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Game Theory 12

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When Amazon first came out with its e-book reading device, the Kindle, it priced the books at $9.99, below the royalties that Amazon had to pay the publishers. Analysts figured that Amazon’s plan was to lose money on the books in order to sell more Kindle devices at high margins. As we discussed in Chapter 11’s Freakonomics box, however, Apple soon thereafter released the iPad equipped with its own e-book reader as well as many other capabilities. Competition between the devices drove Amazon to cut the price of its Kindle significantly. Next, Amazon created a Kindle app for the iPad that allowed iPad users to purchase and read their Kindle books on their Apple devices. Then, to compete directly with Apple’s iPad, Amazon released its own tablet device, the Kindle Fire, at a price lower than the iPad. Each of these decisions entailed strategic considerations by Apple and Amazon. When deciding what to do, the companies needed to think through the moves they could make and the countermoves their competitor would likely undertake in response.

In the previous chapter, we looked at various ways in which firms make price and quantity decisions in industries in which they have some market power but also face some competition. We discussed how market equilibrium in these situations requires more than just quantity supplied equaling quantity demanded. Each individual firm must also be unwilling to change its price or output decisions once it knows its competitors’ price or output decisions. In other words, the point at which quantity demanded equals quantity supplied must also be a Nash equilibrium.

The firm interactions we covered in the last chapter, just like the interactions between Amazon and Apple, are more complicated than those in perfectly competitive or monopolistic markets. These market structures involve many possible market outcomes because of strategic interactions between imperfectly competitive firms. Each firm’s actions affect not only its own payoff but also the other firms’ payoffs. Because every firm takes this interconnectedness into account when planning what to do, decision making can become quite complex.

Being able to understand what might happen when economic actors interact strategically, as they do in oligopoly markets, is the purpose of game theory, the focus of this chapter. Game theory studies behavior when several players are making strategic decisions—that is, decisions made when their actions affect others, others’ actions affect them, and they are trying to anticipate the actions of others.

Game theory applies to real games, too. Playing chess well involves choosing your moves based on how you believe your opponent will respond. In poker, if you raise the bet, you’re thinking about whether the other players believe you have good cards and will therefore fold, or believe you are bluffing and will call your bet. In this chapter, we learn that game theory can be used to better understand all kinds of economic decisions, such as when movies are released, what products companies choose to produce, how to deter the entry of competitors, and many others. Truth be told, we already used a fair amount of game theory in the previous chapter. The oligopoly models—collusion, Bertrand, Cournot, Stackelberg, and differentiated-product Bertrand—are all specific applications of game theory.

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In this chapter, we study three basic categories of games. First are simultaneous games, in which participants have to choose their strategies at the same time without knowing what strategies their opponents are pursuing. Examples of simultaneous games include Chapter 11’s Cournot and Bertrand models, in which firms choose quantities or prices simultaneously. Next, we look at repeated games in which the players play the same simultaneous game over and over. Our discussion in Chapter 11 about how collusion could be stable in some circumstances even though every colluding firm has an incentive to cheat on the agreement can be explained by considering the collusive model as a repeated game. Finally, we look at sequential games, in which one firm moves first and the next firm gets to see what the first mover did. These games are like the Stackelberg oligopoly we analyzed in Chapter 11.

Being comfortable with these three basic types of game structures gives us an extremely useful tool for understanding many economic scenarios. That said, though, there are many other, more advanced areas of game theory we won’t cover in this chapter. For example, a very important area of game theory studies situations in which some players have information that other players do not. These are known as games with asymmetric information; we discuss the role of asymmetric information in economic decision making in Chapter 16. Another set of games we won’t cover are cooperative games, in which players are able to make binding commitments to one another and can form coalitions that play as a single unit. We instead focus on noncooperative games, in which it’s every player for herself, a more accurate reflection of the nature of most games between firms and, often, consumers as well.

Several themes emerge as we apply game theory to understand the strategic interactions producers and consumers engage in every day. First, understanding game theory is all about being able to see the world through the eyes of the other guy. A player must anticipate what her opponents will do and plan for it. A second theme is that much of game theory (at least the kind we study in this chapter) rests on the view that opponents are rational; that is, they know what’s good for them. If that isn’t true (and who hasn’t had to deal with some irrational bozo, on occasion?), what a player should do may vary quite a lot from the standard game theoretical approach.

A final theme evokes something we discussed while analyzing oligopoly in Chapter 11. How you set up the rules of the game—who gets to move first, or who starts with what—can make a big difference in the outcomes that game theory predicts.