CHAPTER 10

Game Theory: Inside Oligopoly

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 Learning Objectives
1. Apply normal form and extensive form
representations of games to formulate decisions in
strategic environments that include pricing,
advertising, coordination, bargaining, innovation,
product quality, monitoring employees, and entry.
2. Distinguish among dominant, secure, Nash, mixed,
and subgame perfect equilibrium strategies, and
identify such strategies in various games.
3. Identify whether cooperative (collusive) outcomes
may be supported as a Nash equilibrium in a
repeated game, and explain the roles of trigger
strategies, the interest rate, and the presence of
an indefinite or uncertain final period in achieving
such outcomes.
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 Overview of Games and Strategic Thinking

Overview of Games and Strategic

Thinking
• Game theory is a general framework to aid
decision making when agents’ payoffs depends
on the actions taken by other players.
• Games consist of the following components:
– Players or agents who make decisions.
– Planned actions of players, called strategies.
– Payoff of players under different strategy scenarios.
– A description of the order of play.
– A description of the frequency of play or interaction.

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 Overview of Games and Strategic Thinking

Order of Decisions in Games is

Important
• Simultaneous-move game
– Game in which each player makes decisions
without the knowledge of the other players’
decisions.
– Bertrand duopoly game
• Sequential-move game
– Game in which one player makes a move after
observing the other player’s move.

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 Overview of Games and Strategic Thinking

Frequency of Interaction in Games

• One-shot game
– Game in which players interact to make decisions
only once.
• Repeated game
– Game in which players interact to make decisions
more than once.

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 Simultaneous-Move, One-Shot Games

Simultaneous-Move, One-Shot
Games: Theory
• Strategy
– Decision rule that describes the actions a player
will take at each decision point.
• Normal-form game
– A representation of a game indicating the players,
their possible strategies, and the payoffs resulting
from alternative strategies.

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 Simultaneous-Move, One-Shot Games

Normal-Form Game
Set of players Player B’s strategies

Player B
Player B’s
Strategy Left Right possible
Player A payoffs
Up 10, 20 15, 8 from
strategy
Down -10 , 7 10, 10 “right”

Player A’s strategies

Player A’s possible payoffs
from strategy “down”

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 Simultaneous-Move, One-Shot Games

Possible Strategies
• Dominant strategy
– A strategy that results in the highest payoff to a
player regardless of the opponent’s action.
• Secure strategy
– A strategy that guarantees the highest payoff given
the worst possible scenario.
• Nash equilibrium strategy
– A condition describing a set of strategies in which
no player can improve her payoff by unilaterally
changing her own strategy, given the other players’
strategies.

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 Simultaneous-Move, One-Shot Games

Dominant Strategy

Player B

Strategy Left Right

Player A
Up 10, 20 15, 8

Down -10 , 7 10, 10

Player A has a dominant strategy: Up

Player B has no dominant strategy

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 Simultaneous-Move, One-Shot Games

Secure Strategy

Player B
Strategy
Strategy Left Right
Player A
Up 10, 20 15, 8

Down -10 , 7 10, 10

Player A’s secure strategy: Up … guarantees at least a $10 payoff

Player B’s secure strategy: Right … guarantees at least an $8 payoff

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 Simultaneous-Move, One-Shot Games

Nash Equilibrium Strategy

Player B
Strategy Left
Left Right
Right
Player A
Up 10, 20 15, 8

Down -10 , 7 10, 10

A Nash equilibrium results when Player A’s plays “Up”

and Player B plays “Left”

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 Simultaneous-Move, One-Shot Games

Application of One-Shot Games:

Pricing Decisions
Firm B
Strategy Low price High price
Firm A
Low price 0, 0 50, -10

High price -10 , 50 10, 10

A Nash equilibrium results when both players charge “Low price”

Payoffs associated with the Nash equilibrium is inferior from the
firms’ viewpoint compared to both “agreeing” to charge
“High price”: hence, a dilemma.

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 Simultaneous-Move, One-Shot Games

Application of One-Shot Games:

Advertising and Quality Decisions
Firm B
Strategy Advertise Don’ Advertise
Firm A
Advertise $4, $4 $20, $1

Don’t $1 , $20 $10, $10

Advertise

• A Nash equilibrium results when both firms “Advertise”

• Collusion would not work because this is a one-shot game; if you
and your rival “agreed” not to advertise each of you would have an
incentive to cheat on the agreement.

