Strategic Choice in Oligopoly,
Monopolistic Competition, and
Everyday Life
Introductory Microeconomics
1
Games and Strategic Behavior
 Thus far, we have viewed economic decision makers as
confronting an environment that is essentially passive.
 But there exist many cases in which relevant costs and
benefits depend not only on the behavior of the
decision makers themselves but also on the behavior of
others.
2
Example 11.1. Should the prisoners confess?
3
Example 11.1. Should the prisoners confess?
 Two prisoners, X and Y, are held in separate cells for a
serious crime that they did, in fact, commit.
 The prosecutor, however, has only enough hard
evidence to convict them of a minor offense, for which
the penalty is, say, a year in jail.
 Each prisoner is told that if one confesses while the
other remains silent, the confessor will go free while the
other spends 20 years in prison.
 If both confess, they will get an intermediate sentence,
say five years.
4
Example 11.1. Should the prisoners confess?
 It is often convenient to summarize the elements of a
game in the form of a payoff matrix.
 Three elements:
1. Players (2 prisoners)
2. Strategies (confess, remain silent)
3. Payoffs (jail sentences)
5
Example 11.1. Should the prisoners confess?
Prisoner Y
Confess
Confess
5 years
for each
Remain Silent
0 years for X
20 years for Y
Prisoner X
Remain
Silent
20 years for X
0 years for Y
1 year
for each
The two prisoners are not allowed to communicate with one another.
If the prisoners are rational and narrowly self-interested, what will they do?
6
Example 11.1. Should the prisoners confess?
Prisoner Y
Confess
Confess
5 years
for each
Remain Silent
0 years for X
20 years for Y
Prisoner X
Remain
Silent
20 years for X
0 years for Y
1 year
for each
Dominant Strategy:
One that yields a higher payoff
no matter what the other
players in a game choose.
Their dominant strategy is
to confess.
No matter what Y does, X
gets a lighter sentence by
speaking out.
1. If Y too confesses, X gets
five years instead of 20.
2. And if Y remains silent, X
goes free instead of spending
a year in jail.
The payoffs are perfectly
symmetric, so Y also does
better to confess, no matter
what X does.
7
Example 11.1. Should the prisoners confess?
 The difficulty is that when each behaves in a selfinterested way, both do worse than if each had shown
restraint.
 Thus, when both confess, they get five years, instead of
the one year they could have gotten by remaining silent.
 And hence the name of this game, prisoner's
dilemma.
8
Example 11.2.
 Why did students have to wait in line overnight
to buy Cornell hockey tickets?
9
Example 11.2.
 Each year Cornell announced a time at which its ticket
window would open for the sale of a limited number of
hockey tickets for students.
Students showed up
more than 24 hours in
advance to wait in line
for these tickets, even
though no more tickets
were available that way
than if everyone had
shown up only 1 hour
in advance.
10
Example 11.2.
 Suppose that if everyone shows up one hour in advance,
everyone has a 50-50 chance of getting a ticket, and
that the odds of getting a ticket are the same if
everyone shows up 24 hours in advance.
 If you show up 24 hours in advance and everyone else
shows up one hour in advance, you are sure to get a
ticket.
 But if you show up 1 hour in advance and others show
up 24 hours in advance, you have no chance to get a
ticket.
 The same applies to other students.
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Example 11.2.
 Waiting only one hour has no cost to you. But you
would be willing to pay $40 to avoid having to wait 24
hours.
 A 50-50 chance of getting a ticket is worth $50 to you
and a 100 percent chance of getting a ticket is worth
$100.
 Other students value these outcomes just as you do.
What will happen?
12
Example 11.2.
 Your payoff if you and others arrive 24 hours early:
0.50 ($100)
(expected value of ticket)
-
$40
=
(waiting cost)
$10
13
Example 11.2.
Others
Arrive 24
hours early
Arrive 24
hours early
$10 for
everyone
Arrive 1
hour early
$60 for you
0 for others
You
Arrive 1
hour early
0 for you
$60 for others
$50 for
everyone
Everyone's dominant strategy is to come 24 hours early,
and so this is the equilibrium outcome of the game.
But it would be better if everyone came one hour early.
14
Example 11.3.
 Why do hockey players vote in secret ballots for helmet
rules, even though they choose not to wear helmets
when there is no rule?
15
Example 11.3.
 Consider two hockey teams-- say, the Bruins and
Rangers-- each of whose players can choose to wear
helmets or not.
 Not wearing a helmet increases the odds of winning,
perhaps by making it slightly easier to see and hear, or
perhaps by intimidating opposing players (on the view
that it is not safe to challenge someone who is crazy
enough to go without a helmet).
