Game Theory

Basics of Game Theory
Giacomo Bacci and Luca Sanguinetti

Department of Information Engineering University of Pisa, Pisa, Italy {giacomo.bacci,luca.sanguinetti}@iet.unipi.it
April - May, 2010
G. Bacci and L. Sanguinetti (IET)
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Outline
Economic applications
Cournot model of duopoly Bertrand model of duopoly Stackelberg model of duopoly Collusion between Cournot duopolists Cournot competition under asymmetric information
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Common problems
Consider a group of rms in an industry competing for the market.
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Common problems
Consider a group of rms in an industry competing for the market. Many though questions to answer... How does the outcome depends on the rms output, rms nature, cost functions and the number of rms? Will the benets of competition be passed on to customers? Will a reduction in the number of rms generate a less desirable outcome? Many others come to mind... The rst economist attempting to answer some of these questions was Cournot (1838).
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Cournot model of oligopoly

Introduction
Cournot anticipated the notion of Nashs equilibrium in 1838. For simplicity, we focus on a particular model of duopoly in which two rms produce the same product in two dierent quantities, i.e., q1 and q2 . The goal of each rm is to maximize its prot. For rm 1, we have that
u1 (q1 , q2 ) = q1 P (Q) C1 (q1 ) where P (Q) is the inverse demand function and C1 (q1 ) is its cost while
Q = q1 + q2
is the rms total output.
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Cournot model of duopoly

Problem formulation
The question we pose ourselves is simply: What are the optimal quantities chosen simultaneously maximizing prots?
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Problem formulation
The question we pose ourselves is simply: What are the optimal quantities chosen simultaneously maximizing prots? Assume each rms cost per unit is the same (no variable costs)
C1 (q1 ) = c q1 If some xed costs are present, then
with 0 c < a.
C1 (q1 ) =
0 f + c q1
if q1 = 0 if q1 > 0
with 0 c < a and f > 0. For simplicity, in the sequel we concentrate on the rst case.
G. Bacci and L. Sanguinetti (IET) Basics of Game Theory April - May, 2010 5 / 53

Problem formulation
Suppose the inverse demand function is given by (
P (Q ) =
aQ 0
if Q < a if Q a.
with a being the price at which customers are willing to pay the product.
P(Q) a
Under the above circumstances, a response can be easily found.


Game formulation
Translate the problem into a strategic form.
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Game formulation
Translate the problem into a strategic form. Players: rms 1 and 2 Strategies: quantities qi [0, +), i = {1, 2} Utilities: each rms prot is given by q1 (a c Q) cq1 q2 (a c Q) cq2 if Q a if Q > a if Q a if Q > a
u1 (q1 , q2 ) =
u2 (q1 , q2 ) =
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Firms prot
Firms prot as a function of q1 for a given q2 with a = 100 and c = 10.
2500 q =0
2
2000 1500 1000 500 0 500 1000 1500 2000
q2 = 20 q2 = 60 q = 95
2
20
40
60
80
100
120
140
160
180
200
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Nash equilibrium
Nash equilibria are such that
` ` , q\i ui qi , q\ ui qi i
qi 0.
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Nash equilibrium
Nash equilibria are such that
` ` , q\i ui qi , q\ ui qi i
qi 0.
The best response procedure is used to nd Nash equilibria, i.e.,
` qi = arg max ui qi , q\ i .
0qi <
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Nash equilibrium
Consider rm 1 and assume q2 is given. Then,
q1 = arg max u1 (q1 , q2 ) 0q1 <
with
u1 (q1 , q2 ) = q1 (a c q1 q2 ).
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Nash equilibrium
Consider rm 1 and assume q2 is given. Then,
q1 = arg max u1 (q1 , q2 ) 0q1 <
with
u1 (q1 , q2 ) = q1 (a c q1 q2 ).
How to solve the problem?
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Nash equilibrium
When q2 < a c, take the derivate with respect to q1 and set it to zero. This yields
a c q2 2q1 = 0.
The best response function is then given by

a c q2 . 2
q1 =
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Nash equilibrium
When q2 < a c, take the derivate with respect to q1 and set it to zero. This yields
a c q2 2q1 = 0.
The best response function is then given by

a c q2 . 2
q1 =
On the other hand, when q2 a c the maximum is achieved for
q1 = 0 since in these circumstances the prot becomes a negative-decreasing function.