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 Simultaneous-Move, One-Shot Games
Application of One-Shot Games:
Coordination Decisions
Firm B
Strategy 120-Volt Outlets 90-Volt Outlets
Firm A
120-Volt Outlets $100, $100 $0, $0

90-Volt Outlets $0 , $0 $100, $100

There are two Nash equilibrium outcomes associated with this game:
Equilibrium strategy 1: Both players choose 120-volt outlets
Equilibrium strategy 2: Both players choose 90-volt outlets
Ways to coordinate on one equilibrium:
1) permit player communication 2) government set standard
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 Simultaneous-Move, One-Shot Games
Application of One-Shot Games:
Monitoring Employees
Worker
Strategy Monitor Don’t Monitor
Manager
Monitor -1, 1 1, -1
Don’t Monitor 1, -1 -1, 1

There are no Nash equilibrium outcomes associated with this game.

Q: How should the agents play this type of game?
A: Play a mixed (randomized) strategy, whereby a player randomizes
over two or more available actions in order to keep rivals from
being able to predict his or her actions.
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 Simultaneous-Move, One-Shot Games
Application of One-Shot Games:
Nash Bargaining
Union
Strategy 0 50 100

Management 0 0, 0 0, 50 0, 100

50 50 , 0 50, 50 -1, -1

100 100, 0 -1, -1 -1, -1

There three Nash equilibrium outcomes associated with this game:

Equilibrium strategy 1: Management chooses 100, union chooses 0
Equilibrium strategy 2: Both players choose 50
Equilibrium strategy 3: Management chooses 0, Union chooses 100

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 Infinitely Repeated Games

Infinitely Repeated Games: Theory

• An infinitely repeated game is a game that is
played over and over again forever, and in
which players receive payoffs during each play
of the game.
• Disconnect between current decisions and
future payoffs suggest that payoffs must be
appropriately discounted.

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 Infinitely Repeated Games

Review of Present Value

• When a firm earns the same profit, 𝜋, in each
period over an infinite time horizon, the
present value of the firm is:
1+𝑖
𝑃𝑉𝐹𝑖𝑟𝑚 = 𝜋
𝑖

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 Infinitely Repeated Games

Supporting Collusion with Trigger

Strategies
Firm B
Strategy Low price High price
Firm A
Low price 0, 0 50, -40

High price -40 , 50 10, 10

The Nash equilibrium to the one-shot, simultaneous-move

pricing game is: Low, Low
When this game is repeatedly played, it is possible for firms to
collude without fear of being cheated on using trigger strategies.
Trigger strategy: strategy that is contingent on the past play of a
game and in which some particular past action “triggers” a different
action by a player.
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 Infinitely Repeated Games

Supporting Collusion with Trigger

Strategies
Firm B
Strategy Low price High price
Firm A
Low price 0, 0 50, -40

High price -40 , 50 10, 10

• Trigger strategy example: Both firms charge the high price, provided
neither of us has ever “cheated” in the past (charge low price).
If one firm cheats by charging the low price, the other player will
punish the deviator by charging the low price forever after.
• When both firms adopt such a trigger strategy, there are conditions
under which neither firm has an incentive to cheat on the collusive
outcome.
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 Infinitely Repeated Games

Sustaining Cooperative Outcomes

with Trigger Strategies
• Suppose a one-shot game is infinitely repeated and the
interest rate is 𝑖. Further, suppose the “cooperative”
one-shot payoff to a player is 𝜋 𝐶𝑜𝑜𝑝 , the maximum one-
shot payoff if the player cheats on the collusive outcome
is 𝜋 𝐶ℎ𝑒𝑎𝑡 , the one-shot Nash equilibrium payoff is 𝜋 𝑁 ,
𝜋𝐶ℎ𝑒𝑎𝑡 −𝜋𝐶𝑜𝑜𝑝 1
and 𝐶𝑜𝑜𝑝 𝑁 ≤ .
𝜋 −𝜋 𝑖

Then the cooperative (collusive) outcome can be

sustained in the infinitely repeated game with the
following trigger strategy: “Cooperate provided that no
player has ever cheated in the past. If any player cheats,
“punish” the player by choosing the one-shot Nash
equilibrium strategy forever after.
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 Infinitely Repeated Games
Supporting Collusion with Trigger
Strategies In Action
Firm B
Strategy Low price High price
Firm A
Low price 0, 0 50, -40
High price -40 , 50 10, 10

Suppose firm A and B repeatedly play the game above, and the
interest rate is 40 percent. Firms agree to charge a high price in
each period, provided neither has cheated in the past.
Q: What are firm A’s profits if it cheats on the collusive agreement?
A: If firm B lives up to the collusive agreement but firm A cheats,
firm A will earn $50 today and zero forever after.
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 Infinitely Repeated Games
Supporting Collusion with Trigger
Strategies in Action
Firm B
Strategy Low price High price
Firm A
Low price 0, 0 50, -40
High price -40 , 50 10, 10

Q: What are firm A’s profits if it does not cheat on the collusive
agreement?
10 10 10 1+0.4
A: 10 + + +⋯= = $35
1+0.4 1+0.4 2 0.4

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 Infinitely Repeated Games
Supporting Collusion with Trigger
Strategies in Action
Firm B
Strategy Low price High price
Firm A
Low price 0, 0 50, -40
High price -40 , 50 10, 10

Q: Does an equilibrium result where the firms charge the high price
in each period?
A: Since $50 > $35, the present value of firm A’s profits are higher
if A cheats on the collusive agreement. In equilibrium both firms
will charge low price and earn zero profit each period.