16
Example 11.3.
At the same time, not
wearing a helmet increases
the odds of getting hurt.
If players value the higher
odds of winning more than
they value the extra safety,
explain why they will choose
not to wear helmets, even
though the odds of winning
when players on both sides
wear helmets are no different
from the odds when no one
wears helmets.
17
Example 11.3.
The dominant strategy for each team is to go without
helmets, even though this combination of choices is worse
for both teams than the alternative in which each team
wears helmets.
Bruin s
W ear
Helmets
Ran gers
W ear
Helmets
S econd best
for each
Don't W ear Best for Rangers
W orst for Bruins
Helmets
Don't W ear
Helmets
Best for Bruins
W orst for Rangers
T hird best
for each
18
Example 11.4. Why do people shout at
cocktail parties?
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Example 11.4.
Why do people shout at cocktail parties?
 Whenever large numbers of people gather for
conversation in a closed space, the ambient noise level
rises sharply.
 After attending such gatherings, people often complain
of sore throats and hoarse voices from having to speak
so loudly to be heard.
20
Example 11.4.
Why do people shout at cocktail parties?
 If everyone instead spoke at a normal voice level at
cocktail parties, they would avoid these symptoms.
 And because the overall noise level would be lower,
they would hear just as well as when they all shout at
one another.
So why shout?
21
Example 11.4.
Why do people shout at cocktail parties?
The dominant strategy for everyone is to speak more loudly.
But when all follow their dominant strategies, we get a worse outcome
than if everyone had continued speaking normally.
Other Conversation Pairs
Speak normally
Speak normally
Second best
for you and others
Speak more loudly
Best for others
Worst for you
You an d your partn er
Speak more loudly
Best for you
Worst for others
T hird best
for you and others
22
Nash Equilibrium
Nash equilibrium:
a combination of strategies
such that each player's
strategy is the best he/she can
choose given the strategy
chosen by the other player.
John F. Nash Jr.
The Sveriges Riksbank Prize in Economic Sciences in
Memory of Alfred Nobel 1994
23
Nash equilibrium in prisoner’s dilemmas
In prisoner's dilemmas, the Nash equilibrium
occurs when each player plays his dominant
strategy.
Many games have a Nash equilibrium, even
though not every player has a dominant strategy.
Other Conversation Pairs
Speak normally
Speak normally
Second best
for you and others
Speak more loudly
Best for others
Worst for you
You an d your partn er
Speak more loudly
Best for you
Worst for others
T hird best
for you and others
24
Example 11.5.
Should American spend more on advertising?
 Suppose that United Airlines and American are the only
carriers that serve the Chicago-St. Louis market.
25
Example 11.5.
Should American spend more on advertising?
If the relevant payoffs are as shown, does United have a
dominant strategy? Does American?
American
Raise ad
Leave spending
spending
the same
Raise ad
spending
$3000 for U
$8000 for A
$8000 for U
$4000 for A
$4000 for U
$5000 for A
$5000 for U
$2000 for A
United
Leave spending
the same
26
Example 11.5.
Should American spend more on advertising?
American 's dominant strategy is to raise its ad spending.
United, however, does not have a dominant strategy.
American
Raise ad
Leave spending
spending
the same
Raise ad
spending
$3000 for U
$8000 for A
$8000 for U
$4000 for A
$4000 for U
$5000 for A
$5000 for U
$2000 for A
United
Leave spending
the same
27
Example 11.5.
Should American spend more on advertising?
If each firm does the best it can, given what it knows
about the incentives facing the other, what will happen in
this game?
American
Raise ad
spending
Since United can
Raise ad
predict that American
spending
will follow its dominant
strategy, United's best United
move is to leave its
own ad spending the Leave spending
the same
same.
Leave spending
the same
$3000 for U
$8000 for A
$8000 for U
$4000 for A
$4000 for U
$5000 for A
$5000 for U
$2000 for A
The Nash equilibrium is that American will Raise ad spending and
United will leave spending the same.
28
Example 11.6.
Should Michael accept Tom's offer?
 Tom and Michael are subjects in an experiment.
 The experimenter begins by giving $100 to Tom, who must then
propose how to divide the money between himself and Michael.
 He can propose any division he chooses, provided the proposed
amounts are integers and he offers Michael at least one dollar.
 Suppose he proposes $X for himself and $(100-X) for Michael.
Michael must then say whether he accepts the proposal.
 If he does, they each get the amounts proposed.
 But if Michael rejects the proposal, each player gets zero, and the
$100 reverts to the experimenter.