Nash equilibrium
Consider rm 2. Then, we have that
q2 = arg max u1 (q1 , q2 ) 0q2 <
with
, q2 ) = q2 (a c q1 q2 ) u2 (q1
from which using the same arguments it follows that 8 < :

1 2 (a c q1 ) if q1 <ac if q1 ac
q2 =
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Nash equilibrium
The Nash equilibrium is found looking for the solution of the following system 8 a c q2 > <q1 = 2 a c q1 > :q2 = 2
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Nash equilibrium
The Nash equilibrium is found looking for the solution of the following system 8 a c q2 > <q1 = 2 a c q1 > :q2 = 2 Solving the above system yields ac 3
q1 = q2
qc =
from which it follows that
u1 (q1 , q2 ) = u2 (q1 , q2 )=
(a c)2 . 9
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Nash equilibrium
Nash equilibria can also be found graphically. Assume rm 1s strategy satises q1 < a c, rm 2s best response is a c q1 . 2
R2 (q1 ) = If q1 a c, it takes the form
R2 (q1 ) = 0.
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Nash equilibrium
R2(q1)
a c 2
a c
q1
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Nash equilibrium
If q2 < a c, then rm 1s best response is a c q2 . 2
R1 (q2 ) =
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Nash equilibrium
If q2 < a c, then rm 1s best response is a c q2 . 2
R1 (q2 ) =
When q2 a c, it follows that
R1 (q2 ) = 0.
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Nash equilibrium
q2
a c
a c 2
R1(q2)
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Nash equilibrium
The Nash equilibria are given by the intersection points.
q2
a c
a c 2 a c 3
a c a c 3 2
a c
q1
A unique Nash equilibrium exists.


Asymmetric costs
What does it happen if ci (qi ) = ci ?
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Asymmetric costs
What does it happen if ci (qi ) = ci ? Following the same arguments yields 8 < :
1 2
(a c1 q2 ) 0
if q2 a c1 otherwise
R1 (q2 ) =
and
R2 (q1 ) =
8 < :
1 2
(a c2 q1 ) 0
if q1 a c2 otherwise
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Asymmetric costs
If c1 < 1 (a + c2 ) then 2
q2
a c1
a c2 2
a c1 2
a c2
q1
A unique Nash equilibrium exists given by 1 (a 2c1 + c2 ) 3 1 (a 2c2 + c1 ) 3

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q1 =
and
q2 =

Nash equilibrium
If c1 1 (a + c2 ) then 2
q2
a c2 2 a c1
a c1 2
a c2
q1
A unique Nash equilibrium exists given by 1 (a c2 ) 2

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q1 =0
and
q2 =
Cournot model of monopoly

Problem formulation and solution
What if is there only one rm in the market (monopoly)?
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What if is there only one rm in the market (monopoly)? The market price is now given by P (Q ) = a q
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What if is there only one rm in the market (monopoly)? The market price is now given by P (Q ) = a q
A single-user optimization problem arises. The rm is better o producing ac 2
q = yielding the following monopoly prot
qm
u(qm )=
(a c)2 . 4
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Cournot model
Duopoly vs. monopoly
Assume q1 = q2 = qm /2 = (a c)/4. Each rms prot is then given by
u1 (q1 , q2 ) = u2 (q1 , q2 ) =
1 (a c)2 . 8
The above prot exceeds the Nash equilibrium prot, i.e., 1 1 (a c)2 > (a c)2 . 8 9 Both rms would be better o cooperating.
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Cournot model
Assume q1 = q2 = qm /2 = (a c)/4. Each rms prot is then given by
u1 (q1 , q2 ) = u2 (q1 , q2 ) =
1 (a c)2 . 8
The above prot exceeds the Nash equilibrium prot, i.e., 1 1 (a c)2 > (a c)2 . 8 9 Both rms would be better o cooperating. Why do they not cooperate at the equilibrium?
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The problem is that qi = qm /2 is not the best response to q\i = qm /2! Indeed, when q2 = qm /2 we have that
u1 (q1 , q2 )
3 = q1 (a c) q1 4
from which it follows that 1 3 (a c) > (a c). 8 4
q1 =
But if q1 = 3(a c)/8 then
q2 =
1 5 (a c) > (a c). 16 4
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q2
a c
a c
q1
The procedure converges to the Cournot Nash equilibrium.
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Bertrand model of duopoly

