2025 Spring

AGEC 2006 Applied Microeconomics (A)(2)

Office hours:
INSTRUCTOR:
[email protected] Thursday,
MIN-FANG WEI
by appointment
Recap

Isoprofit Curves
• Along a single isoprofit curve,
the profit is constant.
• Lower curves (closer to the
origin) mean higher profit for
Firm 1.

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Why choose the "tops"?
• Firm 1 is trying to move to
higher profit curves.
• At the "top“ of the
isoprofit curve, Firm 1
cannot improve its profit
without changing 𝑦2 .
• Hence, Firm 1 chooses the
top of each isoprofit curve.

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• Similar for Firm 2

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Why is one firm incentivized to cheat on
the other in collusion?
𝜋 𝑚 𝑦1 , 𝑦2
= p 𝑦1 + 𝑦2 ∗ 𝑦1 + 𝑦2 − 𝑐1 𝑦1
− 𝑐2 (𝑦2 )

• Firm 2 takes 𝑦1𝑚 as given, then firm 2

can re-optimizes its own output
based on:
𝜋2 𝑦1𝑚 , 𝑦2 = p 𝑦1𝑚 + 𝑦2 𝑦2 − 𝑐2 (𝑦2 ) 5
• The point 𝑦1𝑚 , 𝑦2∗ shows what
happens when Firm 1 sticks to the
cartel output, but Firm 2 deviates
to its best response.
• Firm 2 moves to a higher isoprofit
curve when it increases output
from 𝑦2𝑚 ​ to 𝑦2∗ — given that Firm 1
sticks to 𝑦1𝑚 ​.
• a short-term profit boost, even
though it hurts the cartel's total.

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CHAPTER 29 OBJECTIVES:

• Define the concepts of dominant strategy, mixed strategy, and

Nash equilibrium.
• Describe the prisoner’s dilemma game, and identify the
dominant strategies.
• Use the extensive-form structure of sequential games to
eliminate strategies that are not credible.

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 Game Theory
• Game theory helps to model strategic behavior by agents who
understand that their actions affect the actions of other agents.

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Some Applications of Game Theory

• The study of oligopolies (industries containing only a few firms)

• The study of cartels, e.g., OPEC
• The study of externalities, e.g., using a common resource such as
a fishery
• The study of military strategies
• Bargaining

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What Is a Game?

• A game consists of
• a set of players
• a set of strategies for each player
• the payoffs to each player for every possible choice of strategies by the
players

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Two-Player Games Examples

• We will study only games in which there are two players, each of
whom can choose between only two actions.

• The players are called A and B.

• Player A has two actions, called “top” and “bottom.”
• Player B has two actions, called “left” and “right.”
• The table showing the payoffs to both players for each of the
four possible action combinations is the game’s payoff matrix.
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Dominant Strategy

• A dominant strategy is a strategy for a player that is best no

matter what the other player does.

• In this example, 𝑇 is a dominant strategy for A.

• Similarly, 𝐿 is a dominant strategy for B.

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Another Example of a Two-Player Game

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Nash Equilibrium

• A play of the game where each strategy is a best reply to the

other is a Nash equilibrium (NE).
• Another way to define NE: the set of strategies that are best,
given what the other player is doing.

• Our example has two Nash equilibria: (𝑇, 𝐿) and (𝐵, 𝑅).

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 Pure Strategies – Example 1

• Up to now, player A has been thought of as choosing to play either 𝑇 or 𝐵, but no

combination of both—in other words, as playing purely 𝑇 or 𝐵.
• 𝑇 and 𝐵 are player A’s pure strategies.
• Similarly, 𝐿 and 𝑅 are player B’s pure strategies. 23
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Pure Strategies – Example 2

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Mixed Strategies

• Instead of playing purely up or down, player A selects a

probability distribution (𝜋𝑇, 1– 𝜋𝑇), meaning that with
probability 𝜋𝑇 player A will play up and with probability
1– 𝜋𝑇 will play down.

• Player A is mixing over the pure strategies up and down.

• The probability distribution (𝝅𝑻, 𝟏– 𝝅𝑻) is a mixed strategy for
player A.

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• Similarly, player B selects a probability
distribution(𝜋𝐿, 1– 𝜋𝐿), meaning that with probability 𝜋𝐿 player B
will play left and with probability 1– 𝜋𝐿 will play right.

• Player B is mixing over the pure strategies left and right.

• The probability distribution (𝝅𝑳, 𝟏– 𝝅𝑳) is a mixed strategy for
player B.

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How Many Nash Equilibria?

• A game with a finite number of players, each with a finite

number of pure strategies, has at least one Nash equilibrium.

• So, if the game has no pure strategy Nash equilibrium then it

must have at least one mixed strategy Nash equilibrium.

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The Prisoner’s Dilemma

• To see if Pareto-preferred outcomes must be what we see in the

play of a game, consider the famous example called the
prisoner’s dilemma game.

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• The players would be jointly better off if each remained silent. 39
• But individual strategies and incentives lead them each to confess, since it is a dominant strategy.
Repeated Games

• A strategic game is a repeated game if it is played once in each

of a number of periods.

• What strategies are sensible for the players depends greatly on

whether the game
• is repeated a fixed number of times, or
• is repeated over an indefinite number of periods.

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The Prisoner’s Dilemma – Example with Fixed Number
of Repetitions

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• Suppose the start of period 𝑡 = 3 has been reached (i.e., the game has already
been played twice). Both should choose confess.
• Now suppose the start of period 𝑡 = 2 has been reached. Clyde and Bonnie
expect each will choose confess next period. Both should choose confess.
• At the start of period 𝑡 = 1 Clyde and Bonnie both expect that each will
choose confess in each of the next two periods. Both should choose confess.
• The only credible Nash equilibrium (NE) for this game is where both Clyde and
Bonnie choose confess in every period.
• This is true even if the game is repeated for a large, but still definite, number of periods.

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The Prisoner’s Dilemma: Example with Repeated Indefinitely

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• (𝐶, 𝐶) forever is one such NE.
• But (𝑆, 𝑆) can also be an NE.

• One to remain in (𝑆, 𝑆) is for each player to adopt a “tit for tat”
strategy of playing whatever the other player played on the
previous turn. If both players start with 𝑆, they will both remain
silent for as long as the game continues.

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Who Plays When?

• In the examples considered so far, the players chose their

strategies simultaneously.
• Such games are simultaneous games.

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• But there are other games in which one player plays before
another player.
• Such games are sequential games.
• The player who plays first is the leader.
• The player who plays second is the follower.

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A Sequential Game Example

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Rewrite it into an Extensive Form

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B, B would be

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𝑇, since 3 > 2.

(𝑇, 𝐿).

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THANK YOU!
• Assignment 3 due May 8 (Thursday) at noon

[email protected]
Office hours: Thursday, by appointment

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