GAME THEORY

Basic Ideas of Game Theory

Game theory is the general theory of

strategic behavior.

Generally depicted in mathematical form. Plays an important role in modern economics.

Rules, Strategies, Payoffs, and Equilibrium

Economic situations are treated as games. The rules of the game state who can do what, and when they can do it.
A player's strategy is a plan for actions in each possible situation in the game.

Rules, Strategies, Payoffs, and Equilibrium

Economic situations are treated as games. A player's payoff is the amount that the player wins or loses in a particular situation in a game. A player has a dominant strategy if that player's best strategy does not depend on what other players do.

Nash Equilibrium
Occurs when each player's strategy is

optimal, given the strategies of the other players.

A player's best response (or best strategy) is the strategy that maximizes that player's payoff, given the strategies of other players. A Nash equilibrium is a situation in which each player makes his or her best response.

Prisoner's Dilemma
Famous example of game theory. Strategies must be undertaken without the full knowledge of what other players will do. Players adopt dominant strategies, but they don't necessarily lead to the best outcome.

Prisoners Dilemma

4 years each

1 year for B and 8 years for A

1 year for A and 8 years for B

2 years each

Bs decision tree

Confess

Not confess

A confesses

4 years in prison

A doesnt confess 1 year in prison

A confesses 8 years in prison

A doesnt confess 2 years in prison

Game Theory Applied to the Aviation Industry

British Airways and Virgin Atlantic August 2004 to March 2006

Cartel formed and fuel surcharge prices raised on long haul flights

Virgin Atlantic played whistleblower to OFT in the UK and Department of Justice in the US

Payments/Fines

102 m for a US classaction lawsuit

102 m for a US classaction lawsuit

A max of 10 per passenger on a long haul flight during that period

A max of 10 per passenger on a long haul flight during that period

270 m as fine levied by the Office of Fair Trade in the UK

Went scot-free for acting as a whistleblower

Economic Applications of Game Theory

Cheating on a cartel Trade wars between countries Advertising

Cheating on a Cartel
Cartel members' possible strategies range

from abiding by their agreement to cheating.

Cartel members can charge the monopoly price or a lower price.
Cheating firms can increase profits.

The best strategy is charging the low price.

Cheating on cartels

300 crores each

Coke earns 800 crores Pepsi earns 200 crores

Pepsico earns 800 crores Coke earns 200 crores

Both earn 600 crores each

Cokes decision tree

Charge low price ( cheat on cartel)

Charge Monopoly price (Dont cheat)

Pepsi charges low price (Cheat on cartel) 300 crores

Pepsi charges monopoly price (Doesnt cheat) 800 crores

Pepsi charges low price (Cheat on cartel) 200 crores

Pepsi charges monopoly price (Doesnt cheat) 600 crores

Trade Wars Between Countries

Free trade benefits both trading countries. Tariffs can benefit one trading country. Imposing tariffs can be a dominant strategy and establish a Nash equilibrium even though it may be inefficient.

Effect of tariff on Japanese Televisions

Tariff

Japan

No Tariff

Tariff

$ 5 million each

$9 million for United States $4 million for Japan

United States
No Tariff

$4 million for United States

$9 million for Japan

$8 million each

USAs decision tree

Impose Tariff

Do not impose tariff

Japan has imposed a tariff

Japan has not imposed a tariff

Japan has imposed a tariff

Japan has not imposed a tariff

$ 5 million

$ 9 million

$ 4 million

$ 8 million

Advertising
The prisoner's dilemma applies to

advertising.
All firms advertising tends to equalize the effects.
Everyone would gain if no one advertised.

Advertising Payoff
Advertise

Dont Advertise

Advertise

$ 0 each

$4 for A

$-5 for B

B
Dont Advertise

$4 for B $-5 for A

$ 2each

Thank You!!