1. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 11-1 Chapter 11 Thinking strategically

2. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 11-2 Thinking strategically The payoff to many actions will depend on –the actions themselves. –when the actions are taken. –how the actions relate to those taken by others. An economic naturalist recognises –the interdependencies between these three aspects of any action. –economic decision making is a game in which strategy matters.

3. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 11-3 The Theory of games Basic elements of a game –The players –Their strategies –The payoffs Example –Suppose that Virgin Blue and Qantas are the only airlines that serve the Adelaide to Alice Springs market. Should Virgin Blue spend more money on advertising? –The outcome of each strategy by these two airlines can be represented in the form of a payoff matrix.

4. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 11-4 The payoff matrix for an advertising game Raise spending Leave spending the same Raise spending Leave spending the same Qantas gets $5500 Qantas gets $3500 Qantas gets $8000 Qantas gets $6000 Virgin Blue gets $5500 Virgin Blue gets $8000 Virgin Blue gets $6000 Virgin Blue gets $3500 Qantas’s choice Virgin Blue’s choice

5. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 11-5 The theory of games Dominant strategy –A strategy that yields a player a higher payoff no matter what the other players in a game choose. Dominated strategy –Any other strategy available to a player who has a dominant strategy. Nash equilibrium –A set of strategies one for each player in which each player’s strategy is her or his best choice given the other player’s strategies. –When each player has a dominant strategy equilibrium occurs when each player follows that strategy. –There can be an equilibrium when players do not have a dominant strategy.

6. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 11-6 The theory of games Do Qantas and Virgin Blue have dominant strategies? Does this game have a Nash equilibrium?

7. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 11-7 Equilibrium when one player lacks a dominant strategy Raise ad spending Leave ad spending the same Raise ad spending Leave ad spending the same Qantas gets $3000 Qantas gets $2500 Qantas gets $3500 Qantas gets $2000 Virgin Blue gets $3500 Virgin Blue gets $5500 Virgin Blue gets $5000 Virgin Blue gets $4000 Qantas’s choice Virgin Blue’s choice

8. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 11-8 What should Virgin Blue and Qantas do if their payoff matrix is modified? Raise ad spending Leave ad spending the same Raise ad spending Leave ad spending the same Qantas gets $2000 Qantas gets $3000 Qantas gets $3000 Qantas gets $4000 Virgin Blue gets $3000 Virgin Blue gets $4000 Virgin Blue gets $3000 Virgin Blue gets $2000 Qantas’s choice Virgin Blue’s choice

9. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 11-9 The prisoner’s dilemma Prisoner’s dilemma –A game in which each player has a dominant strategy, and when each plays their dominant strategy the resulting payoffs are smaller than if each had played a dominated strategy. Example –Should Horace and Jasper confess?

10. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 11-10 The payoff matrix for a prisoner’s dilemma Confess Remain silent Confess Remain silent Jasper gets 5 years Jasper gets 20 years Jasper gets 0 years Jasper gets 1 years Horace gets 5 years Horace gets 0 years Horace gets 1 years Horace gets 20 years Jasper’s choice Horace’s choice

11. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 11-11 The prisoner’s dilemma Exercise –Holden and Ford must both decide whether to invest in a new robotic production process. The following two games show how their profits depend on the decision they might make. Which of these games is a prisoner’s dilemma?

12. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 11-12 Which of these games is a prisoner’s dilemma? Don’t invest Don’t invest Invest 10 for Holden 12 for Holden 4 for Holden 5 for Holden 10 for Ford 4 for Ford 5 for Ford 12 for Ford Holden’s choice Ford’s choice GAME 1 Invest

13. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 11-13 Which of these games is a prisoner’s dilemma? 12 for Holden 5 for Holden 10 for Holden 4 for Holden 4 for Ford 5 for Ford 12 for Ford 10 for Ford Holden’s choice Ford’s choice GAME 2 Don’t invest Invest

14. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 11-14 Prisoner’s dilemmas confronting imperfectly competitive firms Cartel: Any group of firms that conspires to coordinate production and pricing decisions in an industry for the purpose of earning an economic profit. –Firms agree to set a monopoly price and equal amount of quantity. –Agreement is not legally enforceable. –Each firm has an incentive to charge a lower price than agreed as long as that price is higher than MC. –Captures entire quantity demanded by the market.

15. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 11-15 The prisoner’s dilemma Thinking as an economist –Why are cartel agreements often unstable?

16. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 11-16 The market demand for mineral water Price $/bottle) Bottles/day Assume 2 firms (Aquapure & Mountain Spring) MC = 0 Cartel is formed & agree to split output and profits 2000 D 1.00 1000 MR 2.00 Impact of cartel Q = 1000 bottles/day P = $1/bottle Each firm makes $500/day

17. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 11-17 The temptation to violate a cartel agreement Price $/bottle) Bottles/day D 1.00 10002000 MR 2.00 1100 0.90 Aquapure lowers P P = $.90/bottle Q = 1100 bottles/day Mountains Spring retaliates P = $.90/bottle Both firms split 1100 bottles/day at $.90 Profit = $495/day

18. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 11-18 The payoff matrix for a cartel agreement Charge $1Charge $0.90 Charge $1 Charge $0.90 Mountain Spring’s choice Aquapure’s choice $990/day for Mountain Spring $0/day for Mountain Spring $495/day for Mountain Spring $500/day for Aquapure $0/day for Aquapure $495/day for Aquapure $990/day for Aquapure $500/day for Mountain Spring

19. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 11-19 Prisoner’s dilemmas in everyday life Thinking as an economist –Why do people often stand at concerts even though they can see just as well when everyone sits? –Why do athletes use anabolic steroids when the potential risks are so high?

20. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 11-20 Standing versus sitting at a concert as a prisoner’s dilemma StandSit Stand Sit Other people’s choice Your choice -$2 for others -$2 for you$1 for you $0 for you-$3 for you -$3 for others $1 for others$0 for others

21. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 11-21 Tit-for-tat and the repeated prisoner’s dilemma Cooperation between players will increase the payoff in a prisoner’s dilemma. There is a motive to enforce cooperation. Repeated prisoner’s dilemma is a game in which the same pair of players play out a prisoner’s dilemma repeatedly, with the outcome of all previous plays observed before the next play begins.

22. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 11-22 Tit-for-tat and the repeated prisoner’s dilemma (cont.) –Tit-for-tat strategy  Players cooperate on the first move then mimic their partner’s last move on each successive move. –Tit-for-tat strategy requirements  Two players  A stable set of players  Players recall other players’ moves  Players have a stake in future outcomes

23. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 11-23 The prisoner’s dilemma Question –Why is the tit-for-tat strategy unsuccessful in competitive monopolistically competitive and oligopolistic markets?

24. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 11-24 Games in which timing matters The ultimate bargaining game –Should Michael accept Tom’s offer?  Rules of the game Experimenter gives $100 to Tom Tom proposes how to divide $100 with Michael Tom must give Michael at least $1 (X = Tom and $100 - X = Michael) Michael must accept the proposal If he does Tom and Michael get the money If he does not the money goes to the experimenter

25. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 11-25 Decision tree for Tom A Michael accepts Michael refuses $X for Tom $(100 – X) for Michael $0 for Tom $0 for Michael Tom proposes $X for himself $(100 – X) for Michael B Possible moves and payoffs Decision tree is a diagram that describes the possible moves in a game in sequence and lists the payoffs that correspond to each possible combination of moves.

26. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 11-26 Tom’s best strategy in an ultimatum bargaining game A Michael accepts Michael refuses $99 for Tom $1 for Michael $0 for Tom $0 for Michael Tom proposes $99 for himself $1 for Michael B Tom can give Michael a take it or leave it offer Tom will propose $1 Michael will accept The outcome is a Nash equilibrium

27. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 11-27 The ultimatum bargaining game with an acceptance threshold A $X for Tom $(100 – X) for Michael $0 for Tom $0 for Michael Michael announces that he will reject any offer less than $Y B Tom proposes $X < $(100 - Y) for himself $(100 - X) > Y for Michael Tom proposes $X > $(100 - Y) for himself $(100 - X) < Y for Michael New rule: Michael can specify in advance the minimum offer he will accept

28. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 11-28 Credible threats and promises A credible threat is to take an action that is in the threatener’s interest to carry out. –Why couldn’t Michael have threatened to refuse a one-sided offer in the original version of the game? –Why are tourists more likely than local residents to be victims of petty crime? A credible promise is to take an action that is in the promiser’s interest to keep. –Should the business owner open a remote office if she has to employ a manager and believes that mangers are self- interested income-maximisers?

29. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 11-29 Decision tree for the remote office game A Owner does not open remote office Manager manages honestly; owner gets $1000 manager gets $1000 Managerial candidate promises to manage honestly B Owner opens remote office C Manager manages dishonestly; owner gets -$500 manager gets $1500 Owner gets $0 manager gets $500 by working elsewhere Is the outcome an equilibrium?

30. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 11-30 Commitment problem Commitment problem is a situation in which people cannot achieve their goals because of an inability to make credible threats or promises. Commitment device is a way of changing incentives so as to make otherwise empty threats or promises credible.

31. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 11-31 Commitment problem (cont.) Commitment problems –Prisoner’s dilemma –Cartels –Remote office Commitment devices –Underworld code omerta –Military arms control agreements –Tips for waiters

32. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 11-32 Commitment problem (cont.) Thinking as an economist –How do firms achieve commitment in outsourcing arrangements? –Will Miles leave a tip when dining at a restaurant while on holiday at a Gold Coast resort? –How might legislation banning junk food advertising on children’s TV unwittingly solve junk food manufacturers’ prisoner’s dilemma?

33. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 11-33 The strategic role of preferences Game theory assumes that the goal of the players is to maximise their outcome. In most games players do not attain the best outcomes. Altering psychological incentives may also improve the outcome of a game. Question –In an honest society will the business owner open a remote office?

34. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 11-34 The remote office game with an honest manager A Owner does not open remote office Manager manages honestly; owner gets $1000 manager gets $1000 Managerial candidate promises to manage honestly B Owner opens remote office C Manager manages dishonestly; owner gets -$500 manager gets -$8500 Owner gets $0 manager gets $500 by working elsewhere The value of dishonesty to the manager is $10 000

35. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 11-35 The strategic role of preferences Are people fundamentally selfish? –Do you tip at out-of-town restaurants? –What would be your first offer in the ultimatum bargaining game? –Would you refuse a unfair offer? –If narrow self-interest is not the only motive for making choices then the other motives must be understood to predict and explain human behaviour.

36. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 11-36 The strategic role of preferences (cont.) Preferences as solutions to commitment problems –Concerns about fairness, guilt, humour, sympathy etc. do influence the choices people make in strategic interactions. –Commitment to these preferences must be communicated for them to influence choices.