Revision presentation

2. Game Theory Revision
Using Ideas from Game Theory in
your A Level Economics

3. Key Concepts – Game Theory
Cooperative outcome An equilibrium where the players agree to cooperate
Dominant strategy
A dominant strategy is one where a single strategy is best
for a player regardless of what strategy other players in the
game decide to use
Nash equilibrium
Any situation where all participants in a game are pursuing
their best possible strategy given the strategies of all of the
other participants
Tacit collusion
Where firms undertake actions that are likely to minimize a
competitive response, e.g. avoiding price-cutting or not
attacking each other’s market
Whistle blowing
When one or more agents in a collusive agreement report
it to the authorities
Zero sum game
An economic transaction in which whatever is gained by
one party must be lost by the other.

4. Topical Applications of Game Theory
Tacit Collusion between
Firms in an Oligopoly
Patent Races / Innovation
Effort / Product Testing
Central Bank Currency
Policy - Intervention
Business reactions to the
new UK Living Wage
Market Entry / Exit
Decisions
Auction Tactics e.g.
bidding for a franchise

5. Game Theory – The Prisoner’s Dilemma
M: Months
Y: Years
Prisoner B
Silent Betray
Prisoner A
Silent (6M,6M) (10Y,0)
Betray (0,10Y) (5Y,5Y)
Comment on the best strategies for each player and the
likely outcome in this game

6. Game Theory – The Prisoner’s Dilemma
M: Months
Y: Years
Prisoner B
Silent Betray
Prisoner A
Silent (6M,6M) (10Y,0)
Betray (0,10Y) (5Y,5Y)
Comment on the best strategies for each player and the
likely outcome in this game
• The prisoner’s dilemma is
a game that illustrates
why it is difficult to
cooperate, even when it is
in the best interest of
both parties.
• Both players are assumed
to select their own
dominant strategies for
personal gain / self-
interest.
• Eventually, they reach an
equilibrium in which they
are both worse off than
they would have been, if
they could both agree to
select an alternative (non-
dominant) strategy.

7. Game Theory: A Simple Pricing Game
Firm B (right hand figures below)
Expected
Profit ($bn)
High Prices Low Prices
Firm
A
High Prices $3bn; $3bn $0bn, $5bn
Low Prices $5bn; $0bn $1bn, $1bn
In this two firm game, they have to decide whether to set high or low prices
The table shows the profits (pay-offs) that results from each set of choices
The grid above shows a pay-off matrix – it shows a simple pricing game between firm A
and firm B. They are assumed to choose their prices at the same time

8. A Simple Pricing Game
Firm B (right hand figures below)
Expected
Profit ($bn)
High Prices Low Prices
Firm
A
High Prices $3bn; $3bn $0bn, $5bn
Low Prices $5bn; $0bn $1bn, $1bn
To understand the game we isolate one firm and assume that Firm B makes the
first decision. Assume that each firm is a (rational) profit maximiser.
The grid above shows a pay-off matrix – it shows a simple pricing game between firm A
and firm B. They are assumed to choose their prices at the same time

9. A Simple Pricing Game
Firm B (right hand figures below)
Expected
Profit
($bn)
High Prices Low Prices
Firm
A
High Prices $3bn; $3bn $0 bn, $5bn
Low Prices $5bn; $0bn $1bn, $1bn
In this game, regardless of what the other firm decides to do, the best response
of the other firm is to charge a lower price – they may settle at this low price
The grid above shows a pay-off matrix – it shows a simple pricing game between firm A
and firm B. They are assumed to choose their prices at the same time

10. Pricing Game – Incentives to Collude
Firm B (right hand figures below)
Profit $bn High Prices Low Prices
A
High Prices $3bn; $3bn $0 bn, $5bn
Low Prices $5bn; $0bn $1bn, $1bn
If these firms got together and decided to collude by both setting a high price,
then both of them would earn higher total profits – this is pareto optimal
The grid above shows a pay-off matrix – it shows a simple pricing game between firm A
and firm B. They are assumed to choose their prices at the same time

11. Game Theory in the Global Oil Market

12. Game Theory in the Global Oil Market

13. Game Theory in the Global Oil Market

14. Real World Examples of Price Wars
Low cost
airlines
Supermarket
petrol retailers
Mobile phone
tariffs
Price wars and impact on suppliers
Supermarket price war squeezes small supplier profit margins by a third
A report published in November 2015 found that small suppliers with an annual
turnover below £25m lack the negotiating power of big rivals and as a result, their
profit margins have fallen in one year from 3.5% to 2.1%. By contrast, at the
biggest food companies, whose turnover tops £1bn, margins increased from 5.2%
to 5.4% last year

15. Non-Price Competition – Marketing Spend
In this case, the dominant strategy is to advertise, and this would be a Nash equilibrium.
The grid above shows a simple game between two firms competing for the same
customers who must decide whether to launch an expensive advertising campaign
Firm B
Advertise Don’t Advertise
Firm A
Advertise (£6m, £6m) (£8m, £3m)
Don’t Advertise (£3m, £8m) (£5m, £5m)

16. Highest UK Advertising Spending in 2014
221
172
146
140
107
102
86
79
77
75
74
71
68
68
63
0 50 100 150 200 250
British Sky Broadcasting
Procter & Gamble
BT
Unilever UK
Asda Stores
Tesco
Virgin Media
Wim Morrison Supermarkets
Reckitt Benckiser UK
DFS Furniture Co
Sainsburys Supermarkets
TalkTalk Group
McDonald's Restrs
Aldi
Jd Williams & Co
Spending in £ million in 2014

17. Examples of First Mover Advantage
Just Eat Golden Leaf
Holdings
Oculus Rift Spotify
Amazon Web
Services
Infrastructure
Investment Banks
AWS has become the biggest technology
infrastructure provider in the world — and
it is also the fastest growing and most
profitable part of Amazon

18. Evaluating First Mover Advantage
Advantages of being the first mover
• A business first into the market can develop a significant
competitive advantage through learning by doing - making it
difficult and costly for new firms/rivals to enter
• They can exploit internal economies of scale (leading to lower
LRAC) and also build brand loyalty/ repeat demand
• Consumer behaviour can become habitual – hard to eat into!
Critical evaluation points
• Employees from first mover may leave to set up challenge brands –
taking some of the intellectual capital with them
• First movers are often unprofitable, the failure rate can be high
• Second-movers can learn much from first mover mistakes
• First scaler advantage may be more important than first mover

19. Evaluating First Mover Advantage
Advantages of being the first mover
• A business first into the market can develop a significant
competitive advantage through learning by doing - making it
difficult and costly for new firms/rivals to enter
• They can exploit internal economies of scale (leading to lower
LRAC) and also build brand loyalty/ repeat demand
• Consumer behaviour can become habitual – hard to eat into!
Possible first mover disadvantage?
• Employees from first mover may leave to set up challenge brands –
taking some of the intellectual capital with them
• First movers are often unprofitable, the failure rate can be high
• Second-movers can learn much from first mover mistakes
• First-scaler advantage may be more important than first mover

20. Evaluating Relevance of Game Theory
• Game theory becomes relevant to analysing business
decision making when there are relatively few firms
• Standard game theory assumes rational agents are
looking to maximise their own self-interest
• More complex game theory reveals that people /
businesses can develop co-operative / collaborative
behaviours e.g. the rise of joint ventures / altruism
• Repeated games are different from one –shot games
• Key evaluation point for the exam: Game theory can
over-simplify complex decisions, and when there are
more than two rival firms in a market the degree of
complexity increases. Many firms fall back on heuristics