1. MICROECONOMICS: Theory & Applications By Edgar K. Browning & Mark A. Zupan John Wiley & Sons, Inc. 11 th Edition, Copyright 2012 PowerPoint prepared by Della L. Sue, Marist College Chapter 14: Game Theory and the Economics of Information

2. Copyright 2012John Wiley & Sons, Inc. 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. Analyze asymmetric information and market outcomes in the case where consumers have less information than sellers. (continued)

3. Copyright 2012John Wiley & Sons, Inc. 3 Learning Objectives (continued) 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. 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.

4. Copyright 2012John Wiley & Sons, Inc. 4 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

5. Copyright 2012John Wiley & Sons, Inc. 5 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

6. Copyright 2012John Wiley & Sons, Inc. 6 Table 14.1

7. 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) All dominant-strategy equilibria are Nash equilibria. Not all Nash equilibria are dominant-strategy equilibria. Not all games have a Nash equilibria. Nash equilibrium is closely related to the analysis of the Cournot oligopoly model. Copyright 2012John Wiley & Sons, Inc. 7

8. Table 14.2 - Nash Equilibrium Copyright 2012John Wiley & Sons, Inc. 8

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. Dominant-strategy equilibrium Nash equilibrium Wide-applicability Copyright 2012John Wiley & Sons, Inc. 9

10. Table 14.3 Copyright 2012John Wiley & Sons, Inc. 10

11. The Prisoner’s Dilemma and Cheating by Cartel Members Outcome: each party acts in their own self-interest, resulting in all parties being worse off Alternative plan: all parties agree to collude Two strategies for each party: Comply – maximizes combined profit for parties Cheat – stronger incentive for each party with potential for larger individual profit but lower combined profit Success of collusive agreement depends on: Enforceability Number of parties Copyright 2012John Wiley & Sons, Inc. 11

12. Copyright 2012John Wiley & Sons, Inc. 12 Table 14.4

13. Copyright 2012John Wiley & Sons, Inc. 13 Table 14.5

14. 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; 2 alternatives: comply, cheat Out come: Cheating in current period can result in losses in subsequent period Disincentive to cheat Strengthens incentive to collude Copyright 2012John Wiley & Sons, Inc. 14

15. Copyright 2012John Wiley & Sons, Inc. 15 Table 14.6

16. Copyright 2012John Wiley & Sons, Inc. 16 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

17. Market application: pre-owned cars Long-run outcome: low-quality cars tend to drive out high-quality cars in the presence of asymmetric information Market response: increase and improve information information is scarce and, consequently, costly availability of information can increase market efficiency it might be efficient for consumers to be less than fully informed. Copyright 2012John Wiley & Sons, Inc. 17

18. Copyright 2012John Wiley & Sons, Inc. 18 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 Possible outcome – higher-risk customers tend to be insured and lower-risk customers choose to remain uninsured

19. Copyright 2012John Wiley & Sons, Inc. 19 Market Responses to Adverse Selection Outcome is mitigated: there are potential gains to market participants from adjusting their behavior to account for the adverse selection problem Lower benefits, reduce costs, spread risk Examples: Upper limit on insurance coverage Requirement of physical exams and/or a waiting period Group plans covering all employees

20. Copyright 2012John Wiley & Sons, Inc. 20 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.

21. Copyright 2012John Wiley & Sons, Inc. 21 Market Responses to Moral Hazard Application: 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

22. Copyright 2012John Wiley & Sons, Inc. 22 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.

23. Advertising Firms advertise to attempt to increase the demand for their product: Advertising as information about availability, price, and quality Artificial product differentiation: the use of advertising to differentiate products that are essentially the same 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 Copyright 2012John Wiley & Sons, Inc. 23

24. Figure 14.1 – Advertising and a Firm’s Demand Curve Copyright 2012John Wiley & Sons, Inc. 24

25. Copyright 2012John Wiley & Sons, Inc. 25 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.

26. Copyright 2012John Wiley & Sons, Inc. 26 Copyright © 2012 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in section 117 of the 1976 United States Copyright Act without express permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages caused by the use of these programs or from the use of the information herein.