Problem formulation
Assume now that rms choose prices rather than quantities (Bertrands - 1883). Consider two rms selling dierentiated products in the same market, using two dierent prices, i.e., p1 and p2 . The quantity that consumers demand from each rm is a function of both its price and its competitors. As in the Cournot model, assume no xed costs of production and simultaneous actions.
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Game formulation
Translate the above problem into a strategic game.
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Game formulation
Translate the above problem into a strategic game. Players: rms 1 and 2
Strategies: prices pi [0, +), i = {1, 2}
Utilities: each rms prot. For rm 1, we have that
u1 (p1 , p2 ) = q1 (p1 , p2 ) (p1 c) where q1 = a p1 + b p2 is the quantity that consumers demand from rm 1 while b > 0 reects the extent to which rm is product is a substitute for rm 2s product.

Nash equilibrium
The price p1 is the best response to p 2 if

p 1 = arg max u1 (p1 , p2 ) = arg max (a p1 + b p2 )(p1 c) 0p1 < 0p1 <
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Nash equilibrium

The solution is found as follows du1 (p1 , p 2) = a 2p 1 + b p2 + c = 0. dp1 p1 = p

1
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Nash equilibrium

The solution is found as follows du1 (p1 , p 2) = a 2p 1 + b p2 + c = 0. dp1 p1 = p

1
Paralleling the steps for p 2 , it is found that Nash equilibria have to satisfy 8 1 > <p1 = 2 (a + c + b p2 )
> : (a + c + b p p2 = 1 1) 2
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Nash equilibrium
The solution is found to be a+c , 2b
p i =
i = 1, 2
from which it follows that b 2 (otherwise the prices would be negative). What happens if b = 0?
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Nash equilibrium
The solution is found to be a+c , 2b
p i =
i = 1, 2
from which it follows that b 2 (otherwise the prices would be negative). What happens if b = 0? The Bertrand equilibrium yields the monopoly quantity, i.e., no player interaction.
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Stackelberg model of duopoly

Problem formulation
Stackelberg (1934) proposed a dynamic model of duopoly a leader moves rst, and a follower moves second. Assume for simplicity the rms choose quantities (Cournot model). The fundamental dierence is that here the rms choices are sequential rather than simultaneous.
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Problem formulation
The timing of the Stackelberg model is as follows: rm 1 chooses a quantity q1 0; rm 2 observes q1 and then chooses a quantity q2 0; the payo of rm i {1, 2} is given by the prot function
` ui qi , q\i = qi (P (Q) c) where
P (Q) = a qi q\i and c < a is the constant marginal cost (xed costs are zero).
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Game formulation
Translate the above problem into an extensive game. Players: the leader (rm 1) and the follower (rm 2);
Terminal histories: (q1 , q2 ), with q1 , q2 0;
Player function: P () = leader, P (q1 ) = follower;
` ` Payos: ui qi , q\i = qi (p c) = qi a c qi q\i
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Subgame perfect equilibrium
Apply the backward-induction procedure.
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Apply the backward-induction procedure. Compute rst rm 2s reaction to an arbitrary quantity q1 by rm 1:
R2 (q1 ) = arg max

0q2 <
u2 (q1 , q2 ) = arg max

0q2 <
q2 (a c q1 q2 ).
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R2 (q1 ) = arg max

