Name ___________________________________ Period__________ UNIT 4.
GAME THEORY PART A GAME THEORY is the study of how people behave in strategic situations. Economists use game theory to predict the STRATEGIC BEHAVIORS of firms that dominate oligopolistic industries. These firms make decisions that affect each of the other firms in the industry, and so oligopolistic firms must carefully use a strategy that depends on the strategy that they believe or know the other firms in the industry will use. This will ensure the best possible outcome and highest possible PAYOFF for the firm. As a result, game theory provides crucial insight into how business decisions are made by oligopolistic firms. Read through the process below and study the game theory MATRIX provided. Be prepared to answer the questions provided on the next page.
THE PRISONER 2 PRISONER’S DILEMMA RAT OUT STAY QUIET SCENARIO Two criminals are arrested for PRISONER 1
armed robbery and taken to
RAT OUT 5 YEARS, 5 YEARS GO FREE, 10 YEARS separate holding cells at a local police station. Each is interrogated by detectives and given two options STAY QUIET 10 YEARS, GO FREE 6 MONTHS, 6 MONTHS with potential payoffs. Neither prisoner can talk to the other and neither knows the other’s payoffs.
PLAYERS • In every game, there are TWO PLAYERS. In this game, the players are PRISONER 1 and PRISONER 2.
STRATEGIES • In every game, each player has TWO POSSIBLE STRATEGIES. In this game, Prisoner 1, as the row player, can choose to either RAT OUT the other prisoner or STAY QUIET about the crime. Prisoner 2, as the column player, can choose to either RAT OUT the other prisoner or STAY QUIET about the crime.
PAYOFFS • In every game, each player has FOUR POSSIBLE PAYOFFS. In this game, if both prisoners rat each other out, they BOTH GO TO JAIL FOR 5 YEARS. If Prisoner 1 stays quiet and Prison 2 rats him out, Prisoner 1 GOES TO JAIL FOR 10 YEARS and Prisoner 2 GOES FREE. If Prisoner 2 stays quiet and Prison 1 rats him out, Prisoner 2 GOES TO JAIL FOR 10 YEARS and Prisoner 1 GOES FREE. If both prisoners stay quiet, they BOTH GO TO JAIL FOR 6 MONTHS. GAME THEORY PRISONER’S DILEMMA PRISONER 2
RAT OUT STAY QUIET
PRISONER 1
RAT OUT 5 YEARS, 5 YEARS GO FREE, 10 YEARS
STAY QUIET 10 YEARS, GO FREE 6 MONTHS, 6 MONTHS
For both prisoners, what is the most desirable payoff in this game?
Neither prisoner is aware of the other prisoner’s potential payoffs. How will this affect the outcome?
If they were able to collude, which strategy would the prisoners choose to do together? Explain.
Considering the payoffs and their inability to collude, what will be the outcome of this game? Explain. STRATEGIES & OUTCOMES PART B Game theory illustrates the importance of INTERDEPENDENCY in oligopolistic industries. Firms must carefully use a STRATEGY that depends on the strategy that they believe or know the other firms in the industry will use. When firms are aware of the potential PAYOFFS in any scenario, they can successfully predict which strategy the other firm will use and choose the best possible strategy to achieve the highest possible payoff. This can also lead to predictable OUTCOMES. Read through the process below and study the game theory matrix provided. Be prepared to answer the questions provided on the next page.
FIRM Z SCENARIO HIGH LOW Firm Y and Firm Z are non-colluding oligopolistic firms in the gasoline market. They have the choice to set HIGH $2000, $2000 $500, $5000 their prices high or set their prices FIRM Y
low in the gas market. Their
potential daily profits are listed in the matrix provided. They are aware of LOW $5000, $500 $1000, $1000 the potential payoffs but their choices are hidden from each other.
DOMINANT STRATEGY • A dominant strategy is the BEST strategy for one player REGARDLESS of the strategy chosen by the other player. A player’s dominant strategy will guarantee a BETTER PAYOFF, regardless of the other player’s strategy. As a result, a player will ALWAYS choose to follow their dominant strategy if they have one! DOMINATED STRATEGY • A dominated strategy is the WORST strategy for one player REGARDLESS of the strategy chosen by the other player. A player’s dominated strategy will guarantee a LOWER PAYOFF, regardless of the other player’s strategy. PARETO OPTIMAL OUTCOME • A Pareto Optimal outcome occurs when there is NO OTHER outcome that makes every player just as well off and at least one player strictly better off. The outcome CANNOT be improved upon without hurting at least one player. NASH EQUILIBRIUM OUTCOME • A Nash Equilibrium outcome occurs when each player chooses the strategy that makes them BETTER OFF GIVEN THE OTHER PLAYER’S STRATEGY. It guarantees the better payoff, knowing the chosen strategy of the other player. STRATEGIES & OUTCOMES FIRM Z
HIGH LOW
HIGH $2000, $2000 $500, $5000
FIRM Y
LOW $5000, $500 $1000, $1000
What is Firm Y’s DOMINANT STRATEGY? Explain why this strategy is dominant for Firm Y.
