1 GAME THEORY AND OLIGOPOLY l Principles of Microeconomic Theory, ECO 284 l John Eastwood l CBA 247 l l address:

2 n Game Theory is a field of mathematics first developed by John Von Neumann, and Oskar Morgenstern (Theory of Games and Economic Behavior). What is Game Theory?

3 Payoff Matrix n Two players, each may choose between two strategies. There are four possible mutually exclusive outcomes. n Matrix shows the payoff to each player. n If Jill (x) holds out, & Jack (y) confesses, the payoff,(x,y) = (-6,0), means Jill gets 6 years, and Jack goes free.

4 Strategy, Outcomes & Equilibria n A dominant strategy is a player’s best response to any strategy other players might pick n A Nash equilibrium is an outcome that is stable once reached. No player has an incentive to change strategy unless other players change.

5 Terminology n In a cooperative game, players may make binding agreements, or form coalitions. n In a noncooperative game, players may neither make binding agreements, nor form coalitions. n A zero-sum game is one in which one player may gain only what others lose; poker is an example.

6 More terminology n The Prisoners’ Dilemma is a non- cooperative, nonzero sum game. n Whether Jack or Jill moves first is unimportant. n Moving first is advantageous in many other games.

7 Dynamic Games n Grim strategy -- refusal to commit to a position until the other player commits to a position. n A tit-for-tat strategy begins cooperatively, and then echo what the opponent did in the previous period

8 Other Strategies n A player who follows the Trigger Strategy cooperates as long as the other player cooperates, but adopts the most extreme form of punishment possible if their agreement is broken. n Reputation building: Players gain a reputation through consistent behavior for several rounds of the game.

9 An Asymmetric Payoff Matrix n In an asymmetric payoff, the payoffs from cooperation for at least one party are higher than the payoffs to some other players. n The seller may seek a reputation as a non- polluter, so that consumers will always buy.

10 Predatory Behavior n Predatory behavior occurs when a firm attempts to drive rivals from the industry and deter entry. n The predator sets P < ATC, while producing the quantity demanded. n If all rivals shut down to reduce their SR losses AND exit in the LR, the predator monopolizes the market.

11 Strategic BTE, Predation and Accommodation n Strategic BTE may be viewed as predatory weapons. n Less costly to acquire your rival? n Accommodation: Allowing a rival to enter (or survive) may be less costly.

12 Jack & Jill

13 Oz & Lilliput

14 Duopoly and Advertising