0q2 <
u2 (q1 , q2 ) = arg max

0q2 <
q2 (a c q1 q2 ).
This yields the same result obtained for the strategic Cournot game, i.e., a c q1 2
R2 (q1 ) = provided that q1 < a c.
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R2 (q1 ) = arg max

0q2 <
u2 (q1 , q2 ) = arg max

0q2 <
q2 (a c q1 q2 ).
This yields the same result obtained for the strategic Cournot game, i.e., a c q1 2
R2 (q1 ) = provided that q1 < a c.
The dierence is that R2 (q1 ) is now rm 2s reaction to rm 1s observed quantity.
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Firm 1 knows that q1 will be met with reaction R2 (q1 ). Then, rm 1s problem in the rst stage of the game amounts to solving
q1 = arg max 0q1 <
u1 (q1 , R2 (q1 )) = arg max

0q1 <
q1 [a c q1 R2 (q1 )]
= arg max
0q1 <
q1
a c q1 . 2
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Firm 1 knows that q1 will be met with reaction R2 (q1 ). Then, rm 1s problem in the rst stage of the game amounts to solving
q1 = arg max 0q1 <
u1 (q1 , R2 (q1 )) = arg max

0q1 <
q1 [a c q1 R2 (q1 )]
= arg max
0q1 <
q1
a c q1 . 2
Solving the above problem yields

q1 =
ac . 2
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Then, in the Stackelberg game we have that

q1 =
ac 2
and
q2 =
ac . 4
Firm 1s prot results given by 1 (a c)2 8
u1 (q1 , q2 )=
while rm 2s prot is 1 (a c)2 . 16
u1 (q1 , q2 )=
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Stackelberg vs. Cournot
By contrast in the strategic Cournot game each rm produces 1 (a c) 3
qc =
and each prot is given by (a c)2 . 9
u1 (qc , qc ) = u2 (qc , qc )=
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Then, rm 1 is better o in the subgame perfect equilibrium, i.e., (a c)2 (a c)2 > u1 (qc , qc )= . 8 9
u1 (q1 , q2 )=
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Then, rm 1 is better o in the subgame perfect equilibrium, i.e., (a c)2 (a c)2 > u1 (qc , qc )= . 8 9
u1 (q1 , q2 )=
On the other hand, rm 2 is always worse o (a c)2 (a c)2 < u2 (qc , qc )= . 16 9
u2 (q1 , q2 )=
Dierently from single-player problems, in multi-player problems more information can make a player worse o. What is the impact of this information? Just try to remove it.
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Consider rm 2 chooses q2 without observing q1 . What happens now? Firm 2 has to form a belief.
If rm 2 supposes that rm 1 will choose its Stackelberg quantity, then q2 = (a c)/4.
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But rm 1 knows that rm 2 will have this belief, then it prefers to choose its best response to (a c)/4. This yields 3 (a c) 8
q1 =
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But rm 1 knows that rm 2 will have this belief, then it prefers to choose its best response to (a c)/4. This yields 3 (a c) 8
q1 =
Firm 2 knows this and then prefers to choose its best response to 3(a c)/8, i.e., 5 (a c) 16
q2 =
Iterating this procedure, we end up with the Cournot equilibrium!

Collusion between Cournot duopolists

Problem formulation
Consider again a Cournot model for duopoly without a leader and a follower.
If qi = qc = (a c)/3
` ui qi , q\i
while if qi = qm /2 = (a c)/4
uc =
1 (a c)2 9
` ui qi , q\i Although
um 1 = (a c)2 . 2 8
1 1 (a c)2 > (a c)2 8 9

the absence of cooperation leads both rms to choose qi = qc .