Does Firm Z have a DOMINATED STRATEGY? Explain.
At the outcome of this game, what will be the daily profits for both firms?
Which outcome would be the PARETO OPTIMAL outcome of this game?
If Firm Z discovers that Firm Y has chosen to set its price HIGH, what would be the NASH EQUILIBRIUM outcome of this game? Explain. GAME THEORY PART C Use the GAME THEORY MATRIX provided to answer the questions below.
NORTHERN SCENARIO CLOSE OPEN Northern and Southern are colluding firms in an oligopolistic market. As a cartel, they are trying to decide SOUTHERN
whether to operate during the
CLOSE $2200, $2200 $1600, $2500 weekends or shut their doors on Saturdays and Sundays. Their potential weekly profits are listed in OPEN $2500, $1600 $1800, $1800 the matrix provided. They are aware of the potential payoffs.
What is the DOMINANT STRATEGY for Southern?
What is the DOMINATED STRATEGY for Northern?
Through collusion, which strategy will Northern and Southern choose? Explain and identify their profits.
What is the PARETO OPTIMAL outcome of this game?
Suppose collusion breaks down and Northern and Southern seek to maximize profits on their own. If Northern discovers that Southern will close its doors on the weekends, what is the NASH EQUILIBRIUM outcome of this game? Explain. GAME PART D THEORY Use the GAME THEORY MATRIX provided to answer the questions below.
ATLANTIC SCENARIO MAINTAIN REDUCE Pacific and Atlantic are interdependent firms in an oligopolistic railroad industry. Due to unanticipated changes in costs, MAINTAIN $1500, $1800 $1300, $1200 PACIFIC
both firms must make a decision
about the pricing of their passenger tickets. Listed are the potential daily REDUCE $1200, $1300 $1400, $1100 profits for each firm. Each company is aware of the potential payoffs.
If Pacific chooses to MAINTAIN its passenger fare, which strategy is better for Atlantic? Explain.
Does Pacific have a DOMINANT STRATEGY? Explain.
Assume Pacific and Atlantic choose their strategies simultaneously and do not collude. What will be the outcome of this game? Explain.
If Pacific and Atlantic decide to collude, what will be the outcome of this game? Explain. GAME THEORY PART E Use the GAME THEORY MATRIX provided to answer the questions below.
ICEELAND SCENARIO ADVERTISE NOT ADVERTISE Rockies and Iceeland are the only two frozen yogurt shops in a small town. Each shop must choose either to advertise or not advertise in the ADVERTISE ROCKIES
$275, $210 $455, $280 local newspaper. Each shop’s
potential daily profits are listed in the matrix provided. Both shops know NOT ADVERTISE $185, $470 $380, $450 the information in the game theory matrix.
Does Iceeland have a DOMINANT STRATEGY? Explain.
What strategy should Rockies choose if Iceeland chooses to advertise? Explain.
Identify the daily profits earned by both firms in the NASH EQUILIBRIUM outcome:
ROCKIES —
ICEELAND —
Suppose that advertising costs are $50 per firm. After adjusting the daily profits for both firms given the $50 advertising cost, identify the daily profits for both firms at the outcome of this game:
ROCKIES —
ICEELAND — GAME PART F THEORY Use the GAME THEORY MATRIX provided to answer the questions below.
DELISH SCENARIO PRICE HIGH PRICE LOW Yummy and Delish are the only two bakeries in a small town. Each shop can choose to set their prices high or set their prices low. The matrix PRICE HIGH $110, $115 $50, $140 YUMMY
provided shows the daily profits for
each shop given their potential strategies. Both shops know the PRICE LOW $125, $90 $85, $75 information in the game theory matrix.
Does Yummy have a DOMINANT STRATEGY? Explain.
Assume Yummy and Delish choose their strategies simultaneously and do not collude. What will be the outcome of this game? Explain.
What is the PARETO OPTIMAL outcome of this game? Explain.
Suppose the local government provides a $40 subsidy to any firm that chooses to make food more affordable by setting prices low. After adjusting the daily profits for both firms given the $40 subsidy, identify the daily profits for both firms at the outcome of this game:
