Copyright

2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
11-1

• The payoff to many actions will depend on
– the actions themselves.
– when the actions are taken.
– how the actions relate to those taken by others.
• An economic naturalist recognises
– the interdependencies between these three aspects of any action.
– economic decision making is a game in which strategy matters.
Copyright
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2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
11-2

• Basic elements of a game
– The players
– Their strategies
– The payoffs
• Example
– Suppose that Virgin Blue and Qantas are the only airlines that serve the Adelaide to Alice Springs market. Should
Virgin Blue spend more money on advertising?
– The outcome of each strategy by these two airlines can be represented in the form of a payoff matrix.
Copyright
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2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
11-3

The payoff matrix for an advertising game
Raise spending
Qantas’s choice
Leave spending the same
Qantas gets $3500
Qantas gets $5500
Raise spending
Virgin Blue’s choice
Virgin Blue gets
$5500
Leave spending the same
Qantas gets $8000
Virgin Blue gets
$3500
Virgin Blue gets
$8000
Qantas gets $6000
Virgin Blue gets
$6000
Copyright
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2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
11-4

• Dominant strategy
– A strategy that yields a player a higher payoff no matter what the other players in a game choose.
• Dominated strategy
– Any other strategy available to a player who has a dominant strategy.
• Nash equilibrium
– A set of strategies one for each player in which each player’s strategy is her or his best choice given the other player’s strategies.
– When each player has a dominant strategy equilibrium occurs when each player follows that strategy.
– There can be an equilibrium when players do not have a dominant strategy.
Copyright
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2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
11-5

• Do Qantas and Virgin Blue have dominant strategies?
• Does this game have a Nash equilibrium?
Copyright

2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
11-6

Qantas’s choice
Leave ad spending
Raise ad spending the same
Qantas gets $2500
Qantas gets $3000
Raise ad spending
Virgin Blue’s choice
Leave ad spending the same
Virgin Blue gets
$3500
Qantas gets $3500
Virgin Blue gets
$4000
Virgin Blue gets
$5500
Qantas gets $2000
Virgin Blue gets
$5000
Copyright

2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
11-7

What should Virgin Blue and Qantas do if their payoff matrix is modified?
Qantas’s choice
Raise ad spending
Leave ad spending the same
Qantas gets $2000
Qantas gets $3000
Raise ad spending
Virgin Blue’s choice
Leave ad spending the same
Virgin Blue gets
$3000
Qantas gets $3000
Virgin Blue gets
$2000
Virgin Blue gets
$4000
Qantas gets $4000
Virgin Blue gets
$3000
Copyright
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2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
11-8

• 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.
• Example
– Should Horace and Jasper confess?
Copyright
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2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
11-9

The payoff matrix for a prisoner’s dilemma
Confess
Horace’s choice
Remain silent
Confess
Jasper’s choice
Remain silent
Jasper gets
5 years
Jasper gets
20 years
Horace gets
5 years
Horace gets
0 years
Jasper gets
0 years
Jasper gets
1 years
Horace gets
20 years
Horace gets
1 years
Copyright

2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
11-10

• Exercise
– Holden and Ford must both decide whether to invest in a new robotic production process. The following two games show how their profits depend on the decision they might make. Which of these games is a prisoner’s dilemma?
Copyright

2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
11-11

Which of these games is a prisoner’s dilemma?
GAME 1
Don’t invest
Holden’s choice
Invest
10 for
Holden
12 for
Holden
Don’t invest
Ford’s choice
Invest
10 for
Ford
4 for
Holden
4 for
Ford
5 for
Holden
12 for
Ford
5 for
Ford
Copyright

2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
11-12

Which of these games is a prisoner’s dilemma?
GAME 2
Don’t invest
Holden’s choice
Invest
12 for
Holden
5 for
Holden
Don’t invest
4 for
Ford
5 for
Ford
Ford’s choice
10 for
Holden
4 for
Holden
Invest
10 for
Ford
12 for
Ford
Copyright

2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
11-13

• Cartel: Any group of firms that conspires to coordinate production and pricing decisions in an industry for the purpose of earning an economic profit.
– Firms agree to set a monopoly price and equal amount of quantity.
– Agreement is not legally enforceable.
– Each firm has an incentive to charge a lower price than agreed as long as that price is higher than MC .
– Captures entire quantity demanded by the market.
Copyright

2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
11-14

• Thinking as an economist
– Why are cartel agreements often unstable?
Copyright

2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
11-15

2.00
1.00
Assume
• 2 firms (Aquapure &
Mountain Spring)
• MC = 0
•
Cartel is formed & agree to split output and profits
Impact of cartel
•
Q = 1000 bottles/day
• P = $1/bottle
• Each firm makes $500/day
MR
D
2000 1000
Bottles/day
Copyright
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2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
11-16

The temptation to violate a cartel agreement
Aquapure lowers P
•
P = $.90/bottle
•
Q = 1100 bottles/day
2.00
1.00
0.90
MR
1000 1100
Bottles/day
Copyright

2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
Mountains Spring retaliates
• P = $.90/bottle
• Both firms split 1100 bottles/day at $.90
•
Profit = $495/day
D
2000
11-17

Mountain Spring’s choice
Charge $1
$500/day for
Mountain Spring
Charge $0.90
$990/day for
Mountain Spring
Charge $1
Aquapure’s choice
Charge $0.90
$500/day for
Aquapure
$0/day for
Mountain Spring
$0/day for
Aquapure
$495/day for
Mountain Spring
$990/day for
Aquapure
$495/day for
Aquapure
Copyright

