MicroEconomics theory and application 12th by browning an zupan chapter 14

Prepared by Dr. Della Lee Sue, Marist College

MICROECONOMICS: Theory & Applications
Chapter 14: Game Theory and the Economics of
Information
By Edgar K. Browning & Mark A. Zupan
John Wiley & Sons, Inc.
12th Edition, Copyright 2015

Copyright © 2015 John Wiley & Sons, Inc. All rights reserved.


Learning Objectives





Understand the basics of game theory: a mathematical technique to
study choice under conditions of strategic interaction.
Describe the prisoner’s dilemma and its applicability to oligopoly
theory as well as many other situations.
Explore how the outcome in the case of a prisoner’s dilemma differs in
a repeated-game versus a single-period setting.
Analyze asymmetric information and market outcomes in the case
where consumers have less information than sellers.
(continued)

Copyright © 2015 John Wiley & Sons, Inc. All rights reserved.

2

Learning Objectives

(continued)



Explain how insurance markets may function when information is
imperfect and there is the possibility of either adverse selection or moral
hazard.



Show how limited price information affects price dispersion for a
product.



Investigate advertising and the extent to which it serves to artificially
differentiate products versus provide information to consumers about
the availability of products and their prices and qualities.

Copyright © 2015 John Wiley & Sons, Inc. All rights reserved.

3


Understand the basics of game theory: a mathematical technique to study
choice under conditions of strategic interaction.

14.1 GAME THEORY

Copyright © 2015 John Wiley & Sons, Inc. All rights reserved.

4


Game Theory


Game theory – a method of analyzing situation in which the outcomes
of your choices depend on others’ choices, and vice versa



Elements common to all game theory:




Players – decision makers whose behavior we are trying
to predict and/or explain
Strategies – the possible choices of the players
Payoffs – the outcomes or consequences of the strategies
chosen

Copyright © 2015 John Wiley & Sons, Inc. All rights reserved.

5

Determination of Equilibrium


Payoff matrix – a simple way of representing how each combination of
choices affects players’ payoffs in a game theory setting



Dominant strategy – a case where a player is better off adopting a
particular strategy regardless of the strategy adopted by the other player



Dominant-strategy equilibrium – the simplest game theory outcome,
resulting from both players having dominant strategies

Copyright © 2015 John Wiley & Sons, Inc. All rights reserved.

6


Table 14.1

Copyright © 2015 John Wiley & Sons, Inc. All rights reserved.

7

Nash Equilibrium


Definition: a set of strategies such that each player’s choice is the best
one possible given the strategy chosen by the other player(s)



All dominant-strategy equilibria are Nash equilibria.



Not all Nash equilibria are dominant-strategy equilibria.



Not all games have a Nash equilibria.



Nash equilibrium is closely related to the analysis of the Cournot
oligopoly model.

Copyright © 2015 John Wiley & Sons, Inc. All rights reserved.

8


Table 14.2 - Nash Equilibrium

Copyright © 2015 John Wiley & Sons, Inc. All rights reserved.

9


Describe the prisoner’s dilemma and its applicability to oligopoly theory
as well as many other situations.

14.2 THE PRISONER’S DILEMMA
GAME

Copyright © 2015 John Wiley & Sons, Inc. All rights reserved.

10


The Prisoner’s Dilemma Game


The most famous game theory model in which self-interest on the part
of each player leads to a result in which all players are worse off than
they could be if different choices were made.



Dominant-strategy equilibrium



Nash equilibrium



Wide-applicability

Copyright © 2015 John Wiley & Sons, Inc. All rights reserved.

11


Table 14.3

Copyright © 2015 John Wiley & Sons, Inc. All rights reserved.

12


The Prisoner’s Dilemma and Cheating
by Cartel Members


Outcome: each party acts in their own self-interest, resulting in all
parties being worse off



Alternative plan: all parties agree to collude



Two strategies for each party:





Comply – maximizes combined profit for parties
Cheat – stronger incentive for each party with potential
for larger individual profit but lower combined profit

Success of collusive agreement depends on:



Enforceability
Number of parties

Copyright © 2015 John Wiley & Sons, Inc. All rights reserved.

13


Table 14.4

Copyright © 2015 John Wiley & Sons, Inc. All rights reserved.

14


Table 14.5

Copyright © 2015 John Wiley & Sons, Inc. All rights reserved.

15


Explore how the outcome in the case of a prisoner’s dilemma differs in a
repeated-game versus a single-period setting.

14.3 REPEATED GAMES

Copyright © 2015 John Wiley & Sons, Inc. All rights reserved.

16


Repeated Games


Repeated Game Model – a game theory model in which the “game”
is played more than once



“Tit-for-tat” – a strategy in which each player mimics the action
taken by the other player in the preceding period; 2 alternatives:
comply, cheat



Outcome:
 Cheating in current period can result in losses in subsequent
period
 Disincentive to cheat
 Strengthens incentive to collude

Copyright © 2015 John Wiley & Sons, Inc. All rights reserved.

17


Table 14.6

Copyright © 2015 John Wiley & Sons, Inc. All rights reserved.

18


Do Oligopolistic Firms Always
Collude?


Restrictive assumptions underlying Repeated Prisoner’s Dilemma
Game:
 Only two firms
 No entry into the market
 Firms have identical costs
 Firms produce the same product
 Each firm has complete knowledge of both firms’ payoffs for all
strategy combinations

 Demand and cost conditions do not vary over time
 The game is repeated indefinitely



Relaxing any assumption weakens the stability of collusive behavior in
an oligopolistic industry.

Copyright © 2015 John Wiley & Sons, Inc. All rights reserved.

19


Game Theory and Oligopoly: A
Summary


Game theory – provides a technique that is suited to investigate
strategic interactions between oligopolies



No general theory of oligopoly exists

Copyright © 2015 John Wiley & Sons, Inc. All rights reserved.

20


Analyze asymmetric information and market outcomes in the case where

consumers have less information than sellers.

14.4 ASYMMETRIC INFORMATION

Copyright © 2015 John Wiley & Sons, Inc. All rights reserved.

21


Asymmetric Information


Imperfect information – the case when market participants lack some
information relevant to their decisions



Asymmetric information – a case in which participants on one side of
the market know more about a good’s quality than do participants on
the other side


The “Lemons” Model

Copyright © 2015 John Wiley & Sons, Inc. All rights reserved.

22


The “Lemons” Model



Market application: pre-owned cars



Long-run outcome: low-quality cars tend to drive out high-quality cars
in the presence of asymmetric information



Market responses:






availability of information can increase market
efficiency
information is scarce and, consequently, costly
 Benefit from information will not always be worth
the cost
it might be efficient for consumers to be less than fully
informed
Copyright © 2015 John Wiley & Sons, Inc. All rights reserved.

23

Explain how insurance markets may function when information is
imperfect and there is the possibility of either adverse selection or moral
hazard.

14.5 ADVERSE SELECTION AND
MORAL HAZARD

Copyright © 2015 John Wiley & Sons, Inc. All rights reserved.

24


Adverse Selection


Adverse selection – a situation in which asymmetric information
causes higher-risk customers to be more likely to purchase or sellers to
be more likely to supply low-quality goods



Application – insurance markets in which the assumption of full
information (both firms and customers know the risks) is modified



Possible outcome – higher-risk customers tend to be insured and lowerrisk customers choose to remain uninsured

Copyright © 2015 John Wiley & Sons, Inc. All rights reserved.

25