 It is common knowledge that Tom and Michael will play this game
only once and that each has the goal of making as much money for
himself as possible.
What should Tom propose?
29
Example 11.6.
Should Michael accept Tom's offer?
 Unlike earlier games, the timing of each player’s decision in this
game is important.
 The payoffs for this game are better represented in a game tree,
rather than a payoff matrix.
$X for Tom
$(100-X) for
Michael
Tom proposes
$X for himself,
$(100-X) for
Michael
A
Michael accepts
B
Michael refuses
$0 for Tom
$0 for Michael
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Example 11.6.
Should Michael accept Tom's offer?
 Suppose Tom proposes $99 for himself, $1 for Michael.
$99 for Tom
$1 for Michael
Tom proposes
$99 for himself,
$1 for Michael
A
Michael accepts
B
Michael refuses
$0 for Tom
$0 for Michael
This is the most advantageous offer Tom can make, and at point B,
Michael's best bet is to accept it.
Michael's problem is that he cannot make a credible threat to refuse
Tom's one-sided offer.
31
Example 11.7. Should the business owner
open a distant branch?
 The owner of a thriving local business wants to start up
a satellite outlet in a distant city.
32
Example 11.7. Should the business owner
open a distant branch?
 If the outlet is managed honestly, the owner can pay the manager
$1000 per week and still earn an economic profit of $1000 per
week from the outlet.
 The manager’s best alternative employment pays $500 per week.
 The owner's concern is that she will not be able to monitor the
behavior of the outlet manager, and that this person would
therefore be in a position to embezzle heavily from the business.
 The owner knows that if the distant outlet is managed dishonestly,
the manager can earn $1500 per week, while causing the owner a
financial loss of $500 per week.
If the owner believes that all managers are selfish income-maximizers,
will she open the new outlet?
33
Example 11.7. Should the business owner
open a distant branch?
First step: Construct the game tree for the distant-outlet game .
$1000 for owner
$1000 for manager
manage honestly
Managerial
candidate
promises to
manage
honestly
A
C
manage dishonestly
-$500 for owner
Open distant outlet
$1500 for manager
B
Don’t open outlet
Owner gets $0
Manager gets $500
for working elsewhere
34
Example 11.7. Should the business owner
open a distant branch?
To predict how game will play out, work backward from end of the tree.
$1000 for owner
$1000 for manager
manage honestly
Managerial
candidate
promises to
manage
honestly
A
C
manage dishonestly
-$500 for owner
Open distant outlet
$1500 for manager
B
Don’t open outlet
Owner gets $0
Manager gets $500
for working elsewhere
35
Example 11.7. Should the business owner
open a distant branch?
If the outlet is opened, the manager must decide at C whether to
manage honestly.
$1000 for owner
$1000 for manager
manage honestly
C
manage dishonestly
-$500 for owner
Open distant outlet
$1500 for manager
If his only goal is to make as much money for himself as he can, he will
manage dishonestly (bottom branch at C), since that way he earns $500
more than by managing honestly (top branch at C).
So if the owner opens the new office, she will end up with a financial loss
of $500.
36
Example 11.7. Should the business owner
open a distant branch?
If instead she had chosen not to open the office (bottom branch at
point B), she would have ended up with a financial return of zero.
Open outlet
Owner gets -$500
Manager gets $1500
B
Don’t open outlet
Owner gets $0
Manager gets $500
for working elsewhere
And since zero is better than -$500, she will choose not to open the
satellite office.
37
Example 11.7. Should the business owner
open a distant branch?
Even though opening the outlet and managing it honestly would be
better for both the owner and manager, purely self-interested
persons cannot achieve this outcome.
$1000 for owner
$1000 for manager
manage honestly
Managerial
candidate
promises to
manage
honestly
A
C
manage dishonestly
-$500 for owner
Open distant outlet
$1500 for manager
B
Don’t open outlet
Owner gets $0
Manager gets $500
for working elsewhere
38
A Thought Experiment
 I have just gotten home from a crowded concert and
discover I have lost $1000 in cash. The cash had been
in my coat pocket in a plain envelope with my name
and address written on it.
 Do you know anyone who you feel certain would return
it to me if he or she found it?
39
Resolving Prisoner's Dilemmas and Other
Commitment Problems
 In games like the prisoner's dilemma, the hockey
helmet game, the ultimatum bargaining game, and the
satellite office game, players have trouble arriving at
the outcomes they desire because they are unable to
make credible commitments.
