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Lecture Principles of microeconomics - Chapter 10: Thinking strategically

This chapter introduces you to strategic thinking and how to use game theory to model economic behaviour. You will learn that making self-interested choices sometimes leaves you worse off than you would expect. | Thinking Strategically Slide 10 - What is Chapter 10 about? Slide 10 - I. The Theory of Games Slide 10 - Why do economists study “games” ? In a perfectly competitive market, each firm must take the market price as a given Only decision = how much to produce No longer run feedback from that decision, hence no strategic choices exist at firm level But many (most) markets are not like that When firm can influence market price, firm knows this will affect behavior of other firms – which will influence future markets Strategic choices now have to be made Slide 10 - Theory of Games The payoff of many actions depends upon the actions of others Imperfectly competitive firm must weigh the responses of rivals when deciding whether to cut prices Implication: decisions of competing firms are interdependent Game theory now dominates economic analysis of industrial organization Slide 10 - Elements of a Game Basic elements The players The strategies The payoffs Payoff matrix A . | Thinking Strategically Slide 10 - What is Chapter 10 about? Slide 10 - I. The Theory of Games Slide 10 - Why do economists study “games” ? In a perfectly competitive market, each firm must take the market price as a given Only decision = how much to produce No longer run feedback from that decision, hence no strategic choices exist at firm level But many (most) markets are not like that When firm can influence market price, firm knows this will affect behavior of other firms – which will influence future markets Strategic choices now have to be made Slide 10 - Theory of Games The payoff of many actions depends upon the actions of others Imperfectly competitive firm must weigh the responses of rivals when deciding whether to cut prices Implication: decisions of competing firms are interdependent Game theory now dominates economic analysis of industrial organization Slide 10 - Elements of a Game Basic elements The players The strategies The payoffs Payoff matrix A table that describes the payoffs in a game for each possible combination of strategies Slide 10 - Strategies Dominant strategy: A strategy that yields 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: Any combination of strategies in which each player’s strategy is his best choice, given the other players’ strategies Slide 10 - Table 10.1 The Payoff Matrix for an Advertising Game Slide 10 - Am I better off if .? Note that each player is better off if they increase ad spending, under either possible choice of their opponent Greater ad spending is a dominant strategy Slide 10 - Table 10.2 The Payoff Matrix for an Advertising Game When One Player Lacks a Dominant Strategy Slide 10 - II. The Prisoner’s Dilemma Slide 10 - Prisoner’s Dilemma Prisoner’s Dilemma: Each player has a dominant strategy The dilemma is: Payoffs are smaller than they would