Chapter 14

Game Theory

 Chapter Outline
CHALLENGE: Intel and AMD’s Advertising Strategies
14.1 Static Games
Normal-Form Games
Dominant Strategies
Best Response and Nash Equilibrium
Failure to Maximize Joint Profits
Application: Strategic Advertising
Multiple Equilibria
Solved Problem 14.1
Mixed Strategies
Application: Tough Love
Solved Problem 14.2

14.2 Repeated Dynamic Games

Strategies and Actions in Dynamic Games
Cooperation in a Repeated Prisoners’ Dilemma Game
Signaling
Threatening to Punish
Solved Problem 14.3

14.3 Sequential Dynamic Games

Game Tree
Subgame Perfect Nash Equilibrium
Credibility
Dynamic Entry Game
Exclusion Contracts
Solved Problem 14.4
Application: Keeping Out Casinos
Limit Pricing
Solved Problem 14.5

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248  Perloff • Microeconomics, Eighth Edition

Questions and Problems

1. The following game is called a zero-sum game because the winnings of one player are always taken
directly from the other player (such as a market share battle between two firms). In the payoff matrix
shown below, payoffs shown are for Player A (B gets minus one times what A receives). What strategy
would each player select in a Nash equilibrium? Does it matter which player gets to choose first?
Would collusion alter the outcome? Why or why not?
B
B1 B2
A A1 4 1
A2 2 1

2. In each payoff matrix shown below, determine the dominant strategy of each player assuming that
they must play simultaneously. Would collusion alter the outcome? Why? Payoffs shown are A, B.
a. B
B1 B2
A1 4, 2 1, 1
A
A2 2, 1 0, 0

b. B
B1 B2
A1 1, 2 1, 3
A
A2 2, 3 2, 2

c. B
B1 B2
A1 3, 3 7, 2
A
A2 1, 7 6, 6

3. In the following payoff matrix, each firm has two possible strategies and must move simultaneously.
Assuming that each knows only its own payoff structure, what decision would each firm make? Is
this a Nash equilibrium? Suppose each player can see the entire payoff structure instead of only its
own. How would this affect Firm 2? Payoffs shown are Firm 1, Firm 2.

Firm 2
A B
A 3, 1 2, 0
Firm 1
B 2, 4 1, 5

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 Chapter 14 Game Theory  249
4. In the following game, players must move simultaneously. How many Nash equilibria are there?
Which will occur without collusion? Which will occur if collusion is allowed?
Firm 2
A B
A 3, 1 7, 0
Firm 1
B 2, 4 5, 3

5. In the following game, assume that you are an interested bystander (such as the local government in
the town where Firm 1 is located). Can either firm make a credible commitment to enter regardless of
the other firm’s strategy? How could you alter the incentives (payoffs) with a nonfirm specific prize to
ensure that Firm 1 enters the market?

Firm 2
Enter Don’t Enter
Enter 1, 2 4, 0
Firm 1
Don’t Enter 0, 4 0, 0

6. Two firms are considering entering a new market. Entrance requires construction of a highly specialized
plant. Demand is sufficient for either one to be profitable but not both. A newspaper writer, observing
the posturing of the two firms, each stating that they are planning to go ahead with plans for the new
facility, noted, “Sunk costs make for credible threats.” What does she mean by this statement?

7. Suppose an industry has one incumbent and three potential new entrants. Any firm can produce as the
incumbent does, with no fixed costs, and marginal cost MC  bq. Is entry blockaded? Can or should it
be deterred? What type of equilibrium will result?

8. What are the merits and disadvantages to developing word processing software that has a very different
command structure than others on the market?

9. Consider the following game, called battle of sexes or dating game, which has elements of both
coordination and conflict.
Chris is the row player, and Pat is the column player.

Red White
Steak 2, 1 0, 0

Chicken 0, 0 1, 2

What are the pure- and mixed-strategy Nash equilibria?

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250  Perloff • Microeconomics, Eighth Edition
10. Assume that the payoffs in the following matrix are profits from various output choices, based on a
noncooperative game, with A as the leader. Because of product tie-ins, the firms must choose to
produce either 60 or 30 units. No other output levels are possible. Rewrite the payoffs in extended
“tree” form. Payoffs shown are A, B. What is the equilibrium? How would your answer change if B
was the leader?
Player B’s Output
60 30
60 3, 3 8, 4
Player A’s Output
30 4, 8 6, 6

11. Suppose in Question 10 above that movement was simultaneous rather than sequential. Is there a
unique equilibrium? If so, what is it? Instead, suppose movement was simultaneous but collusion was
permitted. Would the outcome change?

