Download Document

MICROECONOMICS: Theory &
Applications
Chapter 14: Game Theory and the Economics of
Information
By
Edgar K. Browning & Mark A. Zupan
John Wiley & Sons, Inc.
10th Edition, Copyright 2009
PowerPoint prepared by Della L. Sue, Marist College
Learning Objectives

Understand the basics of game theory: a
mathematical technique to study choice under
conditions of strategic interaction.
 Describe the prisoner’s dilemma and its applicability
to oligopoly theory as well as many other situations.
 Explore how the outcome in the case of a prisoner’s
dilemma differs in a repeated-game versus a singleperiod setting.
 Analyze asymmetric information and market
outcomes in the case where consumers have less
information than sellers.
(continued)
Copyright 2009
John Wiley & Sons, Inc.
2
Learning Objectives



(continued)
Explain how insurance markets may function when
information is imperfect and there is the possibility of
either adverse selection or moral hazard.
Show how limited price information affects price
dispersion for a product.
Investigate advertising and the extent to which it
serves to artificially differentiate products versus
provide information to consumers about the
availability of products and their prices and qualities.
Copyright 2009
John Wiley & Sons, Inc.
3
Game Theory
Game theory – a method of analyzing
situation in which the outcomes of your
choices depend on others’ choices, and vice
versa
 Elements common to all game theory:




Players – decision makers whose behavior we are
trying to predict and/or explain
Strategies – the possible choices of the players
Payoffs – the outcomes or consequences of the
strategies chosen
Copyright 2009
John Wiley & Sons, Inc.
4
Determination of Equilibrium
Payoff matrix – a simple way of representing
how each combination of choices affects
players’ payoffs in a game theory setting
 Dominant strategy – a case where a player
is better off adopting a particular strategy
regardless of the strategy adopted by the
other player
 Dominant-strategy equilibrium – the simplest
game theory outcome, resulting from both
players having dominant strategies

Copyright 2009
John Wiley & Sons, Inc.
5
Dominant-Strategy Equilibrium: A Simple
Oligopoly Game
Copyright 2009
[Table 14.1]
John Wiley & Sons, Inc.
6
Nash Equilibrium

A set of strategies
such that each
player’s choice is
the best one
possible given the
strategy chosen by
the other player(s)

Table 14.2
Copyright 2009
John Wiley & Sons, Inc.
7
The Prisoner’s Dilemma Game

The most famous game
theory model in which
self-interest on the part of
each player leads to a
result in which all players
are worse off than they
could be if different
choices were made.

Table 14.3
Copyright 2009
John Wiley & Sons, Inc.
8
The Prisoner’s Dilemma and Cheating by
Cartel Members
Copyright 2009
[Table 14.4]
John Wiley & Sons, Inc.
9
Table 14.5
Copyright 2009
John Wiley & Sons, Inc.
10
Repeated Games



Repeated Game Model
– a game theory model
in which the “game” is
played more than once
Tit-for-tat – a strategy in
which each player
mimics the action taken
by the other player in
the preceding period
Table 14.6
Copyright 2009
John Wiley & Sons, Inc.
11
Asymmetric Information
Imperfect information – the case when
market participants lack some
information relevant to their decisions
 Asymmetric information – a case in
which participants on one side of the
market know more about a good’s
quality than do participants on the
other side
 The “Lemons” Model

Copyright 2009
John Wiley & Sons, Inc.
12
Market Responses to Asymmetric
Information
Information is a scarce good.
 The benefits from acquiring information
about product quality will not always be
worth its costs.
 It might be efficient for consumers to be
less than fully informed.

Copyright 2009
John Wiley & Sons, Inc.
13
Adverse Selection
Adverse selection – a situation in which
asymmetric information causes higherrisk customers to be more likely to
purchase or sellers to be more likely to
supply low-quality goods
 Application – insurance markets in
which the assumption of full information
(both firms and customers know the
risks) is modified

Copyright 2009
John Wiley & Sons, Inc.
14
Market Responses to Adverse
Selection
Key: there are potential gains to
market participants from adjusting
their behavior to account for the
adverse selection problem
 Examples:

Upper limit on insurance coverage
 Requirement of physical exams and/or a
waiting period
 Group plans covering all employees

Copyright 2009
John Wiley & Sons, Inc.
15
Moral Hazard
Moral hazard – a situation that occurs
when, as a result of having insurance,
an individual becomes more likely to
engage in risky behavior
 The problem arises when insurance
companies lack knowledge of the
actions people take that may affect
the occurrence of unfavorable events.

Copyright 2009
John Wiley & Sons, Inc.
16
Market Responses to Moral Hazard
Example: medical insurance market
Limitation on the services covered by
insurance
 Requirement of the insured person to
pay part of the costs:



Copyright 2009
Coinsurance rate – the share of the cost
borne by the patient
Deductibles – the amount that the
patient must pay before insurance
coverage is effective
John Wiley & Sons, Inc.
17
Limited Price Information
Price dispersion – a range of prices for the
same product, usually as a result of
customers’ lacking price information
 Search costs – the costs that customers
incur in acquiring information
 Price dispersion will fall when the benefit
from search is higher than the cost.

Copyright 2009
John Wiley & Sons, Inc.
18
Advertising
[Figure 14.1]
Firms advertise to
attempt to increase the
demand for their
product:


Artificial product
differentiation: the use of
advertising to differentiate
products that are
essentially the same
Advertising as information
about availability, price,
and quality
Copyright 2009
John Wiley & Sons, Inc.
19
Advertising and Its Effects on
Products’ Prices and Qualities
Firms advertise to provide information
to customers.
 Effects of advertising:

Reduce price dispersion and lower the
average price
 Solve the lemons problems by giving highquality sellers an advantage over lowquality sellers
 Introduce consumers to new products

Copyright 2009
John Wiley & Sons, Inc.
20
Advertising, the Full Price of a
Product, and Market Efficiency

Full price – the sum of the money price and the
search costs that consumers incur

Advertising is a substitute for the consumer’s own
search efforts, and thereby reduce search costs.

Advertising is a low-cost way of conveying
information, and thereby increases market
efficiency.
Copyright 2009
John Wiley & Sons, Inc.
21
Copyright © 2009 John Wiley & Sons, Inc. All rights
reserved. Reproduction or translation of this work
beyond that permitted in section 117 of the 1976
United States Copyright Act without express
permission of the copyright owner is unlawful.
Request for further information should be addressed
to the Permissions Department, John Wiley & Sons,
Inc. The purchaser may make back-up copies for
his/her own use only and not for distribution or
resale. The Publisher assumes no responsibility for
errors, omissions, or damages caused by the use of
these programs or from the use of the information
herein.
Copyright 2009
John Wiley & Sons, Inc.
22