2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
11-18

• Thinking as an economist
– Why do people often stand at concerts even though they can see just as well when everyone sits?
– Why do athletes use anabolic steroids when the potential risks are so high?
Copyright

2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
11-19

Standing versus sitting at a concert as a prisoner’s dilemma
Other people’s choice
Stand Sit
-$2 for others -$3 for others
Stand
-$2 for you $1 for you
Your choice
$1 for others $0 for others
Sit
-$3 for you $0 for you
Copyright
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2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
11-20

• Cooperation between players will increase the payoff in a prisoner’s dilemma.
• There is a motive to enforce cooperation.
• Repeated prisoner’s dilemma is 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.
Copyright
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2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
11-21

– Tit-for-tat strategy
 Players cooperate on the first move then mimic their partner’s last move on each successive move.
– Tit-for-tat strategy requirements
 Two players
 A stable set of players
 Players recall other players’ moves
 Players have a stake in future outcomes
Copyright
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2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
11-22

• Question
– Why is the tit-for-tat strategy unsuccessful in competitive monopolistically competitive and oligopolistic markets?
Copyright

2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
11-23

• The ultimate bargaining game
– Should Michael accept Tom’s offer?
 Rules of the game
• Experimenter gives $100 to Tom
• Tom proposes how to divide $100 with Michael
• Tom must give Michael at least $1 (X = Tom and
$100 - X = Michael)
• Michael must accept the proposal
• If he does Tom and Michael get the money
• If he does not the money goes to the experimenter
Copyright
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2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
11-24

Decision tree is a diagram that describes the possible moves in a game in sequence and lists the payoffs that correspond to each possible combination of moves.
Possible moves and payoffs
$X for Tom
$(100 – X) for Michael
Michael accepts
B A
Tom proposes
$X for himself
$(100
– X) for
Michael
Michael refuses
$0 for Tom
$0 for Michael
Copyright

2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
11-25

Tom’s best strategy in an ultimatum bargaining game
$99 for Tom
$1 for Michael
Michael accepts
A
Tom proposes
$99 for himself
$1 for Michael
B
Michael refuses
$0 for Tom
$0 for Michael
• Tom can give Michael a take it or leave it offer
• Tom will propose $1
• Michael will accept
• The outcome is a Nash equilibrium
Copyright

2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
11-26

New rule: Michael can specify in advance the minimum offer he will accept
$X for Tom
$(100 – X) for Michael
Tom proposes
$X < $(100 - Y) for himself
$(100 - X) > Y for Michael
A
Michael announces that he will reject any offer less than $Y
B
Tom proposes
$X > $(100 - Y) for himself
$(100 - X) < Y for Michael
$0 for Tom
$0 for Michael
Copyright
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2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
11-27

• A credible threat is to take an action that is in the threatener’s interest to carry out.
– Why couldn’t Michael have threatened to refuse a one-sided offer in the original version of the game?
– Why are tourists more likely than local residents to be victims of petty crime?
• A credible promise is to take an action that is in the promiser’s interest to keep.
– Should the business owner open a remote office if she has to employ a manager and believes that mangers are selfinterested income-maximisers?
Copyright

2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
11-28

Manager manages honestly; owner gets $1000 manager gets $1000
Owner opens remote office
C
Manager manages dishonestly; owner gets -$500 manager gets $1500
A
Managerial candidate promises to manage honestly
B
Owner does not open remote office
Is the outcome an equilibrium?
Owner gets $0 manager gets $500 by working elsewhere
Copyright

2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
11-29

• Commitment problem is a situation in which people cannot achieve their goals because of an inability to make credible threats or promises.
• Commitment device is a way of changing incentives so as to make otherwise empty threats or promises credible.
Copyright

2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
11-30

• Commitment problems
– Prisoner’s dilemma
– Cartels
– Remote office
• Commitment devices
– Underworld code omerta
– Military arms control agreements
– Tips for waiters
Copyright

2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
11-31

• Thinking as an economist
– How do firms achieve commitment in outsourcing arrangements?
– Will Miles leave a tip when dining at a restaurant while on holiday at a Gold Coast resort?
– How might legislation banning junk food advertising on children’s TV unwittingly solve junk food manufacturers’ prisoner’s dilemma?
Copyright

2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
11-32

• Game theory assumes that the goal of the players is to maximise their outcome.
• In most games players do not attain the best outcomes.
• Altering psychological incentives may also improve the outcome of a game.
• Question
– In an honest society will the business owner open a remote office?
Copyright

2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
11-33

The remote office game with an honest manager
The value of dishonesty to the manager is $10 000
Manager manages honestly; owner gets $1000 manager gets $1000
Owner opens remote office
C
Manager manages dishonestly; owner gets -$500 manager gets -$8500
A
Managerial candidate promises to manage honestly
B
Owner does not open remote office
Owner gets $0 manager gets $500 by working elsewhere
Copyright

2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
11-34

• Are people fundamentally selfish?
– Do you tip at out-of-town restaurants?
– What would be your first offer in the ultimatum bargaining game?
– Would you refuse a unfair offer?
– If narrow self-interest is not the only motive for making choices then the other motives must be understood to predict and explain human behaviour.
Copyright

2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
11-35

• Preferences as solutions to commitment problems
– Concerns about fairness, guilt, humour, sympathy etc. do influence the choices people make in strategic interactions.
– Commitment to these preferences must be communicated for them to influence choices.
Copyright

2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
11-36