chap8 - Chapter 8: Game Theory Models of Pricing Unlike...

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1 1 Chapter 8: Game Theory Models of Pricing Chapter 8: Game Theory Models of Pricing Unlike monopoly or perfect competition, most firms must consider the likely responses of competitors when they make decisions about price, advertising, and investments in new product lines Premise of game theory is that players (decisionmakers) are rational and act to maximize profits Key element of strategy is understanding your opponents actions and how he/she will respond to your actions 2 Two types of games: cooperative and Two types of games: cooperative and noncooperative noncooperative Cooperative games are based on binding contracts between parties - firms enter agreement to make a joint investment in a new technology - firms agree to divide profit from joint venture General focus of game theory is on noncooperative games - firms make no formal agreements among themselves - alternatively, agreements may exist but they are not fully observed
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2 3 Advertising Game in Duopoly: How Does Advertising Game in Duopoly: How Does a Firm Develop an Advertising Strategy? a Firm Develop an Advertising Strategy? This is called the payoff matrix, because it summaries the outcome of the game for different choices of Firm A and B The first number is each cell is the payoff to A and the second is the payoff to B For example, if both firms advertise, then A make a profit of 10 and B makes a profit of 5 10,5 6,8 15,0 10,2 Advertise Don’t Advertise Advertise Don’t Advertise Firm B Firm A 4 What Strategy Should Firm A Choose? What Strategy Should Firm A Choose? Consider A’s strategy - If B advertises, then A makes more profit by advertising (10 instead of 6) - If B does not advertise, A also makes more profit by advertising (15 instead of 10) In this case, A is better off advertising irrespective of what B does This is a special case where Firm A has a dominant strategy – i.e., a strategy that is optimal no matter what his opponent chooses 10,5 6,8 15,0 10,2 Advertise Don’t Advertise Advertise Don’t Advertise Firm B Firm A
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3 5 What Strategy Should Firm B Choose? What Strategy Should Firm B Choose? Consider B’s strategy - If A advertises, then B makes more profit by advertising (5 instead of 0) - If A does not advertise, B also makes more profit by advertising (8 instead of 2) In this case, B is also better off advertising irrespective of what A does – advertising is a dominant strategy for B as well Since both firms are rational, we predict that each will pursue its dominant strategy and the outcome will be that both firms will advertise 10,5 6,8 15,0 10,2 Advertise Don’t Advertise Advertise Don’t Advertise Firm B Firm A 6 Modified Advertising Game Modified Advertising Game Advertising is still dominant for Firm B, but Firm A has no dominant strategy - If B advertises, then A does best by advertising - If B does not advertise, the A does best by not advertising What should A do? -
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This note was uploaded on 12/08/2008 for the course ECON 101 taught by Professor Buddin during the Spring '08 term at UCLA.

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chap8 - Chapter 8: Game Theory Models of Pricing Unlike...

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