Problem formulation
How to force cooperation in the Cournot model? Playing the game repeatedly! Friedman (1971) showed that cooperation could be achieved in an innitely repeated game by using trigger strategies. The original application was for a Cournot duopoly.
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Trigger strategy
Consider the innitely repeated game based on the Cournot stage-game. Assume both rms have the same discount factor . Compute the values of for which the following trigger strategy is a subgame-perfect equilibrium.
Start producing qm /2. At time t, produce qm /2 if both rms have produced qm /2 in the t 1 previous periods; otherwise produce the Cournot quantity.
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Trigger strategy
If rm \i is going to produce qm /2 at time t, then the quantity that maximizes rm is prot at time t is
qd =
3 (a c) 8
where the subscript d stands for deviation.
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Trigger strategy
If qi = qc = (a c)/3 for i = 1, 2
` ui qi , q\i
If qi = qm /2 = (a c)/4 for i = 1, 2,
uc =
1 (a c)2 9
` ui qi , q\i
If qi = qd and q\i = qm /2
1 um = (a c)2 2 8
` ui qi , q\i
ud =
9 (a c)2 64
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Trigger strategy
The trigger strategy is a subgame perfect equilibrium provided that um (1 ) ud + uc 2
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Trigger strategy
The trigger strategy is a subgame perfect equilibrium provided that um (1 ) ud + uc 2 Using all the above results yields 9/17.
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Modied trigger strategy
How can cooperation be enforced for < 9/17?
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How can cooperation be enforced for < 9/17?

Simply computing for any the most protable quantity q the rms can produce if they both play trigger strategies.
To compute this quantity, let us consider the following trigger strategy:

Start producing q . At time t, produce q if both rms have produced q in the t 1 previous periods; otherwise produce the Cournot quantity.
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If both rms play q
` ui qi , q\i
u = q (a c 2q )
If one deviates, the deviation payo is now qd = (a c q )/2 with
` ui qi , q\i
u d =
1 2 (a c q ) 4
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As before, the following inequality has to be satised
u (1 ) u d + uc .
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u (1 ) u d + uc . Solving with respect to produces 9 5 (a c). 3(9 )
q =
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u (1 ) u d + uc . Solving with respect to produces 9 5 (a c). 3(9 )
q =
How does q vary with ?
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How does q vary with ? q =
9 5 (a c) 3(9 )
q*
a c 3 a c 2
9/17
Clearly, for = 0 the Cournot strategy is played.
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Cournot competition under asymmetric information

Problem formulation
Consider again a Cournot duopoly model with (
` pi (Q) = pi qi , q\i =
a Q, 0,
Q<a Qa
The payo function for both rms is equal to
` ui qi , q\i = qi (pi ci ) and the cost for rm 1 is c1 (q1 ) = c (and this is known to both rms) while rm 1 knows only that rm 2s marginal cost c2 (q2 ) is given by (
c2 (q2 ) =
cH , cL ,
with probability with probability 1
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Nash equilibrium
The Nash equilibrium is computed as it were a three-player game.
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Nash equilibrium

If rm 2 cost is cH , it will choose q2 (cH ) to solve (cH ) = arg max q2 0q2 < u2 (q1 , q2 ) (a q1 q2 cH ) q2
= arg max
0q2 <
a cH q1 2
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Nash equilibrium

If rm 2 cost is cH , it will choose q2 (cH ) to solve (cH ) = arg max q2 0q2 < u2 (q1 , q2 ) (a q1 q2 cH ) q2
= arg max
0q2 <
a cH q1 2
If rm 2 cost is cL instead, it will choose q2 (cL ) to solve q2 (cL ) = arg max 0q2 < u2 (q1 , q2 ) (a q1 q2 cL ) q2
= arg max
0q2 <
a cL q1 2
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Nash equilibrium
Firm 1 chooses q1 to solve the following optimization problem
q1 = arg max
0q1 <
u1 (q1 , q2 ) [(a q1 q2 (cH ) c) q1 ] + (1 ) [(a q1 q2 (cL ) c) q1 ]
= arg max
0q1 <
(a c q2 (cH )) + (1 ) (a c q2 (cL )) 2
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Nash equilibrium
Firm 1 chooses q1 to solve the following optimization problem
q1 = arg max
0q1 <
u1 (q1 , q2 ) [(a q1 q2 (cH ) c) q1 ] + (1 ) [(a q1 q2 (cL ) c) q1 ]
= arg max
0q1 <
(a c q2 (cH )) + (1 ) (a c q2 (cL )) 2
The Nash equilibrium is found solving the system 8 (a c q2 (cH )) + (1 ) (a c q2 (cL )) > > = q 1 > > 2 < a cH q1 q2 (cH ) = > 2 > > a cL q1 > :q2 (cL ) = 2

