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Managerial Economics in a Global Economy, 5th Edition by Dominick SalvatoreChapter 10 Game Theory and Strategic Behavior

Prepared by Robert F. Brooker, Ph.D.

Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved.

Slide 1

Strategic Behavior Decisions that take into account the predicted reactions of rival firms Interdependence of outcomes

Game Theory Players Strategies Payoff matrix

Prepared by Robert F. Brooker, Ph.D.

Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved.

Slide 2

Strategic Behavior Types of Games Zero-sum games Nonzero-sum games

Nash Equilibrium Each player chooses a strategy that is optimal given the strategy of the other player A strategy is dominant if it is optimal regardless of what the other player doesPrepared by Robert F. Brooker, Ph.D. Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 3

Advertising Example 1

Firm A

Advertise Don't Advertise

Firm B Advertise Don't Advertise (4, 3) (5, 1) (2, 5) (3, 2)

Prepared by Robert F. Brooker, Ph.D.

Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved.

Slide 4

Advertising Example 1What is the optimal strategy for Firm A if Firm B chooses to advertise?

Firm A

Advertise Don't Advertise

Firm B Advertise Don't Advertise (4, 3) (5, 1) (2, 5) (3, 2)

Prepared by Robert F. Brooker, Ph.D.

Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved.

Slide 5

Advertising Example 1What is the optimal strategy for Firm A if Firm B chooses to advertise? If Firm A chooses to advertise, the payoff is 4. Otherwise, the payoff is 2. The optimal strategy is to advertise.

Firm A

Advertise Don't Advertise

Firm B Advertise Don't Advertise (4, 3) (5, 1) (2, 5) (3, 2)

Prepared by Robert F. Brooker, Ph.D.

Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved.

Slide 6

Advertising Example 1What is the optimal strategy for Firm A if Firm B chooses not to advertise?

Firm A

Advertise Don't Advertise

Firm B Advertise Don't Advertise (4, 3) (5, 1) (2, 5) (3, 2)

Prepared by Robert F. Brooker, Ph.D.

Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved.

Slide 7

Advertising Example 1What is the optimal strategy for Firm A if Firm B chooses not to advertise? If Firm A chooses to advertise, the payoff is 5. Otherwise, the payoff is 3. Again, the optimal strategy is to advertise.

Firm A

Advertise Don't Advertise

Firm B Advertise Don't Advertise (4, 3) (5, 1) (2, 5) (3, 2)

Prepared by Robert F. Brooker, Ph.D.

Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved.

Slide 8

Advertising Example 1Regardless of what Firm B decides to do, the optimal strategy for Firm A is to advertise. The dominant strategy for Firm A is to advertise.

Firm A

Advertise Don't Advertise

Firm B Advertise Don't Advertise (4, 3) (5, 1) (2, 5) (3, 2)

Prepared by Robert F. Brooker, Ph.D.

Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved.

Slide 9

Advertising Example 1What is the optimal strategy for Firm B if Firm A chooses to advertise?

Firm A

Advertise Don't Advertise

Firm B Advertise Don't Advertise (4, 3) (5, 1) (2, 5) (3, 2)

Prepared by Robert F. Brooker, Ph.D.

Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved.

Slide 10

Advertising Example 1What is the optimal strategy for Firm B if Firm A chooses to advertise? If Firm B chooses to advertise, the payoff is 3. Otherwise, the payoff is 1. The optimal strategy is to advertise.

Firm A

Advertise Don't Advertise

Firm B Advertise Don't Advertise (4, 3) (5, 1) (2, 5) (3, 2)

Prepared by Robert F. Brooker, Ph.D.

Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved.

Slide 11

Advertising Example 1What is the optimal strategy for Firm B if Firm A chooses not to advertise?

Firm A

Advertise Don't Advertise

Firm B Advertise Don't Advertise (4, 3) (5, 1) (2, 5) (3, 2)

Prepared by Robert F. Brooker, Ph.D.

Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved.

Slide 12

Advertising Example 1What is the optimal strategy for Firm B if Firm A chooses not to advertise? If Firm B chooses to advertise, the payoff is 5. Otherwise, the payoff is 2. Again, the optimal strategy is to advertise.

Firm A

Advertise Don't Advertise

Firm B Advertise Don't Advertise (4, 3) (5, 1) (2, 5) (3, 2)

Prepared by Robert F. Brooker, Ph.D.

Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved.

Slide 13

Advertising Example 1Regardless of what Firm A decides to do, the optimal strategy for Firm B is to advertise. The dominant strategy for Firm B is to advertise.

Firm A

Advertise Don't Advertise

Firm B Advertise Don't Advertise (4, 3) (5, 1) (2, 5) (3, 2)

Prepared by Robert F. Brooker, Ph.D.

Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved.

Slide 14

Advertising Example 1The dominant strategy for Firm A is to advertise and the dominant strategy for Firm B is to advertise. The Nash equilibrium is for both firms to advertise.

Firm A

Advertise Don't Advertise

Firm B Advertise Don't Advertise (4, 3) (5, 1) (2, 5) (3, 2)

Prepared by Robert F. Brooker, Ph.D.

Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved.

Slide 15

Advertising Example 2

Firm A

Advertise Don't Advertise

Firm B Advertise Don't Advertise (4, 3) (5, 1) (2, 5) (6, 2)

Prepared by Robert F. Brooker, Ph.D.

Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved.

Slide 16

Advertising Example 2What is the optimal strategy for Firm A if Firm B chooses to advertise?

Firm A

Advertise Don't Advertise

Firm B Advertise Don't Advertise (4, 3) (5, 1) (2, 5) (6, 2)

Prepared by Robert F. Brooker, Ph.D.

Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved.

Slide 17

Advertising Example 2What is the optimal strategy for Firm A if Firm B chooses to advertise? If Firm A chooses to advertise, the payoff is 4. Otherwise, the payoff is 2. The optimal strategy is to advertise.

Firm A

Advertise Don't Advertise

Firm B Advertise Don't Advertise (4, 3) (5, 1) (2, 5) (6, 2)

Prepared by Robert F. Brooker, Ph.D.

Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved.

Slide 18

Advertising Example 2What is the optimal strategy for Firm A if Firm B chooses not to advertise?

Firm A

Advertise Don't Advertise

Firm B Advertise Don't Advertise (4, 3) (5, 1) (2, 5) (6, 2)

Prepared by Robert F. Brooker, Ph.D.

Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved.

Slide 19

Advertising Example 2What is the optimal strategy for Firm A if Firm B chooses not to advertise? If Firm A chooses to advertise, the payoff is 5. Otherwise, the payoff is 6. In this case, the optimal strategy is not to advertise.

Firm A

Advertise Don't Advertise

Firm B Advertise Don't Advertise (4, 3) (5, 1) (2, 5) (6, 2)

Prepared by Robert F. Brooker, Ph.D.

Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved.

Slide 20

Advertising Example 2The optimal strategy for Firm A depends on which strategy is chosen by Firms B. Firm A does not have a dominant strategy.

Firm A

Advertise Don't Advertise

Firm B Advertise Don't Advertise (4, 3) (5, 1) (2, 5) (6, 2)

Prepared by Robert F. Brooker, Ph.D.

Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved.

Slide 21

Advertising Example 2What is the optimal strategy for Firm B if Firm A chooses to advertise?

Firm A

Advertise Don't Advertise

Firm B Advertise Don't Advertise (4, 3) (5, 1) (2, 5) (6, 2)

Prepared by Robert F. Brooker, Ph.D.

Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved.

Slide 22

Advertising Example 2What is the optimal strategy for Firm B if Firm A chooses to advertise? If Firm B chooses to advertise, the payoff is 3. Otherwise, the payoff is 1. The optimal strategy is to advertise.

Firm A

Advertise Don't Advertise

Firm B Advertise Don't Advertise (4, 3) (5, 1) (2, 5) (6, 2)

Prepared by Robert F. Brooker, Ph.D.

Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved.

Slide 23

Advertising Example 2What is the optimal strategy for Firm B if Firm A chooses not to advertise?

Firm A

Advertise Don't Advertise

Firm B Advertise Don't Advertise (4, 3) (5, 1) (2, 5) (6, 2)

Prepared by Robert F. Brooker, Ph.D.

Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved.

Slide 24

Advertising Example 2What is the optimal strategy for Firm B if Firm A chooses not to advertise? If Firm B chooses to advertise, the payoff is 5. Otherwise, the payoff is 2. Again, the optimal strategy is to advertise.

