Intermediate Microeconomic Theory I
ECON 2300 – Summer 2011 – Mark Melatos
Topic 8 – Game Theory – July 7
Introduction to Games
- Economic agents often have to make strategic choices:
o Firms decide whether or not to enter an industry.
o Firms decide how much advertising to undertake.
o How much output should a firm produce and/or what price should it
o Governments have to determine how consumers/investors will respond to
a new policy.
o Countries decide what trade policy to follow.
o How are these choices made?
o How does an economic agent choose its optimal strategy?
- An agent has to take into account how its opponents will respond to his/her
o I.e. your opponent’s expected response determines what action you take.
What Does a Game Look Like?
- There are 2 types of strategic game:
o Cooperative – players (agents) negotiate binding contracts that allow them
to plan joint strategies.
o Non-cooperative – when negotiation and enforcement of a binding
contract are not possible.
- Components of game
o Players (only 2 for us).
o A set of actions (strategies) for each player.
o A way of determining the payoffs to each player from all possible
outcomes of the game.
How are Games Played?
- We make 2 important assumptions:
o Players are rational – they always seek to maximise their own playoffs.
o Plays have full information about the game. Each knows what the payoff
matrix looks like.
- Games can be played in one of two ways:
o Simultaneous movement – players move at the same time and do not
observe their opponent’s action.
Players make a conjecture about what their rival will do based on
the payoff matrix.
o Sequential movement – one player moves first; the other player observed
their choice of action and responds. The Outcome of the Game
- The Nash Equilibrium (NE)
o A NE is a set of strategies or actions:
Such that each player is doing the best they can, given the actions
of its opponents.
From which no player has an incentive to deviate the strategies are
- A dominant strategy is an action that is optimal for a player, regardless what its
The Prisoners’ Dilemma
o Promising to collude is not credible.
o Once one firm commits to colluding it is optimal for the other firm to ‘not
- An inefficient outcome results because the players cannot trust each other, and
there is no mechanism (e.g. a court of law) that can force players to keep their