1. MICROECONOMICS: Theory & Applications Chapter 14 Game Theory and the Economics of Information
By Edgar K. Browning & Mark A. Zupan
John Wiley & Sons, Inc.
9th Edition, copyright 2006
PowerPoint prepared by Della L. Sue, Marist College

2. Learning Objectives
Understand the basics of game theory: a mathematical technique to study choice under conditions of strategic interaction.
Describe the prisoner’s dilemma and its applicability to oligopoly theory as well as many other situations.
Explore how the outcome in the case of a prisoner’s dilemma differs in a repeated-game versus a single-period setting.
(Continued)
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3. Learning Objectives (continued)
Analyze asymmetric information and market outcomes in the case where consumers have less information than sellers.
Explain how insurance markets may function when information is imperfect and there is the possibility of either adverse selection or moral hazard.
Show how limited price information affects price dispersion for a product.
(Continued)
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4. Learning Objectives (continued)
Investigate advertising and the extent to which it serves to artificially differentiate products versus provide information to consumers about the availability of products and their prices and qualities.
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5. Game Theory
Game theory – a method of analyzing situation in which the outcomes of your choices depend on others’ choices, and vice versa
Elements common to all game theory:
Players – decision makers whose behavior we are trying to predict and/or explain
Strategies – the possible choices of the players
Payoffs – the outcomes or consequences of the strategies chosen
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6. Determination of Equilibrium
Payoff matrix – a simple way of representing how each combination of choices affects players’ payoffs in a game theory setting
Dominant strategy – a case where a player is better off adopting a particular strategy regardless of the strategy adopted by the other player
Dominant-strategy equilibrium – the simplest game theory outcome, resulting from both players having dominant strategies
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7. Dominant-Strategy Equilibrium: A Simple Oligopoly Game [Figure 14.1]
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8. Nash Equilibrium
A set of strategies such that each player’s choice is the best one possible given the strategy chosen by the other player(s)
Figure 14.2
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9. The Prisoner’s Dilemma Game
The most famous game theory model in which self-interest on the part of each player leads to a result in which all players are worse off than they could be if different choices were made.
Figure 14.3
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10. The Prisoner’s Dilemma and Cheating by Cartel Members [Figure 14.4]
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11. Repeated Games
Repeated Game Model – a game theory model in which the “game” is played more than once
Tit-for-tat – a strategy in which each player mimics the action taken by the other player in the preceding period
Table 14.6
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12. Asymmetric Information
Imperfect information – the case when market participants lack some information relevant to their decisions
Asymmetric information – a case in which participants on one side of the market know more about a good’s quality than do participants on the other side
The “Lemons” Model
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13. Market Responses to Asymmetric Information
Information is a scarce good.
The benefits from acquiring information about product quality will not always be worth its costs.
It might be efficient for consumers to be less than fully informed.
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14. Adverse Selection
Adverse selection – a situation in which asymmetric information causes higher-risk customers to be more likely to purchase or sellers to be more likely to supply low-quality goods
Application – insurance markets in which the assumption of full information (both firms and customers know the risks) is modified
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15. Market Responses to Adverse Selection
Key: there are potential gains to market participants from adjusting their behavior to account for the adverse selection problem
Examples:
Upper limit on insurance coverage
Requirement of physical exams and/or a waiting period
Group plans covering all employees
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16. Moral Hazard
Moral hazard – a situation that occurs when, as a result of having insurance, an individual becomes more likely to engage in risky behavior
The problem arises when insurance companies lack knowledge of the actions people take that may affect the occurrence of unfavorable events.
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17. Market Responses to Moral Hazard
Example: medical insurance market
Limitation on the services covered by insurance
Requirement of the insured person to pay part of the costs:
Coinsurance rate – the share of the cost borne by the patient
Deductibles – the amount that the patient must pay before insurance coverage is effective
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18. Limited Price Information
Price dispersion – a range of prices for the same product, usually as a result of customers’ lacking price information
Search costs – the costs that customers incur in acquiring information
Price dispersion will fall when the benefit from search is higher than the cost.
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19. Advertising and Its Effects on Products’ Prices and Qualities
Firms advertise to provide information to customers.
Effects of advertising:
Reduce price dispersion and lower the average price
Solve the lemons problems by giving high-quality sellers an advantage over low-quality sellers
Introduce consumers to new products
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20. Advertising, the Full Price of a Product, and Market Efficiency
Full price – the sum of the money price and the search costs that consumers incur
Advertising is a substitute for the consumer’s own search efforts, and thereby reduce search costs.
Advertising is a low-cost way of conveying information, and thereby increases market efficiency.
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