Nash equilibrium
It turns out that
a 2c + cH + (1 ) cL 3 a 2cH + c 1 q2 (cH ) = + (cH cL ) 3 6 a 2cL + c (cH cL ) q2 (cL ) = 3 6

q1 =
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Nash equilibrium
It turns out that
a 2c + cH + (1 ) cL 3 a 2cH + c 1 q2 (cH ) = + (cH cL ) 3 6 a 2cL + c (cH cL ) q2 (cL ) = 3 6

q1 =
Compare this solution to the Cournot equilibrium under complete information with unequal costs c1 and c2 , i.e.,
a 2c1 + c2 3 a 2c2 + c1 q2 = 3
q1 = For example, how about q2 (cH ) and q2 (cL )?

Nash equilibrium
It is easily seen than q2 (cH ) > q2 while q2 (cL ) < q2 . Why?
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Nash equilibrium
This occurs because rm 2 not only tailors its quantity to its cost but also responds to the fact that rm 1 cannot do so.
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Nash equilibrium
This occurs because rm 2 not only tailors its quantity to its cost but also responds to the fact that rm 1 cannot do so. For instance, assume rm 2s cost is high. The best quantity q2 is higher than that in the complete-information case because rm 2 knows that rm 1 will produce a quantity that maximizes its expected prot. This expected prot is smaller than that rm 1 would produce if it knew rm 2s cost to be high.
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Game Theory

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Game Theory

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Basics of Game Theory

Giacomo Bacci and Luca Sanguinetti

April - May, 2010

G. Bacci and L. Sanguinetti (IET)

Basics of Game Theory

April - May, 2010

G. Bacci and L. Sanguinetti (IET)

Basics of Game Theory

April - May, 2010

Consider a group of rms in an industry competing for the market.

G. Bacci and L. Sanguinetti (IET)

Basics of Game Theory

April - May, 2010

G. Bacci and L. Sanguinetti (IET)

Basics of Game Theory

April - May, 2010

Cournot model of oligopoly

is the rms total output.

G. Bacci and L. Sanguinetti (IET)

Basics of Game Theory

April - May, 2010

Cournot model of duopoly

G. Bacci and L. Sanguinetti (IET)

Basics of Game Theory

April - May, 2010

Cournot model of duopoly

C1 (q1 ) = c q1 If some xed costs are present, then

Cournot model of duopoly

Suppose the inverse demand function is given by (

Under the above circumstances, a response can be easily found.

Cournot model of duopoly

Translate the problem into a strategic form.

G. Bacci and L. Sanguinetti (IET)

Basics of Game Theory

April - May, 2010

Cournot model of duopoly

G. Bacci and L. Sanguinetti (IET)

Basics of Game Theory

April - May, 2010

Cournot model of duopoly

Firms prot as a function of q1 for a given q2 with a = 100 and c = 10.

2000 1500 1000 500 0 500 1000 1500 2000

G. Bacci and L. Sanguinetti (IET)

Basics of Game Theory

April - May, 2010

Cournot model of duopoly

Nash equilibria are such that

G. Bacci and L. Sanguinetti (IET)

Basics of Game Theory

April - May, 2010

Cournot model of duopoly

Nash equilibria are such that

The best response procedure is used to nd Nash equilibria, i.e.,

G. Bacci and L. Sanguinetti (IET)

Basics of Game Theory

April - May, 2010

Cournot model of duopoly

q1 = arg max u1 (q1 , q2 ) 0q1 <

G. Bacci and L. Sanguinetti (IET)

Basics of Game Theory

April - May, 2010

Cournot model of duopoly

q1 = arg max u1 (q1 , q2 ) 0q1 <