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Lecture 4
Strategic Interaction
Game Theory
Pricing in Imperfectly Competitive markets
Game Theory
• Tool used for analyzing multiagent
economic situations involving strategic
interdependence
How Do We Describe a Game?
• A game is described by:
– number of players/agents
– the “strategies” available to each player
– each player’s preferences over outcomes of
the game
• For any game, a strategy choice by each
one of the players results in a unique
outcome of the game
What is a Strategy?
• A strategy is an action plan for a player. It
specifies:
– what action the player takes
– when the player takes the action
– the way that the action choice depends on the
information the player has when taking the
action
• Two action plans that specify different
actions represent two different strategies
Predicting Behavior in Games
• If games are to help us understand observables,
we need a way of predicting how agents behave
in game settings; i.e., we need a notion of
equilibrium for games
• The standard notion of equilibrium is the Nash
equilibrium
• Roughly speaking a Nash equilibrium has the
feature that each player’s strategy choice is best
for that player given other players’ strategies
Pricing in Imperfectly
Competitive Markets
Determinants of Pricing
Decision
• Economic analysis of pricing in imperfectly
competitive markets identifies the following
elements of the market environment as
important to pricing decision:
– number of competitors/ease of entry
– similarity of competitors’ products
– capacity limitations
– on-going interactions
– Information on past pricing decisions
Bertrand
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Simultaneous price setting
Identical products
No capacity constraints
One time interaction
Price competition results in price equal
marginal cost for all firms and zero profits
Bertrand
• Bertrand paradox (p=mc even though few
firms in market) can be resolved by
relaxing certain assumptions:
• No Capacity Constraints
• Undifferentiated Products
• One-shot competition
Capacity Constraints
• Suppose each firm has max capacity of Ki
• If firm j sets a higher price than firm i, j
may get the left-over demand that firm i
can’t satisfy if demand exceeds i’s
capacity
• So setting price above MC may be
worthwhile
Cournot
• Same analysis can be applied to situations
where firms decide first on how much to
produce and then on what price to set
• If total quantity produced is low relative to
market demand, then it is as if constrained
• Firms will set prices such that total
demand just clears total output
Cournot
• Capacity (or output) constraint limits the
usefulness of price competition
• Can get p>mc and firms can earn
economic profits
Cournot vs. Bertrand
• Cournot:
-when demand is large relative to capacity
-when capacity is more difficult to adjust
than price
• Bertrand:
-when demand is small relative to capacity
-when capacity is easier to adjust than price