Microeconomic Analysis

ECON 520 - SS 22
KFUPM - Fall-22
Dr. Muhammad Imran Chaudhry, CFA
 Overview-Game Theory
• Strategic considerations in many facets of life, from the
mundane to the pivotal:
– Contributions towards public goods, installing exhaust in your car,
business strategy, raising children and arms race.
• Common element to these interactions:
– You do not operate in a vacuum, but surrounded by active
decision makers whose choices interact with your choices.
• Over the next few weeks we develop the tools to study
outcomes in situations of strategic interdependence:
– Dealing with competitive situations where outcomes of our
actions depend on choices of others and vice versa.
– Game theory is the formal discipline to deal with situations of
strategic interdependence.
 Overview-Game Theory
• Game theory is an analytical tool that allows manager to
“systematically ”deal with situations characterized by
strategic interdependence.
• Game theoretic analysis has two dimensions:
– Science: mathematical foundations to get a firm grip over
elementary concepts.
– Art: Modeling human behavior and life is complex, often no
“correct” answers but only imperfect ways to deal with
problems.
• Assumptions implicit in game theoretic analysis:
– People are (generally) not stupid (all the time)! Or in other
words behave like rational economic agents most of the time.
 Business Relevance
• Businesses face two types of uncertainties:
– Uncertainty about the state of nature e.g. how much oil in a well etc.
– Competitive uncertainty: strategic behavior of other firms.
• Being able to put yourself in the other person’s shoes, understanding how
other player plays a game greatly increases your chances of success.
• Analyzing a strategic interaction:
– Success of a strategy hinges upon the “anticipating” and optimally
“reacting” to competitors actions. Whenever facing a strategic
situation have a precise question in mind e.g. “lower prices or not”,
“enter market or not” and etc.
• Price setting dynamics between Coke & Pepsi in 1980s:
– Both better off without reducing prices, but in the absence of trust,
self interest dictates lowering prices.
 Example-Prisoner’s Dilemma Game
• A two-player, simultaneous-move game that offers insights into the
optimal decisions of firms in oligopolistic markets.
– Two robbers, person-A and person-B, are arrested by police, and placed in a
different prison cell, so that they cannot see or talk to one another.
– The investigating officer has no clear implicating evidence, and explains
(separately) to person-A and person-B :
• If person-A confesses and person-B does not confess, than person-A will be
set free as part of a plea-bargain and person-B will face 15 years in prison.
• If both confess, then both will have to face a prison sentence of 8 years.
• If both don’t confess, then both will face a prison sentence of only 1 year.
• If person-B confesses and person-A does not confess, than person-B will be
set free as part of a plea-bargain and person-A will face 15 years in prison.
– Note that payoff of each player (person-A or person-B) is interlinked i.e.,
depends on action of the other player, in addition to his own actions.
 Primers of Game Modeling
– Who are the players in the game?
– What are the actions available to each player &
what is the timing of those actions?
• Sequential or Simultaneous move games
– What information is available to each player?
• Perfect or imperfect information e.g. are the players
actions observable or are players types observable?
– What are the different strategies (combinations of
actions) and the associated pay-offs.
 Example-Prisoner’s Dilemma Game
• In order to solve this game (i.e., strategic interaction) we utilize
a simple payoff matrix:
– The equilibrium outcome (also known as Nash Equilibrium) is that both
person-A and person-B confess to the crime. Why?
• For each person, regardless of whether the other person confesses or does
not confess, he earns a higher pay-off (for himself) by confessing. In simple
words confessing is the dominant strategy of each player.
• Paradoxically, as each person plays his dominant strategy, both are worse
off than they could have been if they did not use their dominant strategy!!
– More generally, in a prisoner’s dilemma, each player has two available
actions to cooperate or to defect, and defect is dominant strategy for all
players.
• Pursuit of one’s own self-interest does not lead to an outcome that is best
for all, or oneself, in such situations!! What about invisible hand theorem?
 Prisoner’s Dilemma Definitions
• Dominant Strategy: A player is said to have a dominant
strategy if his payoff from that strategy is better than
his payoffs from all his other available strategies, no
matter what strategy the other player chooses.
• Rule #1: Players always play their dominant strategy.
– Or equivalently players never play their dominated strategy
• Prisoner’s Dilemma: When both players use their
dominant strategy, both are worse off than they would
have been if they could “jointly” & “credibly” agree
not to use their dominant strategy.
 Application-Prisoner’s Dilemma Game
• Assume that only two firms sell oil in a market. If both produce
“high” output, each earns a profit of $8 million. If both produce
“low” output, each earns profits of $10 million. If one produces
“high” output and the other produces “low” output, than firm
with “low” output gets $7 million and firm with “high” output
makes $12 million. Let’s find the equilibrium of this game?
– Who are the players? What are the available actions? What’s timing of
actions? Associated pay-offs?
– In a Nash equilibrium, both firms produce “high” output leading to low
profits. Intuitively, why does this happen?
– There is a tension between personal incentives and collective interests.
• Cartels are not stable! Thus, exercise caution before attributing
suboptimal economic phenomena to cartels.
– PPA, Cement and Fertilizer Sector in Pakistan? OPEC, internationally?
 Relevance of Prisoner’s Dilemma Game
• Many business contexts but one underlying concept:
– Production in excess of allocated quotas e.g. OPEC.
• Dynamics are complicated, we will see by playing an in-class game today.
– Prices wars between two firms e.g. Pepsi vs Coke.
• Price wars often lead to marginal cost pricing.
– Over exploitation of natural resources e.g. fisheries.
• If all fishermen fish conservatively, and a given fisherman goes for a bigger
catch, he can make higher profits without depleting fisheries.
• If all fishermen think like this and fish aggressively, then a single fisherman
would be a fool to try conservation single handedly!
– In the above situations there is some type of strategic interdependence
between the payoffs of economic agents.