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 Infinitely Repeated Games

Factors Affecting Collusion in

Pricing Games
• Sustaining collusion via trigger strategies is
easier when firms know:
– who their rivals are, so they know whom to
punish, if needed.
– who their rival’s customers are, so they can “steal”
those customers with lower prices.
– when their rivals deviate, so they know when to
begin punishment.
– be able to successfully punish rival.

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 Infinitely Repeated Games
Factors Affecting Collusion in
Pricing Games
• Number of firms in the market
• Firm size
• History of the market
• Punishment mechanisms

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 Finitely Repeated Games

Finitely Repeated Games

• Finitely repeated games are games in which a
one-shot game is repeated a finite number of
times.
• Variations of finitely repeated games: games in
which players
– do not know when the game will end
– know when the game will end

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 Finitely Repeated Games

Games with an Uncertain Final Period

Firm B
Strategy Low price High price
Firm A
Low price 0, 0 50, -40
High price -40 , 50 10, 10

Suppose the probability that the game will end after a given play is
𝜃, where 0 < 𝜃 < 1.
An uncertain final period mirrors the analysis of infinitely repeated
games. Use the same trigger strategy.
No incentive to cheat on the collusive outcome associated with a
finitely repeated game with an unknown end point above, provided:
𝐶ℎ𝑒𝑎𝑡 10
Π𝐴 = 50 ≤ = Π𝐴 𝐶𝑜𝑜𝑝
𝜃
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 Finitely Repeated Games

Repeated Games with a Known Final

Period: End-of-Period Problem
Firm B
Strategy Low price High price
Firm A
Low price 0, 0 50, -40
High price -40 , 50 10, 10

When this game is repeated some known, finite number of times

and there is only one Nash equilibrium, then collusion cannot work.
The only equilibrium is the single-shot, simultaneous-move Nash
equilibrium; in the game above, both firms charge low price.

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 Finitely Repeated Games

Applications of the End-of-Period

Problem
• Resignations and Quits
• The “Snake-Oil” Salesman

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 Multistage Games

Multistage Games: Theory

• Multistage games differ from the previously
examined games by examining the timing of
decisions in games.
– Players make sequential, rather than simultaneous,
decisions.
– Represented by an extensive-form game.
• Extensive form game
– A representation of a game that summarizes the
players, the information available to them at each
stage, the strategies available to them, the sequence
of moves, and the payoffs resulting from alternative
strategies.

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 Multistage Games
Theory: Sequential-Move Game in
Extension Form
Player A payoff Player B payoff
(10,15)
Decision node
denoting the
beginning of the
game B

(5,5)
A
(0,0)

Player A feasible strategies:

Up B
Down Player B’s decision nodes
Player B feasible strategies: (6,20)
Up, if player A plays Down and Down, if player A plays Down
Up, if player A plays Up and Down, if player A plays Up
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 Multistage Games

Equilibrium Characterization

(10,15)

(5,5)
A
(0,0)

Nash Equilibrium
Player A: Down B
Player B: Down, if player A chooses Up,
and Down if Player A chooses Down
Is this Nash equilibrium reasonable? (6,20)
No! Player B’s strategy involves a non-credible threat since if A plays Up,
B’s best response is Up too!
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 Multistage Games

Subgame Perfect Equilibrium

• A condition describing a set of strategies that
constitutes a Nash equilibrium and allows no
player to improve his own payoff at any stage
of the game by changing strategies.

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 Multistage Games

Equilibrium Characterization

(10,15)

(5,5)
A
(0,0)

B
Subgame Perfect Equilibrium
Player A: Up
Player B: Up, if player A chooses Up,
(6,20)
and Down if Player A chooses Down

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 Multistage Games
Application of Multistage Games:
Nash Equilibrium I:
The Entry Game
Player A: Out (−1,1)
Player B: Hard, if player A chooses In
Non-credible, threat since if A plays
In, B’s best response is Soft
B

(5,5)
A

Nash Equilibrium II:

Player A: In
Player B: Soft, if player A chooses In
Credible. This is subgame perfect equilibrium.

(0,10)
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