40
Resolving Prisoner's Dilemmas and Other
Commitment Problems
 For example, if both players in the prisoner's dilemma
could somehow reach a binding agreement to remain
silent, each would be assured of getting a shorter
sentence.
Hence the logic of the
underworld code of
Omerta, under which the
family of anyone who
provided evidence against
a fellow mob member
would be killed.
41
Resolving Prisoner's Dilemmas and Other
Commitment Problems
Likewise, the helmet rule results in a better outcome for
hockey players by committing them to wear helmets in
circumstances in which they would otherwise choose not to
do so.
42
Example 11.8. Will the restaurateur pay the
waiter extra to provide good service?
The restaurateur wants his waiter to provide
good service so that customers will enjoy their
meals and come back in the future.
If the waiter provides good service, the owner
can pay him $100 per day.
But if the waiter provides bad service, the most
he can pay the waiter is $60 per day.
The waiter is willing to provide bad service for
$60 per day, and for $30 extra would be willing
to provide good service.
The owner's problem is that he cannot tell
whether the waiter has provided good service.
43
Example 11.8. Will the restaurateur pay the
waiter extra to provide good service?
Restaurateu r
P ay waiter
$100/day
P rovide
S econd best
good service
for each
Waiter
P rovide bad Best for waiter
W orst for owner
service
P ay waiter
$60/day
Best for owner
W orst for waiter
T hird best
for each
Each side has a dominant strategy:
Restaurateur- pay $60/day; waiter- provide bad service.
Outcome is lower-right cell and that is inefficient.
The tip is a solution to this commitment problem.
44
Changing material incentive as a solution to
commitment problem
 The Mafia's code of silence, hockey helmet rules, tips
for waiters -- all work by changing the material
incentives facing the relevant decision makers.
 But it is not always practical to changes material
incentives in precisely the desired ways.
45
Example 11.9. Tipping
 What if the restaurant is located in a distant city the
diner doesn’t expect to visit again?
46
Example 11.9. Tipping
 Unlike case of restaurant with local patrons, this waiter has no way
to penalize the diner in the future if he leaves no tip.
Diner
Leave
15% tip
P rovide
S econd best
good service
for each
Waiter
P rovide bad Best for waiter
W orst for diner
service
Leave
no tip
Best for diner
W orst for waiter
T hird best
for each
Dominant strategy for the waiter: provide bad service.
Dominant strategy for diner: leave no tip.
Again a worse outcome for each than if waiter had provided good
service and diner had tipped.
47
Moral Sentiments as Commitment Devices
 If commitment problems cannot be solved by altering
the relevant material incentives, it may nonetheless be
possible to solve them by altering people's psychological
incentives.
 For example, feelings of guilt when they cause harm to
others, feelings of sympathy for the interests of their
trading partners, feelings of outrage when they are
treated unjustly, and so on.
 These feelings may lessen the incentive to behave in
opportunistic and mutually destructive ways.
48
Two Standards of Rationality
1. The Self-interest Standard:
 A person is rational if she is efficient in pursuit of
her own interests.
 The self-interest model is often not descriptive.
Return wallets
Rescues
Bone marrow
donation
Blood donation
49
Two Standards of Rationality
2. The Adaptive Rationality Standard:
 A taste can be added to the self-interest model, but
only upon a plausible showing that someone
motivated by that taste would not be handicapped
in the quest to acquire the resources needed for
survival and reproduction..
Return wallets
Rescues
Bone marrow
donation
Blood donation
50
The Possibility of Honest Managers
 If the owner believes that the managerial candidate
comes from a society whose members have been
strongly conditioned to behave honestly, will she open
the new office?
51
The Possibility of Honest Managers
 Suppose that the effect of the conditioning is to cause
the managerial candidate to be willing to pay $10,000
to avoid the guilt he would feel if he managed
dishonestly.
52
The Possibility of Honest Managers
Manager manages
honestly.
Owner gets $1000,
manager gets $1000
C
Owner opens
satellite office
Managerial
candidate
promises to
manage
honestly
Manager manages
dishonestly.
Owner gets -$500,
manager gets -$8500
Owner does not
open satellite office
Owner gets $0,
Manager gets $500 by
working elsewhere
53
A taste
 A taste for actions that result in avoidable costs cannot
be favored by natural selection unless others can infer
the presence of that taste.
54
Who are more likely to be honest (i.e. , to have
a taste of honesty)?
 The person is very religious, e.g., buddhist, christian,
etc.
 The person listens to classical music.
 The person belongs to some hiking club.
 The person is more educated, e.g., holds higher degree,
such as PhD in Economics.
 The person has gotten a written recommendation from
Mr. Li Ka Shing.
55
End
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