 Answers Questions and Problems

1. In the payoff matrix, Player A’s highest payoff is in the upper left (A1, B1), but B regards this as the
least preferred. Because B will not select B1, A’s best response is to choose A2. This solution would be
the outcome regardless of which player goes first because it is the unique Nash equilibrium. Collusion
would never alter the outcome of a zero-sum game because by definition the total payoff is zero in
any outcome, so there are no possible gains from cooperating.

2. a. Dominant strategies are A1, B1. Collusion would not alter the outcome because there is no other
combination in which both players are at least as well off.
b. Dominant strategies are A2, B1. Collusion would not alter the outcome because there is no other
combination in which both players are at least as well off.
c. Prisoner’s dilemma. Dominant strategies are A1, B1. If the players could collude they would
choose A2, B2, which has a higher payoff for both.

3. Firm 1 has a dominant strategy of A. However, without knowledge of the other player’s possible
outcomes, Firm 2 must guess what Firm 1 will play, as Firm 2 does not have a dominant strategy. The
solution (A, A) is a Nash equilibrium, but (A, B) is not because Firm 2 would rather switch, given
Firm 1’s choice of strategy A. If they can each see the entire matrix before play, Firm 2 will select
strategy A because they will know that Firm 1’s dominant strategy is A.
4. Each player has the dominant solution of strategy A, which is the only Nash equilibrium and will
occur if collusion is not allowed. However, if collusion is allowed, (B, B) will be the outcome, even
though it is not a Nash equilibrium.

5. As the matrix is written, neither player has a dominant strategy, nor can they make a credible threat of
entry because each loses if both enter. However, if the local government offers a $1 prize to any firm
that enters the market, Firm 1 can make a credible threat of entry.
Payoffs with a $1 Prize for All Entering Firms
Firm 2
Enter Don’t Enter
Enter 0, 1 5, 0

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 Chapter 14 Game Theory  251

Firm 1
Don’t Enter 0, 5 0, 0

6. The fact that a firm must invest in fixed costs does not ensure a credible commitment because the
cost may be partially or totally recoverable (as in the case of an airplane placed on a particular route).
Sunk costs are nonrecoverable. Thus, a firm willing to begin the building process by spending funds
that cannot be recovered is making a very credible threat that they plan to proceed because they are
changing their payoffs in the next stage by incurring costs today that cannot be recouped.

7. In this case, the lack of fixed costs means that entry is neither blocked nor should it be deterred. If the
products are identical, a Bertrand equilibrium will likely occur, with all three firms entering and
pricing at marginal cost, where MC  p at Q  4q. If products are differentiated, a Cournot equilibrium
will occur with all three potential entrants entering and all four firms producing the same quantity. If
the firms form a cartel, output and price will be identical to the monopoly result.

8. Difference in command structure creates switching costs in the software market. If the product enjoys
or is able to capture a high market share by some other means, such as advertising or quality, switching
costs can create market power. If, however, a new product attempts to take market share from an
established market leader, but users must pay switching costs, success is much less likely. In addition,
with products such as word processing and spreadsheet programs such as Lotus 1, 2, 3 and Excel,
users are reluctant to switch if the new software is unique, and thus, they would not be able to interact
with other users of popular programs. This reluctance creates additional switching costs.

9. This game has two pure strategy NE: (steak, red), (chicken, white) and the mixed strategy NE:
[(2/3, 1/3), (1/3, 2/3)].

10. See the following figure. Firm A as the leader will choose to produce 60, knowing that B’s best
response is to produce 30. Because the matrix is symmetric, if B were the leader, the outcome would
involve the same total output, but B would produce 60, and A would produce 30.

11. If movement were simultaneous, there is no unique equilibrium because neither player has a dominant
strategy. There are two pure-strategy Nash equilibria, (30, 60) and (60, 30), and at least one mixed
strategy. If collusion were allowed, the equilibrium would not change because there is no outcome
with a higher combined payoff than either of the pure-strategy Nash equilibria.

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