strategic

behavior
 Game Theory
• Game theory was pioneered by the
mathematician John Von Neumann and
the economist Oskar Morgensten in 1944.
• It is an instrument used to analyze
cooperation and conflicts between firms in
oligopolistic markets.
• In general, game theory is concerned with
the choice of the best or optimal strategy
in conflict situations.
 Example
• Game theory can help a firm determine
the conditions under which lowering its
price would not trigger a ruinous price war.
• Game theory would help us understand
why cheating leads to the collapse of a
cartel.
 The features of a game
• Every game theory model includes:
- The players
- Strategies
- The payoffs
 The players
• There are the decision-makers.
 The strategies
• These are the actions available to each
player
 Payoff
• The payoff is the outcome or
consequence of each action
• We distinguish between a zero-sum
games and a nonzero-sum games
 A Zero-sum games
• It is one in which the gain of one player
comes at the expense and is exactly equal
to the loss of the other player.
• Example: If firm A increases its market
share by 10% and firm B loses 10% of its
market share.
 A nonzero sum game
• It is one in which the gains of one player
do not come at the expense of the other
player.
• Example: If firm A and Firm B increase
their profits as a result of one action.
 Dominant Strategy
• The dominant strategy is the optimal
choice for a player no matter what the
other player does.
 Payoff matrix for an advertising
game
Firm B

Advertise Don’t
advertise
Advertise (4, 3) (5, 1)
Firm A
Don’t (2, 5) (3, 2)
advertise
 The Nash equilibrium
• Not all games have a dominant strategy
for each player.

• It is the situation in where each player

chooses his or her optimal strategy, given
the strategy chosen by the other player.
 Payoff matrix for the advertising
game
Firm B

advertise don’t
(4, 3) (5, 1)
advertise
Firm A (2, 5) (6, 2)
don’t
 The prisoner’s Dilemma
Individual B

Confess don’t
confess

Confess (5, 5) (0, 10)

Individual A

(10, 0) (1,1)
Don’t
confess
 Price competition and the
prisoner’s dilemma
Firm B

Low price High price

Low price (2, 2) (5, 1)
Firm A
(1, 5) (3, 3)

High price
 In-class problems
• Problem #5 page 426
• Problem #8 page 426