1. Chapter ElevenCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 1 Chapter 11 Game Theory and Asymmetric Information

2. Chapter ElevenCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 2 Overview Game theory Game theory and auctions Strategy and game theory Asymmetric information Reputation Standardization Market signaling

3. Chapter ElevenCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 3 Game theory  Economic optimization has two shortcomings when applied to actual business situations assumes factors such as reaction of competitors or tastes and preferences of consumers remain constant managers sometimes make decisions when other parties have more information about market conditions

4. Chapter ElevenCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 4 Game theory  Game theory: is concerned with “how individuals make decisions when they are aware that their actions affect each other and when each individual takes this into account”

5. Chapter ElevenCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 5 Game theory  Fundamental aspects of game theory players are interdependent uncertainty: other players’ actions are not entirely predictable  Types of games zero-sum or non-zero-sum cooperative or non-cooperative two-person or n-person

6. Chapter ElevenCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 6 Games in economics  Prisoners’ Dilemma two-person, non-zero- sum, non-cooperative always has a dominant strategy equilibrium is stable  confessing is dominant strategy for each player, no matter what other player chooses  each player has no incentive to unilaterally change his strategy

7. Chapter ElevenCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 7 Games in economics Oligopoly pricing using prisoners’ dilemma (Low/Low) is a stable equilibrium … no incentive for either firm to deviate better off at (High/High) but it is not stable … each firm has an incentive to deviate (High/High) would be an equilibrium … if the firms were allowed to cooperate

8. Chapter ElevenCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 8 Games in economics  Example: Beach Kiosk Game: a two- person, zero-sum, non-cooperative game Suppose two companies provide snacks and sunscreen on a beach  beachgoers will spread themselves out evenly along the beach  both companies ultimately locate at the midpoint of the beach, otherwise the other company has an advantage (closer to more beachgoers Real life example: location of gas stations

9. Chapter ElevenCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 9 Games in economics  Repeated Game: game is played repeatedly over a period of time in a perpetual repeated game, equilibria that are not stable may become stable due to the threat of retaliation however, if number of periods is fixed, players will have incentive to ‘cheat’ in the last period due to lack of threat of retaliation, which will then allow them to cheat in all periods

10. Chapter ElevenCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 10 Games in economics Example: assume (High, High) equilibrium reached and both firms start off charging the high price  in the next period, if one firm cheats (charges low price), it receives 600 in that period  other firm will change to low prices in the next period to ‘retaliate’ and both will end up at (Low, Low) equilibrium  thus, incentive exists not to cheat in a perpetual repeated game and (High, High) is a viable equilibrium (unlike in the short game)

11. Chapter ElevenCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 11 Games in economics  Simultaneous games are games in which players make their strategy choices at the same time  Sequential games are games in which players make their decisions sequentially In sequential games, the first mover may have an advantage

12. Chapter ElevenCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 12 Games in economics  Consider the following payoff matrix in which firms choose their capacity, either high or low. Suppose firm C has the ability to move first  C would choose Low, then D would choose High

13. Chapter ElevenCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 13 Game theory and auctions  Dutch auction (a non-cooperative, non-zero- sum game): each buyer describes the quantity demanded and price to pay starting at highest price, sum quantity demanded up to the supply available all product is sold at the highest price that clears the market Seller wants to sell at highest price, buyer wants to buy at lowest price Solution: every player’s dominant strategy is to bid as late as possible

14. Chapter ElevenCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 14 Strategy and game theory  Problem: in Prisoners’ Dilemma, players have a dominant strategy that leads to suboptimal results Commitment, explicit or implicit, can be used to achieve preferred outcomes. It must be credible: burn bridges behind you establish and use a reputation write contracts

15. Chapter ElevenCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 15 Strategy and game theory Incentives also can be used to change the game to achieve preferred outcomes Illustration: GM card. GM came up with a strategy where customers could apply 5% of their purchases to a GM vehicle Illustration: Health insurance. Firms provide a menu of care levels.

16. Chapter ElevenCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 16 Strategy and game theory  PARTS: paradigm for studying a situation, predicting players’ actions, making strategic decisions Players: Who are players and what are their goals? Added Value: What do the different players contribute to the pie? Rules: What is the form of competition? Time structure of the game? Tactics: What options are open to the players? Commitments? Incentives? Scope: What are the boundaries of the game?

17. Chapter ElevenCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 17 Asymmetric information  Asymmetric information: market situation in which one party in a transaction has more information than the other party. Leads to many problems in markets: too much or too little production difficult contracting possible fraud market may disappear

18. Chapter ElevenCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 18 Asymmetric information  Adverse selection: prior to transaction, one party may know more about the value of a good than the other Example: ‘lemons’ (bad used cars)… seller knows the vehicle well, but buyer does not, yet market does not divide in two

19. Chapter ElevenCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 19 Asymmetric information  Moral Hazard: transaction changes the incentives of a party because it cannot be monitored after the transaction Example: insurance industry... poor information takes place after the sale, not before

20. Chapter ElevenCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 20 Asymmetric Information  Market responses: obtaining information from third parties relying on reputation of the seller standardization of products market signaling: demonstrated success in one activity provides information about success/quality in another

21. Chapter ElevenCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 21 Asymmetric Information  Example: education as a signal attending college demonstrates certain traits employers see this a screening device

22. Chapter ElevenCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 22 Asymmetric Information  Example: warranties more costly on low quality goods than high quality goods consumers see them as a screening device

23. Chapter ElevenCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 23 Asymmetric Information  Example: banking systems banks know less about the borrower’s ability to repay than the customer arms length banking: US relationship banking: Japan