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Micro Notes Chapter 11

The document discusses game theory and strategic thinking. It covers key concepts like the prisoner's dilemma, Nash equilibrium, dominant and dominated strategies, commitment problems, and how preferences and repeated interactions can influence outcomes. Specifically, it examines how the prisoner's dilemma arises in business between firms in an oligopoly and how the repeated prisoner's dilemma game and the tit-for-tat strategy can encourage cooperation over time through reciprocal actions.

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D Ho
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34 views3 pages

Micro Notes Chapter 11

The document discusses game theory and strategic thinking. It covers key concepts like the prisoner's dilemma, Nash equilibrium, dominant and dominated strategies, commitment problems, and how preferences and repeated interactions can influence outcomes. Specifically, it examines how the prisoner's dilemma arises in business between firms in an oligopoly and how the repeated prisoner's dilemma game and the tit-for-tat strategy can encourage cooperation over time through reciprocal actions.

Uploaded by

D Ho
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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Chapter 11

Thinking strategically

11.1 The theory of games


- In choosing your move, you must anticipate your opponent’s response, how you might
then respond, and what further moves your own response might elicit.

The three elements of a game


- Basic elements of a game – the players, the strategies available to each player, and the
payoffs each player receives for each possible combination of strategies.
- Players may be individuals, firms, or countries.
- Strategies may be decision rules for bidding at an auction, truth-telling, budget
allocations or wartime battle plans.
- Payoffs, or outcomes, are anything that players value.
- Payoff matrix – a table that describes the payoffs to each player in a game for each
possible combination of strategies.
- The essence of strategic thinking is to begin looking at the situation from the other
party’s point of view.
- If the game is perfectly symmetrical, a similar situation holds for both parties.
- Dominant strategy – a strategy that yields a player a higher payoff no matter what other
players in a game choose.
Ø Not all games involve dominant strategies, but some do.
- Dominated strategy – any other strategy available to a player who has a dominant
strategy.
Ø One that leads to a lower payoff than an alternative choice, regardless of the other
player’s choice.

Nash equilibrium
- Nash equilibrium – a set of strategies, one for each player, in which each player’s
strategy is his or her best choice, given the other players’ strategies.
- When a game is in equilibrium, no player has any incentive to deviate from his or her
current strategy.
- If one party does not have a dominant strategy, they will use the prediction of what the
other party will do.

11.2 The prisoner’s dilemma game


- 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.
- Incentives analogous to those found in the prisoner’s dilemma help to explain a broad
range of behaviour in business and everyday life – among them, excessive spending on
advertising, cartel instability, standing at concerts and shouting at parties.

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.
- A monopolist with zero marginal cost will produce the quantity at which marginal
revenue equals zero.
- Cartel activity in Australia is dealt with under the Trade Practices Act 1974.

Prisoner’s dilemmas in everyday life


- The prisoner’s dilemma helps the economic naturalist make sense of human behaviour
not only in the world of business but in other domains of life as well.

Tit-for-tat and the repeated prisoner’s dilemma


- Those who confront prisoner’s dilemma will be on the lookout for ways to create
incentives for mutual cooperation.
Ø They need a way to penalize players who defect.
- Repeated prisoner’s dilemma – 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.
- Tit-for-tat – a strategy for playing the repeated prisoner’s dilemma game in which a
player cooperates on the first move, then mimics their partner’s last move on each
successive move.
- The success of tit-for-tat requires a reasonably stable set of players, each of whom can
remember what other players have done in previous interactions.
Ø One difficulty is that its effectiveness depends on there being only two players in
the game.

11.3 Games in which timing matters


The ultimatum bargaining game
- Decision tree (or game tree) – a diagram that describes the possible moves in a game in
sequence and lists the payoffs that correspond to each possible combination of moves.
- Ultimate bargaining game – a game in which the first player has the power to confront
the second player with a take-it-or-leave-it offer.

Credible threats and promises


- Credible threat – a threat to take an action that is in the threatener’s interest to carry
out.
- Timing can be everything.
- Credible promise – a promise to take an action that is in the promiser’s interest to keep.
- In some games credible threats and promises are impossible to make.

Commitment problems
- Commitment problems – a situation in which people cannot achieve their goals because
of an inability to make credible threats or promises.
- Such problems can sometimes be solved by employing commitment devices, which are
ways of changing incentives to facilitate making credible threats or promises.

11.4 The strategic role of preferences


- Most applications of the theory of games assume that players are self-interested in the
narrow sense of the term.
- Commitment problems arise less often in a society in which people are strongly
conditioned to develop moral sentiments as opposed to societies in which people are
more narrowly self-interested.

Are people fundamentally selfish?


- Everyday people walk away from profitable transactions whose terms they believe to be
“unfair”.

Preferences as solutions to commitment problems


- Preferences clearly affect the choices people make in strategic interactions.
- A sense of justice can prompt a person to incur the cost of retaliation.
- Although preferences can clearly shape behaviour in these ways, that alone does not
solve commitment problems.
- The solution to such problems requires not only that a person have certain preferences
but also that others have some way of discerning them.
- Vigilance in the choice of trading partners is an essential element in solving or avoiding
commitment problems that arise from lack of trust.

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