Lecture-6
Game Theory
What is Game Theory?
• Game Theory is the study of strategic interactions among
rational decision-makers.
• In managerial economics, it helps analyze how businesses
make decisions when the outcomes are influenced by the
choices of other players, such as competitors, customers,
or regulators.
• Players: Firms, managers, governments, etc.
• Strategies: Actions available to each player (e.g., pricing
high or low, entering or staying out of a market).
• Payoffs: Outcomes resulting from a combination of
strategies (e.g., profit, market share).
• Rules: Whether players move simultaneously or
sequentially, how information is shared, etc.
• Example: Two firms (A and B) are considering entering a
new market. Their profits depend not only on their own
decision but also on the competitor’s decision. This
interaction can be analyzed using game theory.
Key Concepts in Game Theory
a. Nash Equilibrium
A Nash Equilibrium occurs when no player can improve
their payoff by changing their strategy, assuming the
other player keeps their strategy unchanged.
• Example: Two firms set prices. If neither can improve their
profit by changing price while the other’s price remains
the same, it’s a Nash Equilibrium.
b. Dominant Strategy
A dominant strategy is best for a player, regardless of
what the opponent does.
• Example: If advertising always leads to higher profit for a
company, regardless of what the competitor does, then
advertising is a dominant strategy.
c. Payoff Matrix
• A payoff matrix shows the profits (or losses) resulting
from each combination of strategies by the players.
Firm B: Low Price Firm B: High Price
Firm A: Low Price A: $2M, B: $2M A: $5M, B: $1M
Firm A: High Price A: $1M, B: $5M A: $3M, B: $3M
This shows how each firm's profit depends on both their own and their
competitor's pricing decision.
d. Prisoner's Dilemma
A scenario where individual rational strategies lead to a worse
collective outcome than cooperation would have.
• Example: Two firms both advertise aggressively (high cost, low
return) because they fear being undercut, even though they
would both benefit more from no advertising.
Types of games
1. Static Games (Simultaneous-Move Games)
In a static game, all players make decisions
simultaneously, or at least without knowing the others’
decisions beforehand. There's no observation of other
players' actions before choosing.
Key Features:
• One-shot decision
• Players move at the same time or without knowing others’
moves
• Use of payoff matrices
• Analyzed using Nash Equilibrium
Example: Pricing Strategy Between Two
Competing Firms
Firm B: Low Price Firm B: High Price
Firm A: Low Price A: $2M, B: $2M A: $5M, B: $1M
Firm A: High Price A: $1M, B: $5M A: $3M, B: $3M
Each firm selects its price without knowing the other’s decision. They
must anticipate and respond to likely moves of the other.
2. Dynamic Games (Sequential-
Move Games)
• In a dynamic game, players make decisions one after
another. Later players observe earlier actions and respond
accordingly.
Key Features:
• Sequential decisions
• Observability of prior moves
• Use of game trees (extensive form)
• Solved using backward induction (looking ahead and
reasoning back)
Example: New Market Entry
1.Firm A (incumbent) decides whether to threaten price cuts
if a competitor enters.
2.Firm B observes A’s strategy and decides whether to enter
the market.
Firm B makes a decision after observing what Firm A does,
making this a dynamic interaction.
3. Cooperative Games
In cooperative games, players can form alliances, coalitions,
or binding agreements to improve outcomes. The focus is on
how to distribute the joint gains among players.
Key Features:
• Players collaborate for mutual benefit.
• Legally enforceable agreements or contracts can be formed.
• The game often focuses on dividing payoffs fairly (e.g., using
the Shapley value).
• Trust, negotiation, and enforcement are crucial.
Example: Strategic Alliance Between Two Firms
Two firms decide to form a joint venture:
• They pool R&D resources to develop a new product.
• They agree to share the profits 60-40 based on
investment.
• This cooperative strategy allows both firms to reduce
risk and increase their chance of success.
4. Non-Cooperative Games
In non-cooperative games, players act independently and
focus on maximizing their own payoff. No binding
agreements are assumed—even if communication is possible.
Key Features:
• No formal cooperation.
• Players may still act in predictable or mutually beneficial ways,
but without enforceable agreements.
• These games are analyzed using tools like Nash Equilibrium.
• Strategic thinking, anticipation, and sometimes deception play a
role.
Example: Pricing War Between Two Competing
Retailers
• Firm A and Firm B compete by setting prices.
• Each wants to attract more customers and increase
market share.
• Neither can form a legal agreement to fix prices (due to
antitrust laws), so they act independently.
• They may fall into a prisoner’s dilemma, where both
lower prices and hurt profits, even though mutual
restraint would be better.
Applications of Game Theory in
Managerial Economics
1. Pricing Strategies in Oligopoly Markets
2. Market Entry and Entry Deterrence
3. Advertising and Promotional Campaigns
4. Contract Negotiations and Bargaining
5. R&D and Innovation Races
6. Mergers and Acquisitions
7. Supply Chain Management
Reference
• Baye, M. R., & Prince, J. (2022). Managerial economics
and business strategy (Tenth edition, international
student edition). McGraw Hill.