Firm A

Advertise Don't Advertise

Firm B Advertise Don't Advertise (4, 3) (5, 1) (2, 5) (6, 2)

Prepared by Robert F. Brooker, Ph.D.

Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved.

Slide 25

Advertising Example 2Regardless of what Firm A decides to do, the optimal strategy for Firm B is to advertise. The dominant strategy for Firm B is to advertise.

Firm A

Advertise Don't Advertise

Firm B Advertise Don't Advertise (4, 3) (5, 1) (2, 5) (6, 2)

Prepared by Robert F. Brooker, Ph.D.

Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved.

Slide 26

Advertising Example 2The dominant strategy for Firm B is to advertise. If Firm B chooses to advertise, then the optimal strategy for Firm A is to advertise. The Nash equilibrium is for both firms to advertise.

Firm A

Advertise Don't Advertise

Firm B Advertise Don't Advertise (4, 3) (5, 1) (2, 5) (3, 2)

Prepared by Robert F. Brooker, Ph.D.

Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved.

Slide 27

Prisoners DilemmaTwo suspects are arrested for armed robbery. They are immediately separated. If convicted, they will get a term of 10 years in prison. However, the evidence is not sufficient to convict them of more than the crime of possessing stolen goods, which carries a sentence of only 1 year.The suspects are told the following: If you confess and your accomplice does not, you will go free. If you do not confess and your accomplice does, you will get 10 years in prison. If you both confess, you will both get 5 years in prison.Prepared by Robert F. Brooker, Ph.D. Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 28

Prisoners DilemmaPayoff Matrix (negative values)

Confess Individual A Don't Confess

Individual B Confess Don't Confess (5, 5) (0, 10) (10, 0) (1, 1)

Prepared by Robert F. Brooker, Ph.D.

Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved.

Slide 29

Prisoners DilemmaDominant Strategy Both Individuals Confess(Nash Equilibrium)

Confess Individual A Don't Confess

Individual B Confess Don't Confess (5, 5) (0, 10) (10, 0) (1, 1)

Prepared by Robert F. Brooker, Ph.D.

Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved.

Slide 30

Prisoners DilemmaApplication: Price Competition

Firm A

Low Price High Price

Firm B Low Price High Price (2, 2) (5, 1) (1, 5) (3, 3)

Prepared by Robert F. Brooker, Ph.D.

Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved.

Slide 31

Prisoners DilemmaApplication: Price CompetitionDominant Strategy: Low Price

Firm A

Low Price High Price

Firm B Low Price High Price (2, 2) (5, 1) (1, 5) (3, 3)

Prepared by Robert F. Brooker, Ph.D.

Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved.

Slide 32

Prisoners DilemmaApplication: Nonprice Competition

Firm A

Advertise Don't Advertise

Firm B Advertise Don't Advertise (2, 2) (5, 1) (1, 5) (3, 3)

Prepared by Robert F. Brooker, Ph.D.

Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved.

Slide 33

Prisoners DilemmaApplication: Nonprice CompetitionDominant Strategy: Advertise

Firm A

Advertise Don't Advertise

Firm B Advertise Don't Advertise (2, 2) (5, 1) (1, 5) (3, 3)

Prepared by Robert F. Brooker, Ph.D.

Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved.

Slide 34

Prisoners DilemmaApplication: Cartel Cheating

Firm A

Cheat Don't Cheat

Firm B Cheat Don't Cheat (2, 2) (5, 1) (1, 5) (3, 3)

Prepared by Robert F. Brooker, Ph.D.

Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved.

Slide 35

Prisoners DilemmaApplication: Cartel CheatingDominant Strategy: Cheat

Firm A

Cheat Don't Cheat

Firm B Cheat Don't Cheat (2, 2) (5, 1) (1, 5) (3, 3)

Prepared by Robert F. Brooker, Ph.D.

Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved.

Slide 36

Extensions of Game Theory Repeated Games Many consecutive moves and countermoves by each player

Tit-For-Tat Strategy Do to your opponent what your opponent has just done to you

Prepared by Robert F. Brooker, Ph.D.

Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved.

Slide 37

Extensions of Game Theory Tit-For-Tat Strategy Stable set of players Small number of players Easy detection of cheating Stable demand and cost conditions Game repeated a large and uncertain number of times

Prepared by Robert F. Brooker, Ph.D.

Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved.

Slide 38

Extensions of Game Theory Threat Strategies Credibility Reputation Commitment Example: Entry deterrence

Prepared by Robert F. Brooker, Ph.D.

Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved.

Slide 39

Entry DeterrenceNo Credible Entry Deterrence

Firm A

Low Price High Price

Firm B Enter Do Not Enter (4, -2) (6, 0) (7, 2) (10, 0)

Credible Entry Deterrence

Firm A

Low Price High Price

Firm B Enter Do Not Enter (4, -2) (6, 0) (3, 2) (8, 0)Slide 40

Prepared by Robert F. Brooker, Ph.D.

Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved.

Entry DeterrenceNo Credible Entry Deterrence

Firm A

Low Price High Price

Firm B Enter Do Not Enter (4, -2) (6, 0) (7, 2) (10, 0)

Credible Entry Deterrence

Firm A

Low Price High Price

Firm B Enter Do Not Enter (4, -2) (6, 0) (3, 2) (8, 0)Slide 41

Prepared by Robert F. Brooker, Ph.D.

Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved.

International CompetitionBoeing Versus Airbus Industries

Boeing

Produce Don't Produce

Airbus Produce Don't Product (-10, -10) (100, 0) (0, 100) (0, 0)

Prepared by Robert F. Brooker, Ph.D.

Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved.

Slide 42

Sequential Games Sequence of moves by rivals Payoffs depend on entire sequence Decision trees Decision nodes Branches (alternatives)

Solution by reverse induction From final decision to first decisionPrepared by Robert F. Brooker, Ph.D. Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 43

High-price, Low-price Strategy GameFirm Aice h Pr Higigh H c P ri e

Firm B

$100

$100

BLow P ricee

$130

$50

ALo w Pri

ric gh P Hice

$180

$80

BLow P rice

$150

$120

Prepared by Robert F. Brooker, Ph.D.

Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved.

Slide 44

High-price, Low-price Strategy GameFirm Aice h Pr Higigh H c P ri e

Firm B

$100

$100

B

Low P

ALo w Pri ce

ric gh P Hi

B

X X

ricee

$130

$50

$180

$80

Low P

rice

$150

$120

Prepared by Robert F. Brooker, Ph.D.

Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved.

Slide 45

High-price, Low-price Strategy GameFirm Aice h Pr HigH igh

Firm B

$100

$100

A

XPri ce

c P ri

e

B

Low P

Lo w

ric gh P Hi

B

X X

ricee

$130

$50

$180

$80

Solution: Both firms choose low price.

Low P

rice

$150

$120

Prepared by Robert F. Brooker, Ph.D.

Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved.

Slide 46

Airbus and BoeingAirbus Boeing

JB

et bo J um c Cr uiser

$50

$50

0 38 AA

Soni

$120

$100

No A3 8

J mbo Ju

et

$0

$150

0

B

Soni

c Cr uiser

$0

$200

Prepared by Robert F. Brooker, Ph.D.

Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved.

Slide 47

Airbus and BoeingAirbus Boeing

JB

et bo J um

X

$50

$50

0 38 AA

Soni

c Cr uiser

$120

$100

No A3 8

J mbo Ju

0

B

X

et

$0

$150

Soni

c Cr uiser

$0

$200

Prepared by Robert F. Brooker, Ph.D.

Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved.

Slide 48

Airbus and BoeingAirbus Boeing

JB

et bo J um

X

$50

$50

0 38 AA

Soni

c Cr uiser

$120

$100

No A3 8

X

J mbo JuB

0

X

et

$0

$150

Soni

c Cr uiser

$0

$200

Solution: Airbus builds A380 and Boeing builds Sonic Cruiser.

Prepared by Robert F. Brooker, Ph.D.

Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved.

Slide 49

Integrating Case Studygh Hi

Firm Ase verti Adc Pri e A

Firm B

60

70

Not Adv er erti Adv

tise

100

50

Bric e

Lo w

se

40

60

gh P

Pri

ce

ANot A dver ti

Hi

75se

70

Ase verti AdHi gh c Pri e A Not Ae

70

50

Prepared by Robert F. Brooker, Ph.D.

w Lo ic Pr

BLo w Pri ce

dver tise

90

40

tise dver A

80

50

ANot Adv er tise

60

30Slide 50

Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved.