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Module 31
Game Theory
What’s New in the Fourth Edition?
• Handouts to use in class
• Updated cases
Module Objectives
• How do the insights gained from game theory help us understand the strategic behavior of
oligopolists?
• Why are oligopolists often able to maintain profits in the long run without formal collusion?
Teaching Tips
Games Oligopolists Play
Creating Student Interest
• Tell students that you are going to give them a pop quiz. The only question on the quiz is, “What
grade would you like to receive on this quiz?” The two permitted answers are “A” or “C” (though
those are not the only possible grades they may receive). Then explain that the grade they will
actually receive on the quiz depends on their answer and the answer of another student in the class.
(Each student will be randomly paired with another student. If there is an odd number of students in
the class, the remaining student will be paired with the instructor.) Tell the students that the grade
assigned for the quiz will be determined by the following payoff matrix:
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think. You will likely get comments like “It’s not fair!” You can also repeat the exercise and/or
change the payoffs.
Presenting the Material
• Use Handout 31-1 to present game theory.
Module Outline
I. Games Oligopolists Play
A. When the decisions of two or more firms significantly affect each other’s profits, they are in a
situation of interdependence.
B. The study of behavior in situations of interdependence is known as game theory.
C. The prisoners’ dilemma
1. The reward received by a player in a game, such as the profits earned by an oligopolist,
is that player’s payoff.
2. A payoff matrix shows how the payoff to each of the participants in a two-player game
depends on the actions of both. Such a matrix helps us analyze situations of
interdependence. This is illustrated in text Figure 31-1, shown next.
a. Prisoners’ dilemma is a game based on two premises: (1) Each player has an
incentive to choose an action that benefits themselves at the other player’s expense,
and (2) when both players act in this way, both are worse off than if they had acted
cooperatively. Figure 31-1
b. An action is a dominant strategy when it is a player’s best action regardless of the
action taken by the other player.
c. A Nash equilibrium, also known as a noncooperative equilibrium, is the result when
each player in a game chooses the action that maximizes his or her payoff given the
actions of the other players, ignoring the effects of that action on the payoffs received
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by those other players.
D. Overcoming the prisoners’ dilemma: repeated interaction and tacit collusion
1. Oligopolists in the real world play repeated games.
2. A firm engages in strategic behavior when it attempts to influence the future behavior
of other firms.
Case Studies in the Text
Economics in Action
The Demise of OPEC—This EIA presents the Organization of Petroleum Exporting Countries as an
example of a real-world cartel.
Ask students the following questions:
1. How successful was OPEC as a cartel in the 1970s, 1980s, and 1990s? (In 1974 and
2. Does OPEC meet in public? (Yes, the cartel meets frequently outside the United States.)
3. How has OPEC’s ability to control price been affected by the 2007–2009 recession,
political instability in the Middle East, and the expansion of shale oil production in
North America? (Demand for oil fell during the recession so it was difficult to maintain
Web Resources
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Handout 31-1
Date_________ Name____________________________ Class________ Professor________________
Game Theory
In this game, there are two airlines, Sky World and Bay City Airlines, and they have the choice of pricing
high or low. Each company’s profit depends on how the other company responds to its pricing strategy.
1. What pricing strategy will Sky World choose if it assumes Bay City will choose a high pricing
strategy?
2. What pricing strategy will Sky World choose if it assumes Bay City will choose a low pricing
strategy?
3. Does Sky World have a dominant strategy?
4. What pricing strategy will Bay City choose if it assumes Sky World will choose a high pricing
strategy?
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5. What pricing strategy will Bay City choose if it assumes Sky World will choose a low pricing
strategy?
6. Does Bay City have a dominant strategy?
7. What pricing strategies will be chosen if there is no collusion?
8. Can the firms improve the outcome if they collude? If so, how would they collude?
9. Would the collusion work in a one-shot game?
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Answers:
1. What pricing strategy will Sky World choose if it assumes Bay City will choose a high pricing
strategy?
2. What pricing strategy will Sky World choose if it assumes Bay City will choose a low pricing
strategy?
3. Does Sky World have a dominant strategy?
4. What pricing strategy will Bay City choose if it assumes Sky World will choose a high pricing
strategy?
5. What pricing strategy will Bay City choose if it assumes Sky World will choose a low pricing
strategy?
6. Does Bay City have a dominant strategy?
7. What pricing strategies will be chosen if there is no collusion? What will be the firms’ profits?
8. Can the firms improve the outcome if they collude? Why? If so, how would they collude?
9. Would the collusion work in a one-shot game? Why?
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Handout 31-2
Date_________ Name____________________________ Class________ Professor________________
Tit for Tat
Prices
(possible
outcomes of
each round)
Total sales
in the
market
Price
Total cost
Total
revenue
(P Q)
($110 fixed
and
$2
variable)
Profit
HHH
60, 60, 60
180
H = $8
During the game, track your pricing and profits with the form below:
Profit or loss statement form (extend this form to show 15 rounds):
HHL
HLL
LLL
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Round
Industry situation
(HHH, HHL, HLL, LLL)
Your firm’s price
(H or L)
Profit
Loss
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15